Lecture Option and Derivative

Remarks

Introduction
Chapter 1
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010
All information is available on Moodle Lectures & Tutorials: I present the theory, please prepare! We discuss the end-of-chapter questions & problems, please prepare! Textbook: Hull, 2011, Fundamentals of Futures and Options Markets, 7th edition, Pearson/Prentice Hall Exam Use one page A4 with formulas & non-progr. calculator
Topics
The Nature of Derivatives
Derivatives: Introduction
Hedging, arbitrage, speculation Markets, history, how to use/price? Markets, hedging and pricing issues Binomial trees vs. Black/Scholes model Greeks: option sensitivities Option strategies, other issues
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Futures/Forwards
Options

A derivative is an instrument whose value depends on the values of other more basic underlying variables
Examples of Derivatives
Ways Derivatives are Used

Futures Contracts Forward Contracts Swaps Options

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
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Futures Contracts
Exchanges Trading Futures

A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)
CBOT and CME (now CME Group) Intercontinental Exchange NYSE Euronext Eurex BM&FBovespa (Sao Paulo, Brazil) and many more (see list at end of book)
Futures Price
Electronic Trading
The futures prices for a particular contract is the price at which you agree to buy or sell It is determined by supply and demand in the same way as a spot price
Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers
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Examples of Futures Contracts

Agreement to: buy 100 oz. of gold @ US$1050/oz. in December sell 62,500 @ 1.5500 US$/ in March sell 1,000 bbl. of oil @ US$75/bbl. in April
Terminology
The party that has agreed to buy has a long position The party that has agreed to sell has a short position
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Example
Over-the Counter Markets

January: an investor enters into a long futures contract to buy 100 oz of gold @ $1050 in April April: the price of gold $1065 per oz What is the investors profit?
The over-the counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers
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Size of OTC and Exchange Markets

(Figure 1.2, Page 4)
Forward Contracts
Forward contracts are similar to futures except that they trade in the over-thecounter market Forward contracts are popular on currencies and interest rates
Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
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Options
A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)
American vs European Options

An American option can be exercised at any time during its life A European option can be exercised only at maturity
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Google Option Prices (July 17, 2009; Stock Price=430.25); See page 6
Calls Sept 2009 54.60 38.30 24.80 14.45 7.45 3.40 Puts Sept 2009 4.40 8.30 14.70 24.25 37.20 53.10
Exchanges Trading Options

Strike price ($) 380 400 420 440 460 480
Aug 2009 51.55 34.10 19.60 9.25 3.55 1.12
Dec 2009 65.00 51.25 39.05 28.75 20.40 13.75
Aug 2009 1.52 4.05 9.55 19.20 33.50 51.10
Dec 2009 15.00 21.15 28.70 38.35 49.90 63.40

Chicago Board Options Exchange International Securities Exchange NYSE Euronext Eurex (Europe) and many more (see list at end of book)
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Options vs Futures/Forwards
Hedging Examples (Example 1.1 and 1.2,

page 11)
A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price
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 $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts
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Value of Microsoft Shares with and without Hedging (Fig 1.4, page 12)
1. Gold: An Arbitrage Opportunity?

Suppose that: The spot price of gold is US$1000 The quoted 1-year futures price of gold is US$1100 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?
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2. Gold: Another Arbitrage Opportunity?

The Futures Price of Gold

If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S=1000, T=1, and r=0.05 so that F = 1000(1+0.05) = 1050
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1. Oil: An Arbitrage Opportunity?

Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$80 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
2. Oil: Another Arbitrage Opportunity?

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Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$65 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
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Futures Contracts
Mechanics of Futures Markets

Chapter 2

Available on a wide range of underlyings Exchange traded Specifications need to be defined:

What can be delivered, Where it can be delivered, & When it can be delivered
Settled daily
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Margins
Example of a Futures Trade

A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract
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An investor takes a long position in 2 December gold futures contracts on June 5

contract size is 100 oz. futures price is US$900 margin requirement is US$2,000/contract (US$4,000 in total) maintenance margin is US$1,500/contract (US$3,000 in total)
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A Possible Outcome
Table 2.1, Page 27
Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) Margin Account Margin Balance Call (US$) (US$) 4,000 (600) . . . (420) . . . (1,140) . . . 260 (600) . . . (1,340) . . . (2,600) . . . (1,540) 3,400 . . . 0 . . . Futures Price (US$) 900.00 5-Jun 897.00 . . . . . . 13-Jun 893.30 . . . . . . 19-Jun 887.00 . . . . . . 26-Jun 892.30
Other Key Points About Futures

Day
They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity
2,660 + 1,340 = 4,000 . . . . . 2,740 + 1,260 = 4,000 . . . . . . 5,060 0
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Collateralization in OTC Markets

Delivery
It is becoming increasingly common for contracts to be collateralized in OTC markets Counterparties then post margin with each other to reflect changes in the value of the contract Regulators are now insisting that clearinghouses (similar to those used for futures) be used for some OTC contracts
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If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash When there is cash settlement contracts are traded until a predetermined time. All are then declared to be closed out.
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Some Terminology
Convergence of Futures to Spot

(Figure 2.1, page 25)
Open interest: the total number of contracts outstanding. This equals to number of long positions or number of short positions Settlement price: the price just before the final bell each day. This is used for the daily settlement process Volume of trading: the number of trades in 1 day
Futures Price Spot Price
Spot Price Futures Price
Time
Time
(a)
(b)
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Forward Contracts
Profit from a Long Forward or Futures Position

Profit
A forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a certain price There is no daily settlement (but collateral may have to be posted). At the end of the life of the contract one party buys the asset for the agreed price from the other party
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Price of Underlying at Maturity
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Profit from a Short Forward or Futures Position

Profit
Forward Contracts vs Futures Contracts (Table 2.3, page 40)

Forward Private contract between two parties Not standardized Usually one specified delivery date Futures Traded on an exchange Standardized Range of delivery dates Settled daily Usually closed out prior to maturity Virtually no credit risk
Price of Underlying at Maturity
Settled at end of contract Delivery or final settlement usual Some credit risk
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Foreign Exchange Quotes

Futures exchange rates are quoted as the number of USD per unit of the foreign currency Forward exchange rates are quoted in the same way as spot exchange rates. This means that GBP, EUR, AUD, and NZD are USD per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per USD.
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Mechanics of Options Markets

Chapter 9
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Types of Options

Option Positions
Long call Long put Short call Short put
A call is an option to buy A put is an option to sell A European option can be exercised only at the end of its life An American option can be exercised at any time
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Long Call
(Figure 9.1, Page 207)
Short Call
Profit from buying one European call option: option price = $5, strike price = $100. 30 Profit ($) 20 10 70 0 -5 80 90 100 Terminal stock price ($) 110 120 130
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Profit from writing one European call option: option price = $5, strike price = $100 Profit ($) 5 0 -10 -20 -30
110 120 130 70 80 90 100 Terminal stock price ($)
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Long Put
Short Put
Profit from buying a European put option: option price = $7, strike price = $70 30 Profit ($)
Profit from writing a European put option: option price = $7, strike price = $70 Profit ($) 7 0 40 50 60 70 80 Terminal stock price ($) 90 100
20 10 0 -7 40 50 60 70 80 Terminal stock price ($) 90 100
-10 -20 -30

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Payoffs from Options

What is the Option Position in Each Case?
Assets Underlying Exchange-Traded Options

Page 210-211
K = Strike price, ST = Price of asset at maturity Payoff Payoff K K Payoff K ST Payoff K ST ST

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ST

Stocks Foreign Currency Stock Indices Futures
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Specification of Exchange-Traded Options

Terminology
Moneyness : At-the-money option In-the-money option Out-of-the-money option
Expiration date Strike price European or American Call or Put (option class)
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Executive Stock Options

Option issued by a company to executives When the option is exercised the company issues more stock Usually at-the-money when issued
Hedging Strategies Using Futures

Chapter 3
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Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010
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Long & Short Hedges

Arguments in Favor of Hedging
A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price
Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables
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Arguments against Hedging

Convergence of Futures to Spot

(Hedge initiated at time t1 and closed out at time t2)
Shareholders are usually well diversified and can make their own hedging decisions It may increase risk to hedge when competitors do not Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult
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Futures Price
Spot Price
Time t1 t2 60
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Basis Risk
Long Hedge
Basis is the difference between spot & futures Basis risk arises because of the uncertainty about the basis when the hedge is closed out

Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset=S2 (F2 F1) = F1 + Basis
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Short Hedge
Choice of Contract
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized=S2+ (F1 F2) = F1 + Basis
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Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. There are then 2 components to basis
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Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged is
h= S F
Hedging Using Index Futures

(Page 63)
where S is the standard deviation of S, the change in the spot price during the hedging period, F is the standard deviation of F, the change in the futures price during the hedging period is the coefficient of correlation between S and F.
To hedge the risk in a portfolio the number of contracts that should be shorted is V A VF where VA is the current value of the portfolio, is its beta, and VF is the current value of one futures (=futures price times contract size)
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Reasons for Hedging an Equity Portfolio

Example
Futures price of S&P 500 is 1,000 Size of portfolio is $5 million Beta of portfolio is 1.5 One contract is on $250 times the index What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?
Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.) Desire to hedge systematic risk
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Changing Beta
Stock Picking
What position is necessary to reduce the beta of the portfolio to 0.75? What position is necessary to increase the beta of the portfolio to 2.0?
If you think you can pick stocks that will outperform the market, futures contract can be used to hedge the market risk If you are right, you will make money whether the market goes up or down
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Rolling The Hedge Forward

We can use a series of futures contracts to increase the life of a hedge Each time we switch from 1 futures contract to another we incur a type of basis risk
Determination of Forward and Futures Prices

Chapter 5
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Consumption vs Investment Assets

Short Selling (Page 104-105)

Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold, silver) Consumption assets are assets held primarily for consumption (Examples: copper, oil)
Short selling involves selling securities you do not own Your broker borrows the securities from another client and sells them in the market in the usual way
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Short Selling
(continued)
Notation
S0: Spot price today F0: Futures or forward price today T: Time until delivery date r: Risk-free interest rate for maturity T
At some stage you must buy the securities back so they can be replaced in the account of the client You must pay dividends and other benefits the owner of the securities receives
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1. Gold: An Arbitrage Opportunity?

2. Gold: Another Arbitrage Opportunity?

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The Futures Price of Gold

If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S=1000, T=1, and r=0.05 so that F = 1000(1+0.05) = 1050
When Interest Rates are Measured with Continuous Compounding
F0 = S0erT
This equation relates the forward price and the spot price for any investment asset that provides no income and has no storage costs
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When an Investment Asset Provides a Known Dollar Income

(page 110, equation 5.2)
When an Investment Asset Provides a Known Yield

(Page 111, equation 5.3)
F0 = (S0 I )erT where I is the present value of the income during life of forward contract
F0 = S0 e(rq )T
where q is the average yield during the life of the contract (expressed with continuous compounding)
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Valuing a Forward Contract

Page 112
Stock Index (Page 115)

Suppose that K is delivery price in a forward contract & F0 is forward price that would apply to the contract today The value of a long forward contract, , is = (F0 K )erT Similarly, the value of a short forward contract is (K F0 )erT
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Can be viewed as an investment asset paying a dividend yield The futures price and spot price relationship is therefore
F0 = S0 e(rq )T
where q is the dividend yield on the portfolio represented by the index during life of contract
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Stock Index
(continued)
Index Arbitrage
For the formula to be true it is important that the index represent an investment asset In other words, changes in the index must correspond to changes in the value of a tradable portfolio The Nikkei index viewed as a dollar number does not represent an investment asset
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When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying the index
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Index Arbitrage
(continued)
Futures and Forwards on Currencies (Page 116-120)

Index arbitrage involves simultaneous trades in futures and many different stocks Very often a computer is used to generate the trades
A foreign currency is analogous to a security providing a dividend yield The continuous dividend yield is the foreign risk-free interest rate It follows that if rf is the foreign risk-free interest rate
F0 = S 0 e
( r rf ) T
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Futures on Consumption Assets

(Page 122)
F0 S0 e(r+u )T
where u is the storage cost per unit time as a percent of the asset value. Alternatively,
F0 (S0+U )erT
where U is the present value of the storage costs.
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Remarks

The Nature of Derivatives

Ways Derivatives are Used

Futures Contracts Forward Contracts Swaps Options

Exchanges Trading Futures

Examples of Futures Contracts

Over-the Counter Markets

Size of OTC and Exchange Markets

American vs European Options

Exchanges Trading Options

Strike price ($) 380 400 420 440 460 480

Aug 2009 51.55 34.10 19.60 9.25 3.55 1.12

Dec 2009 65.00 51.25 39.05 28.75 20.40 13.75

Aug 2009 1.52 4.05 9.55 19.20 33.50 51.10

Dec 2009 15.00 21.15 28.70 38.35 49.90 63.40

Hedging Examples (Example 1.1 and 1.2,

1. Gold: An Arbitrage Opportunity?

2. Gold: Another Arbitrage Opportunity?

The Futures Price of Gold

1. Oil: An Arbitrage Opportunity?

2. Oil: Another Arbitrage Opportunity?

Mechanics of Futures Markets

Available on a wide range of underlyings Exchange traded Specifications need to be defined:

Example of a Futures Trade

An investor takes a long position in 2 December gold futures contracts on June 5

Other Key Points About Futures

2,660 + 1,340 = 4,000 . . . . . 2,740 + 1,260 = 4,000 . . . . . . 5,060 0

Collateralization in OTC Markets

Convergence of Futures to Spot

Futures Price Spot Price

Spot Price Futures Price

Profit from a Long Forward or Futures Position

Price of Underlying at Maturity

Profit from a Short Forward or Futures Position

Forward Contracts vs Futures Contracts (Table 2.3, page 40)

Price of Underlying at Maturity

Foreign Exchange Quotes

Mechanics of Options Markets

110 120 130 70 80 90 100 Terminal stock price ($)

20 10 0 -7 40 50 60 70 80 Terminal stock price ($) 90 100

-10 -20 -30

Payoffs from Options

Assets Underlying Exchange-Traded Options

K = Strike price, ST = Price of asset at maturity Payoff Payoff K K Payoff K ST Payoff K ST ST

Stocks Foreign Currency Stock Indices Futures

Specification of Exchange-Traded Options

Executive Stock Options

Hedging Strategies Using Futures

Long & Short Hedges

Arguments in Favor of Hedging

Arguments against Hedging

Convergence of Futures to Spot

Optimal Hedge Ratio

Hedging Using Index Futures

Reasons for Hedging an Equity Portfolio

Rolling The Hedge Forward

Determination of Forward and Futures Prices

Consumption vs Investment Assets

Short Selling (Page 104-105)

1. Gold: An Arbitrage Opportunity?