Introduction to Options and Futures
Alberto Manconi
email: alberto.manconi@unibocconi.it
Finance Department
via Roentgen
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Thursday, 13:00 – 14:00, over Zoom
Email your question(s) to me 48 hours beforehand
▪ It helps me prepare to answer your questions
▪ It helps you think carefully about the material
Office hours ≠ Tutoring
☺ Specific question(s) about specific point(s)
“I wasn’t paying attention in class, could you explain the whole
topic all over again?”
Thursday, 13:00 – 14:00, over Zoom
Email your question(s) to me 48 hours beforehand
Office hours ≠ Tutoring
Want to discuss your MSc applications and career plans?
▪ I’m very happy to talk about this with you and give you tips
▪ You want to get feedback on your applications/career plans, and
your professors are a good source of information
▪ Key: time! Don’t do it last-minute
Alireza Aghaee Shahrbabaki
email: alireza.aghaee@phd.unibocconi.it
Finance Department
via Roentgen
Main task: Grading
Risk management
Banks, asset mgmt, insurance, and large companies use
derivatives to hedge risk
Asset management
Asset management companies and the prop trading desk of some
banks use derivatives, e.g., to obtain leverage
Financial engineering
The largest, most dynamic financial institutions develop new
derivatives (or combine well-known ones in innovative ways)
Acquire knowledge of the functioning of the
markets for the main derivative instruments
Understand and apply the mathematical and
econometric tools used to formalize financial
problems and data analysis
Understand role of derivative instruments in the
market and as a corporate risk management tool
Develop and train critical thinking about financial
problems
J. Hull, “Options, Futures, and Other
Derivatives”, Prentice Hall, 10th edition
(other editions – within reason – also work!)
There’s a solutions manual – not mandatory,
but handy
Dear professor,
I am currently doing my internship at Goldman Sachs in
London in the Securities division and wanted to thank
you for the course in Options and Futures.
It has been very helpful and I am going back to the slides
you have provided us with.
The book by Hull is everywhere in the floor and it is
considered the “bible”!
Yes
▪ I will assume a solid knowledge of basic financial
mathematics, prob & stats, and calculus
Why?
▪ Valuing derivatives relies on mathematical techniques –
hard to say anything otherwise
▪ Many tasks you will face on the job require you to know
that math: using and/or writing computer code for pricing,
estimating VaR, designing new products, etc.
▪ Anyone can commit a formula to memory. Understanding
where it comes from is more challenging and rewarding!
Lectures
Case studies
Problem sets
“Take-home” mid-terms
Final exam
Wed & Thu
Check Blackboard regularly
Largely follow the textbook, but:
▪ There will be textbook material we don’t go over
in class – still exam material, unless otherwise
stated
▪ There will be enhancements
Hybrid mode
Participation: Making a comment…
< 1 time in 3 classes – don’t be too shy!
> 3 times in 1 class – let others speak too!
This course is hands-on
▪ Develop critical thinking
▪ Practice theory encountered in class
▪ Application to challenging real-world problems
Key component of business education worldwide
Great for practice
We will see some examples in class, but you
should practice on your own
Solving problems is how we learn
The spirit: Apply the tools we learn in class, to
find a solution to problems we have not seen
before
Two (2) “take-home” mid-terms
▪ Distributed via BlackBoard
▪ Per test: Two shots, over a one-week period
Can account for 30% of your grade, for the
first time you take the exam
Expiration: Any retake means you forfeit the
take-home mid-terms grades, and your grade
is 100% based on the exam
Partly about solving problems
▪ Similar to problem sets
▪ We will see some in class
Partly about applying the theory and
discussing its applications
▪ Similar to the kind of discussions we have in class
▪ Plenty of examples to develop intuition
Difficulty
Unreasonably difficult, impossible to pass
Ridicolously easy, guaranteed pass
Dec
Jan I
Jan II
Jul
Sep
First take of the exam:
max {
70% × Final exam score +
15% × Take-home mid-term #1 +
15% × Take-home mid-term #2 ;
100% × Final exam score
Any retake:
100% × Final exam grade
}
I can only write one for you if I know you –
participate in the class discussion!
I need time to write one!
▪ Ask me at least two months before your deadline
My letter will mention your performance on
my course (would not be credible otherwise)
The starting point should be your own idea
I’m happy to supervise empirical work
▪ Final paper ≠ Summary of a bunch of papers you
have read
▪ Get your hands dirty with data
Working on a BSc thesis will not affect your
grade on this course in any way
1973
1997
The Black-Scholes formula:
𝐶 = 𝑆0 𝑁 𝑑 − 𝐾𝑒 −𝑟𝑇 𝑁 𝑑 − 𝜎 𝑇
where:
𝑑=
𝑆
𝜎2
ln 𝐾 + 𝑟 + 2
𝜎 𝑇
𝑇
1998
2003
. LTCM: hedge fund founded by John Meriwether, Myron Scholes
and Robert C. Merton
“Derivatives are financial
weapons of mass
destruction” – W. Buffett
. First years: returns of over 40%
. In 1998: lost $4.6 billion following the Russian financial crisis
“…a love for money can blind us to averting
preventable disasters.”
Source: http://www.forbes.com/sites/stevedenning/2013/01/08/five-years-after-the-financial-meltdown-the-water-is-still-full-of-bigsharks/#3dd17ec65474
You want to buy a car. The dealer offers you a
price of $20,000
Place order today, take delivery in 3 months
Forward contract: you have the right and
obligation to buy in 3m
Let’s see your gains/losses in 3m
You don’t have the loan arranged, and offer
the dealer non-refundable $500 to hold the
price for 3 months
Option contract: you have the right, but not
the obligation, to buy in 3m
Let’s see your gains/losses
Derivative: A financial contract, between two or
more parties, whose value is derived from the
future value of an underlying asset
…in our case, underlying asset = the car
Forward
Buyer and seller agree today on the delivery
of a specified quantity and quality of an asset
at a future date, for a given price
Futures
Similar to forward, except it has a
standardized specification and is traded on
organized exchange. Profits and losses are
realized on a daily basis
FX quotes for GBP (24 May 2010)
Spot
1-month forward
3-month forward
6-month forward
Bid
1.4407
1.4408
1.4410
1.4416
Offer
1.4411
1.4413
1.4415
1.4422
Source: CBOE, reprinted in Hull, Table 1.2
1.60
US$ per £
1.55
1.50
1.45
1.40
15-May
4-Jun
24-Jun
14-Jul
3-Aug
23-Aug
12-Sep
2-Oct
Source: Datastream
Forwards
and Futures
Option
Confers the right, but not the obligation, to
buy (call) or sell (put) a specified asset at a
specified price up until or at a specific date
Google option prices (15 Jun 2010)
Strike
Price
Jul 2010 Sep 2010 Dec 2010
Bid
Bid
Bid
Jul 2010 Sep 2010 Dec 2010
Offer
Offer
Offer
460
43.30
51.90
63.40
44.00
53.90
64.80
480
28.60
39.70
50.80
29.00
40.40
52.30
500
17.00
28.30
40.60
17.40
29.30
41.30
520
9.00
19.10
31.40
9.30
19.90
32.00
540
4.20
12.70
23.10
4.40
13.00
24.00
560
1.75
7.40
16.80
2.10
8.40
17.70
Source: CBOE, reprinted in Hull, Table 1.3
Check more recent quotes: http://www.cboe.com/delayedquote/quotetable.aspx
Options
(& others)
Forwards
and Futures
Option
Confers the right, but not the obligation, to
buy (call) or sell (put) a specified asset at a
specified price up until or at a specific date
Swap
Simultaneous buying and selling of similar
asset or obligation of equivalent capital
between two parties
Options
(& others)
Swaps
Forwards
and Futures
Risk
Derivatives are
used to shift
elements of risk
and act as a form
of insurance
“Impossible to see, the future is”
– Yoda, Jedi Master
Contracts for future delivery of
goods in ancient Mesopotamia
(~1700 BCE):
“Six shekels silver as a šu-lá
loan, Abuwaqar, the son of
Ibqu-Erra, received from
Balnumamhe. In the sixth
month he will repay it with
sesame according to the going
rate.”
Expecting a heavy crop of olives,
Thales buys “forward” use of olivepresses at low prices
Makes a big profit when heavy crop
materializes, selling access to olivepresses
Proves that:
▪ Philosophers can get rich if they so wish
▪ Derivatives can be used for speculation
Thales of Miletus
(626-548 BCE)
Nearly modern forwards
were traded at the
Antwerp bourse (opened
in 1531)
Agreements to purchase
specific quantities of
goods (e.g., wool) at a
future date at a specified
price
Dojima Rice Exchange (1700s Japan)
Futures contracts on rice are traded; crucial for samurai
class, who were paid in rice
Authorities
repeatedly attempt
to shut it down, to
stop “gambling”
1730: Restrictions are
lifted and Dojima
exchange allows
futures trading
CBOT building 1885
1848: Chicago Board of Trade is
founded
Chicago was a major trading hub
connecting the Midwest to the
Atlantic
Initial focus on grain
In May 1865, trading in futures
contracts starts
Hedger
Someone who is exposed to an unwanted risk, and
wants to pass it to another party willing to accept it
Ex. 1: Farmer who wants to protect future value of harvest (corn, grain…)
against price fluctuations
Ex. 2: Manufacturer who will need to buy a commodity (oil, coffee…) and
may buy options to stabilize production costs
Ex. 3: Portfolio manager who wants to guarantee a minimum rate of
return
Hedging
with…
Options
(& others)
Swaps
Forwards
and Futures
Speculator
Buys/sells derivatives in hope of profiting from price
changes to his/her advantage
Arbitrageur
Trades with a view to exploit any price changes
within derivatives markets or relative to cash or
prices in the underlying markets
Hedging
with…
Options
(& others)
Swaps
Pricing…
Forwards
and Futures
Slightly more formalism. Introduce more
specialized concepts, to work with stochastic
processes in the Black-Scholes framework.
Some basic (as well as, time permitting, less
basic) numerical solutions.
Minimal mathematical formalism.
Focus on the building blocks:
• Pricing: Replicating and hedging portfolio
approaches
• Hedging: How to limit the exposure of your
investments to risk, using financial derivatives
Options
(& others)
Swaps
Forwards
and Futures
Source: The Economist, 16 Nov 2009: http://www.economist.com/node/14843667
Regulated exchange floors
▪ CME, LIFFE, etc. have approved members and
rules for safe environment for trading
Over-the-counter (OTC)
▪ Trading takes place directly between dealers and
principals via phone or computer
Electronic system
Exchange traded
Futures, options
Standardized contracts
Prices determined
competitively on the
exchange floor
Positions traded out
OTC
Forwards, options, swaps,…
anything!
Customizable
Market players must contact
each other
Positions need to be
transferred
Notional Outstanding Amt, $Tr
800
640
OTC
Exchange-traded
480
320
160
0
Jun-00
Jun-03
Jun-06
Jun-09
Jun-12
Jun-15
Exchanges trading futures
Chicago Board of Trade
Chicago Mercantile Exchange
LIFFE (London)
Eurex (Europe)
BM&F (Sao Paulo)
TIFFE (Tokyo)
Exchanges trading options
CBOE
American Stock Exchange
Philadelphia Stock Exchange
Pacific Exchange
LIFFE (London)
Eurex (Europe)
Are derivatives “evil”? “Financial weapons of
mass destruction”?
Very versatile financial instruments
Sometimes traders who should hedge or
arbitrage turn into speculators
Using futures: You’re a US trader convinced
that BPD will appreciate in 2 months
▪ Buy £250,000 spot at $1.4470/£
▪ Buy 4 futures (1 contract = £62,500) at $1.4410/£;
margin account = $20,000
Using futures
$1.4470/£ × £250,000
Buy £250,000 spot
Spot price = $1.4470/£
Upfront investment
Buy 4 futures contracts
Futures price = $1.4410
$361,750
$20,000
Profit if future exchange
rate = $1.5/£
$13,250
$14,750
Profit if future exchange
rate = $1.4/£
–$11,750
–$10,250
Derivatives allow you to obtain leverage: Can take a large
speculative position (“exposure”) with a small initial investment
Using options: You have a hunch that IBM,
currently trading at $20, will go up
▪ Buy 100 shares (cost: $2,000)
▪ Buy 20 call option contracts with strike price
$22.5, premium $1, each giving right to buy 100
shares (cost: $2,000)
Using options: If IBM goes up to $27
▪ Profit from buying 100 shares:
100 × $27 − $20 = $700
▪ Profit from buying 20 option contracts:
20 × 100 × $4.50 − $2,000 = $7,000
☺
Using options: If IBM goes down to $15
▪ Loss from buying 100 shares:
100 × $15 − $20 = −$500
▪ Loss from buying 20 option contracts:
−$2,000
Leverage can generate large losses, despite a relatively small initial
investment
Jérôme Kerviel
▪ Futures trader at
Société Générale
▪ Makes it appear as if
he’s arbitraging – but
in fact speculates
▪ 2008: losses
uncovered of $4.9bn
1995: rogue trader Nick
Leeson bankrupts
Barings Bank
2002: John Rusnak
causes $700m loss at
Allied Irish Bank (AIB)
from unauthorized FX
trades
…
Some accounts of the
2007-09 crisis
Complex derivatives
(CDO, CDO2, …) looked
safe, hiding large risk
Investors loaded up on
them, causing the crash
Are derivatives useful, or
a financial weapon of
mass destruction?
Financial
markets and
corporate
applications
Hedging
with…
Options
(& others)
Swaps
Pricing…
Forwards
and Futures
Are derivatives useful, or
a financial weapon of
mass destruction?
More likely: A powerful
financial instrument
See how you feel at the
end of our classes
