Hull Chapter 1

Fundamentals of Futures and Options Markets, 4th edition © 2001 by John C. Hull

1.1

Chapter 1

PDF Creator: PDF4U Pro DEMO Version. If you want to remove this line, please purchase the full version

http://www.pdfpdf.com


1.2

The Nature of Derivatives

A derivative is an instrument whosevalue depends on the values of othermore basic underlying variables




1.3

Examples of Derivatives

• Futures Contracts• Forward Contracts• Swaps• Options




1.4

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 sellingone portfolio and buying another




1.5

Futures Contracts• A futures contract is an agreement to

buy or sell an asset at a certain time inthe future for a certain price

• By contrast in a spot contract there isan agreement to buy or sell the assetimmediately (or within a very shortperiod of time)




1.6

Exchanges Trading Futures

• Chicago Board of Trade• Chicago Mercantile Exchange• LIFFE (London)• Eurex (Europe)• BM&F (Sao Paulo, Brazil)• TIFFE (Tokyo)• and many more (see list at end of book)




1.7

Futures Price

• The futures prices for a particularcontract is the price at which you agreeto buy or sell

• It is determined by supply and demandin the same way as a spot price




1.8

Electronic Trading

• Traditionally futures contracts havebeen traded using the open outcrysystem where traders physically meeton the floor of the exchange

• Increasingly this is being replaced byelectronic trading where a computermatches buyers and sellers




1.9

Examples of Futures Contracts• Agreement to:

– buy 100 oz. of gold @ US$400/oz.in December (COMEX)

– sell £62,500 @ 1.5000 US$/£ inMarch (CME)

– sell 1,000 bbl. of oil @ US$20/bbl.in April (NYMEX)




1.10

Terminology• The party that has agreed

to buy has a long position• The party that has agreed

to sell has a short position




1.11Example

• January: an investor enters into along futures contract on COMEX tobuy 100 oz of gold @ $300 in April

• April: the price of gold $315 per oz

What is the investor’s profit?




1.12

Over-the Counter Markets

• The over-the counter market is animportant alternative to exchanges

• It is a telephone and computer-linkednetwork of dealers who do notphysically meet

• Trades are usually between financialinstitutions, corporate treasurers, andfund managers




1.13

Forward Contracts

• Forward contract are similar to futuresexcept that they trade in the over-the-counter market

• Forward contracts are popular oncurrencies and interest rates




1.14

Foreign Exchange Quotes forGBP (See page 4)

1.51781.51726-month forward



1.51221.5118SpotOfferBid




1.15

Options

• A call option is an option to buy acertain asset by a certain date for acertain price (the strike price)

• A put option is an option to sell acertain asset by a certain date for acertain price (the strike price)




1.16

American vs European Options

• An American options can be exercisedat any time during its life

• A European option can be exercisedonly at maturity




1.17

Cisco Options (May 8, 2000;Stock Price=62.75); See page 5

19.5017.505.002.0080

10.628.2510.877.0065

4.622.6918.8716.8750

OctPut

JulyPut

OctCall

JulyCall

StrikePrice




1.18

Exchanges Trading Options

• Chicago Board Options Exchange• American Stock Exchange• Philadelphia Stock Exchange• Pacific Exchange• LIFFE (London)• Eurex (Europe)• and many more (see list at end of book)




1.19

Options vs Futures/Forwards

• A futures/forward contract gives theholder the obligation to buy or sell at acertain price

• An option gives the holder the right tobuy or sell at a certain price




1.20

Types of Traders• Hedgers

• Speculators

• Arbitrageurs

Some of the large trading losses inderivatives occurred because individualswho had a mandate to hedge risks switchedto being speculators (See Chapter 21)




1.21

Hedging Examples (pages 7-9)

• A US company will pay £10 million forimports from Britain in 3 months anddecides to hedge using a long positionin a forward contract

• An investor owns 1,000 Microsoftshares currently worth $73 per share. Atwo-month put with a strike price of $63costs $2.50. The investor decides tohedge by buying 10 contracts




1.22

Speculation Example (pages 10-11)

• An investor with $4,000 to invest feelsthat Amazon.com’s stock price willincrease over the next 2 months. Thecurrent stock price is $40 and the priceof a 2-month call option with a strike of45 is $2

• What are the alternative strategies?




1.23

Arbitrage Example (pages 12-13)

• A stock price is quoted as £100 inLondon and $172 in New York

• The current exchange rate is 1.7500• What is the arbitrage opportunity?




1.24

1. Gold: An ArbitrageOpportunity?

• Suppose that:– The spot price of gold is US$390– The quoted 1-year futures price of gold

is US$425– The 1-year US$ interest rate is 5% per

annum• Is there an arbitrage opportunity?




1.25

2. Gold: Another ArbitrageOpportunity?

• Suppose that:– The spot price of gold is US$390– The quoted 1-year futures price

of gold is US$390– The 1-year US$ interest rate is

5% per annum• Is there an arbitrage opportunity?




1.26

The Futures Price of GoldIf the spot price of gold is S & the futures price isfor a contract deliverable in T years is F, then

F = S (1+r )T

where r is the 1-year (domestic currency) risk-free rate of interest.In our examples, S=390, T=1, and r=0.05 so that

F = 390(1+0.05) = 409.50




1.27

1. Oil: An ArbitrageOpportunity?

Suppose that:– The spot price of oil is US$19– The quoted 1-year futures price of

oil is US$25– The 1-year US$ interest rate is 5%

per annum– The storage costs of oil are 2% per





1.28

2. Oil: Another ArbitrageOpportunity?

• Suppose that:– The spot price of oil is US$19– The quoted 1-year futures price of

oil is US$16– The 1-year US$ interest rate is 5%

per annum– The storage costs of oil are 2% per




Documents

Hull Chapter 1