1

Introduction

Chapter 1

2

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

3

The Nature of Derivatives

A derivative is an instrument whose value depends on (derives from) the values of other more basic underlying variables

4

Examples of Derivatives

• Forward Contracts

• Futures Contracts

• Swaps

• Options

5

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

6

1.1 Exchange-traded markets• Traditionally exchanges have used the

open-outcry system, but increasingly they are switching to electronic tradingContracts are standard there is virtually no credit risk

7

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

8

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

9

  U.S. $ equiv. Currency per U.S. $

Country Thursday 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

1 Month Forward 0.1375 0.1370 7.2746 7.2981

3 Months Forward 0.1372 0.1367 7.2906 7.3143

6 Months Forward 0.1368 0.1364 7.3091 7.3328

Germany (Mark) 0.4616 0.4601 2.1665 2.1735

1 Month Forward 0.4610 0.4596 2.1690 2.1760

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 121.34 121.76

6 Months Forward 0.008283 0.008252 120.73 121.18

Foreign Exchange Rates Thursday, November 1, 2001

Clearly the market participants expect that the yen will be worth MORE in dollars in six months.

10

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

11

  U.S. $ equiv. Currency per U.S. $

Country Thursday 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

1 Month Forward 0.1375 0.1370 7.2746 7.2981

3 Months Forward 0.1372 0.1367 7.2906 7.3143

6 Months Forward 0.1368 0.1364 7.3091 7.3328

Germany (Mark) 0.4616 0.4601 2.1665 2.1735

1 Month Forward 0.4610 0.4596 2.1690 2.1760

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 121.34 121.76

6 Months Forward 0.008283 0.008252 120.73 121.18

Clearly the market participants expect that the GBP will be worth less in dollars in six months.

Foreign Exchange Rates Thursday, November 1, 2001

12

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.

13

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

14

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?

15

Profit from aLong Forward Position

Profit

Price of Underlying at Maturity, STK

16

Profit from a Short Forward Position

Profit

Price of Underlying at Maturity, STK

17

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.

18

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.

19

Selected Futures Contracts

Contract Contract Size ExchangeAgricultural

Corn 5,000 bushels Chicago BOTWheat 5,000 bushels Chicago & KCCocoa 10 metric tons CSCE

OJ 15,000 lbs. CTNMetals & Petroleum

Copper 25,000 lbs. CMX Gold 100 troy oz. CMX

Unleaded gasoline 42,000 gal. NYMFinancial

British Pound £62,500 IMMJapanese Yen ¥12.5 million IMM

Eurodollar $1 million LIFFE

20

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

21

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.

22

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.

– American options can be exercised at any time up to expiry.

23

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.

24

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

+

25

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.

26

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

27

Call Option Payoffs

-20

100908070600 10 20 30 40 50

-40

20

0

-60

40

60

Stock price ($)

Op

tio

n p

ayo

ffs

($)

Buy a call

Exercise price = $50

28

Call Option Payoffs

-20

100908070600 10 20 30 40 50

-40

20

0

-60

40

60

Stock price ($)

Op

tio

n p

ayo

ffs

($)

Write a call

Exercise price = $50

29

Call Option Profits

-20

100908070600 10 20 30 40 50

-40

20

0

-60

40

60

Stock price ($)

Op

tio

n p

rofi

ts (

$)

Write a call

Buy a call

Exercise price = $50; option premium = $10

30

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.

31

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]

32

Put Option Payoffs

-20

100908070600 10 20 30 40 50

-40

20

0

-60

40

60

Stock price ($)

Op

tio

n p

ayo

ffs

($)

Buy a put

Exercise price = $50

33

Put Option Payoffs

-20

100908070600 10 20 30 40 50

-40

20

0

-60

40

60

Op

tio

n p

ayo

ffs

($)

write a put

Exercise price = $50

Stock price ($)

34

Put Option Profits

-20

100908070600 10 20 30 40 50

-40

20

0

-60

40

60

Stock price ($)

Op

tio

n p

rofi

ts (

$)

Buy a put

Write a put

Exercise price = $50; option premium = $10

10

-10

35

Selling Options

• The seller (or writer) of an option has an obligation.

• The purchaser of an option has an option.

-20

100908070600 10 20 30 40 50

-40

20

0

-60

40

60

Stock price ($)

Op

tio

n p

rofi

ts (

$)

Buy a put

Write a put

10

-10

-20

100908070600 10 20 30 40 50

-40

20

0

-60

40

60

Stock price ($)

Op

tio

n p

rofi

ts (

$)

Write a call

Buy a call

36

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)

37

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

38

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

39

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?

40

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?

41

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

42

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

43

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:

Now you can quit worrying about the price of corn and get back to worrying about the weather.

contracts 10contractper bushels 000,5

bushels 000,50

44

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.

45

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.