MA 592: Mathematical Finance

Lecture 01

Prof. Siddhartha Pratim Chakrabarty

Department of Mathematics
Indian Institute of Technology Guwahati
A Prelude
1 Last 40+ years: Importance of financial derivatives has grown both in
terms of volume as well as global reach.
2 The three types of predominant financial derivatives are options,
forward/futures and swaps.
3 What purpose do financial derivatives serve?
(A) Added to bond issues.
(B) Used in executive compensation.
(C) Transfers risks in mortgages from original lenders to investors.
(D) And others . . .
4 Who enters into financial derivative contracts?
(A) Individuals.
(B) Financial institutions.
(C) Fund managers.
(D) Corporate treasurers.
(E) And others . . .
5 Reality: Cannot ignore financial derivatives, especially considering their
usage in hedging/speculation/arbitrage.
A Prelude (Contd ...)
1 What is a financial derivative?
(A) A financial derivative (henceforth simply referred to as derivative) is
defined as a financial instrument, whose value depends on (or derives
from) the value of other, more basic, underlying variables.
2 So what are these underlying variables?
(A) Typically, the underlying variables of the derivatives are the prices of
traded assets (such as stock option).
(B) However, it can be any variable, such as (to cite a couple of
examples) the price of wheat and the amount of rainfall in a town.
3 These days: Active trading happens in:
(A) Equity derivatives.
(B) Interest rate derivatives.
(C) Foreign exchange derivatives.
(D) Credit derivatives.
(E) Electricity derivatives.
(F) Weather derivatives.
(G) Insurance derivatives.
A Prelude (Contd ...)
1 2007 financial crisis: Led to a great deal of criticism of derivatives.
2 A very important question from mathematical and computational
perspective: Pricing/valuation of derivatives and mechanisms of their
trading.
3 Derivatives market can broadly be classified into:
(A) Exchange-Traded Markets.
(B) Over-the-Counter Markets.
Exchange-Traded Markets
1 Derivative exchange: Market where individuals trade standardized
contracts that have been defined by the exchange.
2 1848: The Chicago Board of Trade (CBOT) was established to bring
farmers and merchants together and within a few-years the first
“futures-type” contract was developed.
3 1919: A rival futures exchange, namely, the Chicago Mercantile Exchange
(CME) was established.
4 Today: Many futures exchanges exist around the globe including the CME
group a , resulting from the merger of CBOT and CBE, and also includes
New York Mercantile Exchange (NYMEX) and Kansas City Board of
Trade (KCBT).
5 1973: Chicago Board Options Exchange (CBOE) b started trading call
options on 16 stocks, with put options being introduced in 1977.
a www.cmegroup.com
b www.cboe.com
Exchange-Traded Markets (Contd ...)
1 What advantages does trading on exchanges offer?
(A) Traders do not have to worry about the creditworthiness of their
counterparties (that is, people they are trading with).
(B) Clearing house takes care of credit risk, by requiring both the parties
to deposit funds (known as “margin”) with the clearing house.
2 Electronic markets:
(A) Traditionally, derivative exchanges have used what is known as the
open “outcry system”, where traders would be physically present on
the floor of the exchange.
(B) Exchanges have now largely replaced the “open outcry system” by
“electronic trading”.
(C) Electronic trading has led to a growth in high-frequency and
algorithmic trading, wherein computer programmes are used to
initiate trades, often without human intervention.
Over-the-Counter Markets
1 Many trades take place in the over-the-counter (OTC) markets.
2 Main participants in OTC markets: Large financial institutions, fund
managers and corporations.
3 How does it work?
(A) Once an OTC trade has been agreed upon, the two parties can either
present it to a central counterparty (CCP) (which acts like an
exchange clearing house) or clear the trade bilaterally.
(B) Large banks often act as market makers for the more commonly
traded instruments, which means that they are always prepared to
quote a bid price (at which they are prepared to take one side of a
derivative transaction) and an offer price (at which they are prepared
to take the other side of the derivative transaction).
4 Post 2007 crisis: Many new regulations were introduced for OTC markets
with the goals of greater transparency and reduction in systemic risk,
resulting in the OTC markets in some respects being forced to become
more like exchange-traded markets.
Options
1 Options, which are traded both on exchanges as well as OTC markets can
broadly be classified into two types:
(A) Call option: A call option gives the holder the right (but not the
obligation) to buy the underlying asset from the writer on or before a
certain future date for a pre-specified price.
(B) Put option: A put option gives the holder the right (but not the
obligation) to sell the underlying asset on or before a certain future
date for a pre-specified price.
2 The pre-specified price in the options contract is known as the exercise
price or the strike price.
3 The date on the contract is known as the expiration date or maturity,
which leads to another classification:
(A) An European option can be exercised (that is, the holder can
exercise the right) only on the expiration date.
(B) An American option can be exercised (that is, the holder can exercise
the right) any time on or before the expiration date a .
a Most options that are traded on exchanges are American
Options (Contd ...)
1 At this stage, we note that there are four types of participants in options
markets.
(A) Buyers of calls (Long position in a call option).
(B) Sellers of calls (Short position in a call option).
(C) Buyers of puts (Long position in a put option).
(D) Sellers of puts (Short position in a put option).
Payoffs and Profits from European Options
1 T : Expiration date or maturity.
2 S(T ): Price of underlying asset at maturity.
3 X : Exercise price or strike price.
4 CE : Price of European call option.
5 PE : Price of European put option.

Type of option Payoff Profit

Long call max (S(T ) − X , 0) max (S(T ) − X , 0) − CE
Short call min (X − S(T ), 0) a min (X − S(T ), 0) + CE
Long put max (X − S(T ), 0) max (X − S(T ), 0) − PE
Short put min (S(T ) − X , 0) b min (S(T ) − X , 0) + PE
Table: Payoffs and profits from European options

a − max (S(T ) − X , 0)
b − max (X − S(T ), 0)