Introduction
Chapter 1
1
Chapter Outline
1.1 Exchange-traded markets
1.2 Over-the-counter markets
1.3 Forward contracts
1.4 Futures contracts
1.5 Options
1.6 Types of traders
1.7 Other derivatives
2
The Nature of Derivatives
A derivative is an instrument whose
value depends on (derives from) the
values of other more basic underlying
variables
3
Examples of Derivatives
•
•
•
•
Forward Contracts
Futures Contracts
Swaps
Options
4
Ways 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
5
1.1 Exchange-traded markets
• Traditionally exchanges have used the
open-outcry system, but increasingly they
are switching to electronic trading
Contracts are standard there is virtually no
credit risk
6
1.2 Over-the-counter markets
• A computer- and telephone-linked network
of dealers at financial institutions,
corporations, and fund managers
• Contracts can be non-standard and there is
some small amount of credit risk
7
1.3 Forward Contracts
• A forward contract specifies that a certain
commodity will be exchanged for another at
a specified time in the future at prices
specified today.
– Its not an option: both parties are expected to hold up
their end of the deal.
– If you have ever ordered a textbook that was not in
stock, you have entered into a forward contract.
• It can be contrasted with a spot contract which is
an agreement to buy or sell immediately
• Forwards are traded in the OTC market
8
Foreign Exchange Rates Thursday, November 1, 2001
U.S. $ equiv.
Country
Thursday
Currency per U.S. $
Wednesday
Thursday
Wednesday
Britain (Pound)
1.4631
1.4540
0.6835
0.6878
1 Month Forward
1.4608
1.4516
0.6846
0.6889
3 Months Forward
1.4560
1.4466
0.6868
0.6913
6 Months Forward
1.4493
1.4400
0.6900
0.6944
Canada (Dollar)
0.6267
0.6294
1.5957
1.5888
1 Month Forward
0.6264
0.6291
1.5964
1.5895
3 Months Forward
0.6262
0.6289
1.5969
1.5901
6 Months Forward
0.6259
0.6286
1.5976
1.5908
France (Franc)
0.1376
0.1372
7.2662
7.2896
0.1375
0.1370
7.2746
Clearly
the
market
participants
expect
3 Months Forward
0.1372
0.1367
7.2906
will be worth
in
6 Months Forward that the yen
0.1368
0.1364 MORE
7.3091
Germany (Mark)
0.4616
0.4601
2.1665
dollars
in
six
months.
1 Month Forward
0.4610
0.4596
2.1690
7.2981
3 Months Forward
0.4600
0.4585
2.1738
2.1809
6 Months Forward
0.4589
0.4574
2.1793
2.1864
Japan (Yen)
0.008197
0.008168
122.00
122.43
1 Month Forward
0.008212
0.008184
121.78
122.19
3 Months Forward
0.008241
0.008213
121.34
6 Months Forward
0.008283
0.008252
120.73
1 Month Forward
7.3143
7.3328
2.1735
2.1760
9
121.76
121.18
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
10
Foreign Exchange Rates Thursday, November 1, 2001
U.S. $ equiv.
Country
Thursday
Currency per U.S. $
Wednesday
Thursday
Wednesday
Britain (Pound)
1.4631
1.4540
0.6835
0.6878
1 Month Forward
1.4608
1.4516
0.6846
0.6889
3 Months Forward
1.4560
1.4466
0.6868
0.6913
6 Months Forward
1.4493
1.4400
0.6900
0.6944
Canada (Dollar)
0.6267
0.6294
1.5957
1.5888
1 Month Forward
0.6264
0.6291
1.5964
1.5895
3 Months Forward
0.6262
0.6289
1.5969
1.5901
6 Months Forward
0.6259
0.6286
1.5976
1.5908
France (Franc)
0.1376
0.1372
7.2662
7.2896
0.1375
0.1370
7.2746
Clearly
the
market
participants
expect
3 Months Forward
0.1372
0.1367
7.2906
will be worth
dollars
6 Months Forward that the GBP
0.1368
0.1364 less in
7.3091
Germany (Mark)
0.4616
0.4601
2.1665
in
six
months.
1 Month Forward
0.4610
0.4596
2.1690
7.2981
3 Months Forward
0.4600
0.4585
2.1738
2.1809
6 Months Forward
0.4589
0.4574
2.1793
2.1864
Japan (Yen)
0.008197
0.008168
122.00
122.43
1 Month Forward
0.008212
0.008184
121.78
122.19
3 Months Forward
0.008241
0.008213
121.34
6 Months Forward
0.008283
0.008252
120.73
1 Month Forward
7.3143
7.3328
2.1735
2.1760
11
121.76
121.18
Terminology: The Long and the Short of it
• IF YOU BENEFIT FROM A RISE IN
THE PRICE OF THE UNDERLYING
COMMODITY, YOU ARE LONG.
• IF YOU BENEFIT FROM A FALL IN
THE PRICE OF THE UNDERLYING
COMMODITY, YOU ARE SHORT.
12
Terminology: The Long and the Short of it
• The party that has agreed to buy (IN
THE FUTURE) has what is termed a
long position
• The party that has agreed to sell has
what is termed a short position
13
Example (page 3)
• On August 16, 2002 the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months at
an exchange rate of 1.4359
• This obligates the corporation to pay
$1,435,900 for £1 million on February 16,
2003
• What are the possible outcomes?
14
Profit from a
Long Forward Position
Profit
K
Price of Underlying
at Maturity, ST
15
Profit from a
Short Forward Position
Profit
K
Price of Underlying
at Maturity, ST
16
Futures Contracts: Preliminaries
• A futures contract is like a forward contract:
– It specifies that a certain commodity will be exchanged
for another at a specified time in the future at prices
specified today.
• A futures contract is different from a forward:
– Futures are standardized contracts trading on organized
exchanges with daily resettlement (“marking to market”)
through a clearinghouse.
17
Futures Contracts: Preliminaries
• Standardizing Features:
– Contract Size
– Delivery Month
• Daily resettlement
– Minimizes the chance of default
• Initial Margin
– About 4% of contract value, cash or T-bills held
in a street name at your brokerage.
18
Selected Futures Contracts
Contract
Agricultural
Contract Size
Exchange
Corn
Wheat
Cocoa
OJ
Metals & Petroleum
Copper
Gold
Unleaded gasoline
Financial
British Pound
Japanese Yen
Eurodollar
5,000 bushels
5,000 bushels
10 metric tons
15,000 lbs.
Chicago BOT
Chicago & KC
CSCE
CTN
25,000 lbs.
100 troy oz.
42,000 gal.
CMX
CMX
NYM
£62,500
¥12.5 million
$1 million
IMM
IMM
LIFFE
19
Futures Markets
• The Chicago Mercantile Exchange
(CME) is by far the largest.
• Others include:
– The Philadelphia Board of Trade (PBOT)
– The MidAmerica Commodities Exchange
– The Tokyo International Financial Futures
Exchange
– The London International Financial Futures
Exchange
20
1.5 Options Contracts: Preliminaries
• An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an
asset on (or perhaps before) a given date, at prices
agreed upon today.
• Calls versus Puts
– Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset at
some time in the future, at prices agreed upon today.
When exercising a call option, you “call in” the asset.
– Put options gives the holder the right, but not the
obligation, to sell a given quantity of an asset at some
time in the future, at prices agreed upon today. When
exercising a put, you “put” the asset to someone.
21
Options Contracts: Preliminaries
• Exercising the Option
– The act of buying or selling the underlying asset through the
option contract.
• Strike Price or Exercise Price
– Refers to the fixed price in the option contract at which the
holder can buy or sell the underlying asset.
• Expiry
– The maturity date of the option is referred to as the
expiration date, or the expiry.
• European versus American options
– European options can be exercised only at expiry.
22
– American options can be exercised at any time up to expiry.
Options Contracts: Preliminaries
• In-the-Money
– The exercise price is less than the spot price of
the underlying asset.
• At-the-Money
– The exercise price is equal to the spot price of
the underlying asset.
• Out-of-the-Money
– The exercise price is more than the spot price of
the underlying asset.
23
Options Contracts: Preliminaries
• Intrinsic Value
– The difference between the exercise price of the option
and the spot price of the underlying asset.
• Speculative Value
– The difference between the option premium and the
intrinsic value of the option.
Option
Premium
=
Intrinsic
Value
+ Speculative
Value
24
Call Options
• Call options gives the holder the
right, but not the obligation, to buy a
given quantity of some asset on or
before some time in the future, at
prices agreed upon today.
• When exercising a call option, you
“call in” the asset.
25
Basic Call Option Pricing Relationships at Expiry
• At expiry, an American call option is worth
the same as a European option with the same
characteristics.
• If the call is in-the-money, it is worth ST - E.
• If the call is out-of-the-money, it is worthless.
CT = Max[ST - E, 0]
• Where
ST is the value of the stock at expiry (time T)
E is the exercise price.
CT is the value of the call at expiry
26
Call Option Payoffs
60
Option payoffs ($)
40
Buy a call
20
0
0
10
20
30
40
50
60
70
80
90
100
Stock price ($)
-20
-40
-60
Exercise price = $50
27
Call Option Payoffs
60
Option payoffs ($)
40
20
0
-20
0
10
20
30
40
50
60
70
80
90
100
Stock price ($)
Write a call
-40
-60
Exercise price = $50
28
Call Option Profits
60
Option profits ($)
40
Buy a call
20
0
-20
0
10
20
30
40
50
60
70
80
90
100
Stock price ($)
Write a call
-40
-60
Exercise price = $50; option premium = $10
29
Put Options
• Put options gives the holder the
right, but not the obligation, to sell a
given quantity of an asset on or
before some time in the future, at
prices agreed upon today.
• When exercising a put, you “put” the
asset to someone.
30
Basic Put Option Pricing Relationships at Expiry
• At expiry, an American put option is
worth the same as a European
option with the same characteristics.
• If the put is in-the-money, it is
worth E - ST.
• If the put is out-of-the-money, it is
worthless.
PT = Max[E - ST, 0]
31
Put Option Payoffs
60
Option payoffs ($)
40
Buy a put
20
0
0
10
20
30
40
50
60
70 80
90
100
Stock price ($)
-20
-40
-60
Exercise price = $50
32
Put Option Payoffs
60
Option payoffs ($)
40
20
0
0
10
20
30
40
50
60
70 80
90
100
Stock price ($)
-20
-40
write a put
-60
Exercise price = $50
33
Option profits ($)
Put Option Profits
60
40
20
10
0
-10
-20
Write a put
0
10
20
30
Stock price ($)
40
50
60
70 80
Buy a put
90
100
-40
-60
Exercise price = $50; option premium = $10
34
($)
profits ($)
Option profitsOption
Selling Options
• The seller (or writer)
60 of an option has an
obligation.
• The purchaser of an
option has an option.
40
20
10
0
-10
-20
Buy a call
Write a put
0
10
20
30
Stock price ($)
40
50
60
70 80
Buy a put
90
100
Write a call
-40
-60
35
Exchanges Trading Options
•
•
•
•
•
•
•
Chicago Board Options Exchange
American Stock Exchange
Philadelphia Stock Exchange
Pacific Stock Exchange
European Options Exchange
Australian Options Market
and many more (see list at end of book)
36
1.6 Types of Traders
• Hedgers
• Speculators
• Arbitrageurs
Some of the large trading losses in
derivatives occurred because individuals
who had a mandate to hedge risks switched
to being speculators
37
Hedging Examples (page 11)
• A US company will pay £10 million for
imports from Britain in 3 months and
decides to hedge using a long position in a
forward contract
• An investor owns 1,000 Microsoft shares
currently worth $73 per share. A two-month
put with a strike price of $65 costs $2.50.
The investor decides to hedge by buying 10
contracts
38
Speculation Example
• An investor with $4,000 to invest feels that
Cisco’s stock price will increase over the
next 2 months. The current stock price is
$20 and the price of a 2-month call option
with a strike of 25 is $1
• What are the alternative strategies?
39
Arbitrage Example (pages 12-13)
• A stock price is quoted as £100 in London
and $172 in New York
• The current exchange rate is 1.7500
• What is the arbitrage opportunity?
40
Hedging
• Two counterparties with offsetting risks can
eliminate risk.
– For example, if a wheat farmer and a flour mill enter
into a forward contract, they can eliminate the risk each
other faces regarding the future price of wheat.
• Hedgers can also transfer price risk to
speculators and speculators absorb price
risk from hedgers.
• Speculating: Long vs. Short
41
Hedging and Speculating Example
You speculate that copper will go up in price,
so you go long 10 copper contracts for
delivery in 3 months. A contract is 25,000
pounds in cents per pound and is at $0.70
per pound or $17,500 per contract.
If futures prices rise by 5 cents, you will gain:
Gain = 25,000 × .05 × 10 = $12,500
If prices decrease by 5 cents, your loss is:
Loss = 25,000 × -.05 × 10 = -$12,500
42
Hedging: How many contacts?
You are a farmer and you will harvest 50,000 bushels
of corn in 3 months. You want to hedge against a
price decrease. Corn is quoted in cents per bushel at
5,000 bushels per contract. It is currently at $2.30
cents for a contract 3 months out and the spot price
is $2.05.
To hedge you will sell 10 corn futures contracts:
50,000 bushels
 10 contracts
5,000 bushels per contract
Now you can quit worrying about the price of corn
and get back to worrying about the weather.
43
Hedging in Interest Rate Futures
• A mortgage lender who has agreed to loan
money in the future at prices set today can
hedge by selling those mortgages forward.
• It may be difficult to find a counterparty in
the forward who wants the precise mix of
risk, maturity, and size.
• It’s likely to be easier and cheaper to use
interest rate futures contracts however.
44
Actual Use of Derivatives
• Because derivatives don’t appear on the
balance sheet, they are present a challenge
to financial economists who which to
observe their use.
• Survey results appear to support the notion
of widespread use of derivatives among
large publicly traded firms.
• Foreign currency and interest rate
derivatives are the most frequently used.
45