Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 21
Chapter 21 - An Introduction to
Derivative Markets and Securities
Questions to be answered:
• What distinguishes a derivative security such as
a forward, futures, or option contract, from
more fundamental securities, such as stocks and
bonds?
• What are the important characteristics of
forward, futures, and option contracts, and in
what sense can the be interpreted as insurance
policies?
Chapter 21 - An Introduction to
Derivative Markets and Securities
• How are the markets for derivative securities
organized and how do they differ from other
security markets?
• What terminology is used to describe
transactions that involve forward, futures, and
option contracts?
• How are prices for derivative securities quoted
and how should this information be interpreted?
Chapter 21 - An Introduction to
Derivative Markets and Securities
• What are similarities and differences between
forward and futures contracts?
• What do the payoff diagrams look like for
investments in forward and futures contracts?
• What do the payoff diagrams look like for
investments in put and call option contracts?
• How are forward contracts, put options, and call
options related to one another?
Chapter 21 - An Introduction to
Derivative Markets and Securities
• How can derivatives be used in conjunction with
stock and Treasury bills to replicate the payoffs
to other securities and create arbitrage
opportunities for an investor?
• How can derivative contracts be used to
restructure cash flow patterns and modify the
risk in existing investment portfolios?
Derivative Instruments
• Value is depends directly on, or is derived from,
the value of another security or commodity,
called the underlying asset
• Forward and Futures contracts are agreements
between two parties - the buyer agrees to
purchase an asset from the seller at a specific date
at a price agreed to now
• Options offer the buyer the right without
obligation to buy or sell at a fixed price up to or
on a specific date
Why Do Derivatives Exist?
• Assets are traded in the cash or spot market
• It is sometimes advantageous enter into a
transaction now with the exchange of asset
and payment at a future time
• Risk shifting
• Price formation
• Investment cost reduction
Derivative Instruments
• Forward contracts are the right and full
obligation to conduct a transaction involving
another security or commodity - the underlying
asset - at a predetermined date (maturity date) and
at a predetermined price (contract price)
– This is a trade agreement
• Futures contracts are similar, but subject to a
daily settling-up process
Forward Contracts
• Buyer is long, seller is short
• Contracts are OTC, have negotiable
terms, and are not liquid
• Subject to credit risk or default risk
• No payments until expiration
• Agreement may be illiquid
Futures Contracts
•
•
•
•
•
Standardized terms
Central market (futures exchange)
More liquidity
Less liquidity risk - initial margin
Settlement price - daily “marking to market”
Options
• The Language and Structure of Options
Markets
– An option contract gives the holder the right-but
not the obligation-to conduct a transaction
involving an underlying security or commodity
at a predetermined future date and at a
predetermined price
Options
• Buyer has the long position in the contract
• Seller (writer) has the short position in the
contract
• Buyer and seller are counterparties in the
transaction
Options
• Option Contract Terms
– The exercise price is the price the call buyer will pay
to-or the put buyer will receive from-the option seller
if the option is exercised
• Option Valuation Basics
– Intrinsic value represents the value that the buyer
could extract from the option if he or she she
exercised it immediately
– The time premium component is simply the difference
between the whole option premium and the intrinsic
component
• Option Trading Markets-options trade both in overthe-counter markets and on exchanges
Options
•
•
•
•
Option to buy is a call option
Option to sell is a put option
Option premium - paid for the option
Exercise price or strike price - price agreed
for purchase or sale
• Expiration date
– European options
– American options
Options
• At the money:
– stock price equals exercise price
• In-the-money
– option has intrinsic value
• Out-of-the-money
– option has no intrinsic value
Investing With Derivative Securities
• Call option
– requires up front payment
– allows but does not require future settlement
payment
• Forward contract
– does not require front-end payment
– requires future settlement payment
Options Pricing Relationships
Factor
Call Option
Stock price
+
Exercise price
Time to expiration
+
Interest rate
+
Volatility of underlying stock price +
Put Option
+
+
+
Profits to Buyer of Call Option
3,000
Profit from Strategy
2,500
Exercise Price = $70
2,000
Option Price
= $6.125
1,500
1,000
500
0
(500)
(1,000)
40
Stock Price at
Expiration
50
60
70
80
90
100
Profits to Seller of Call Option
1,000
Profit from Strategy
Exercise Price = $70
500
Option Price
= $6.125
0
(500)
(1,000)
(1,500)
(2,000)
(2,500)
(3,000)
40
Stock Price at
Expiration
50
60
70
80
90
100
Profits to Buyer of Put Option
3,000
Profit from Strategy
2,500
2,000
Exercise Price = $70
1,500
Option Price
= $2.25
1,000
500
0
Stock Price at
Expiration
(500)
(1,000)
40
50
60
70
80
90
100
Profits to Seller of Put Option
1,000
Profit from Strategy
500
0
Exercise Price = $70
(500)
Option Price
(1,000)
= $2.25
(1,500)
(2,000)
(2,500)
(3,000)
40
Stock Price at
Expiration
50
60
70
80
90
100
The Relationship Between
Forward and Option Contracts
Put-call parity
– Long in WYZ common at price of S0
– Long in put option to deliver WYZ at X on T
• Purchase for P0
– Short in call option to purchase WYZ at X on T
• Sell for C0
• Net position is guaranteed contract (risk-free)
• Since the risk-free rate equals the T-bill rate:
(long stock)+(long put)+(short call)=(long T-bill)
Creating Synthetic Securities
Using Put-Call Parity
• Risk-free portfolio could be created using three
risky securities:
– stock,
– a put option,
– and a call option
• With Treasury-bill as the fourth security, any
one of the four may be replaced with
combinations of the other three
Adjusting Put-Call Spot Parity
For Dividends
• The owners of derivative instruments do not
participate directly in payment of dividends to
holders of the underlying stock
• If the dividend amounts and payment dates are
known when puts and calls are written those are
adjusted into the option prices
(long stock) + (long put) + (short call) = (long T-bill) +
(long present value of dividends)
Put-Call-Forward Parity
• Instead of buying stock, take a long position in a
forward contract to buy stock
• Supplement this transaction by purchasing a put
option and selling a call option, each with the
same exercise price and expiration date
• This reduces the net initial investment compared
to purchasing the stock in the spot market
Put-Call-Forward Parity
The difference between put and call
prices must equal the discounted
difference between the common
exercise price and the contract price of
the forward agreement, otherwise
arbitrage opportunities would exist
An Introduction To The Use Of
Derivatives In Portfolio Management
• Restructuring asset portfolios with forward
contracts
– shorting forward contracts
– tactical asset allocation to time general market
movements instead of company-specific trends
– hedge position with payoffs that are negatively
correlated with existing exposure
– converts beta of stock to zero, making a synthetic
T-bill, affecting portfolio beta
An Introduction To The Use Of
Derivatives In Portfolio Management
• Protecting portfolio value with put options
–
–
–
–
purchasing protective puts
keep from committing to sell if price rises
asymmetric hedge
portfolio insurance
• Either
– hold the shares and purchase a put option, or
– sell the shares and buy a T-bill and a call option
The Internet
Investments Online
www.cboe.com
www.cbot.com
www.cme.com
www.cme.com/educational/hand1.htm
www.liffe.com
www.options-iri.com
End of Chapter 21
–An Introduction to
Derivative Markets
and Securities
Future topics
Chapter 22
• Forward and Futures Contracts