Chapter 1

Introduction

Options, Futures, and Other Derivatives, 8th Edition, Copyright ©

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What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options..

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How Derivatives Are Traded
On exchanges such as the Chicago Board Options
Exchange
In the over-the-counter (OTC) market where traders
working for banks, fund managers and corporate
treasurers contact each other directly.
OTC markets do not have a physical exchange whereas
in Exc.traded markets transactions are executed on a
physical exchange
Mainly currency and bond markets are OTC markets
whereas stock markets are Exchange traded markets
(NYSE, IMKB)
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Size of OTC and Exchange-Traded Markets
(Figure 1.1, Page 3)

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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How 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

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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 (as
shown by the table)

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Terminology
The party that has agreed to buy
has what is termed a long position
The party that has agreed to sell
has what is termed a short position

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 Foreign Exchange Quotes for GBP, May 24, 2010
USD / British Pound Bid (Buy) Offer (Ask or Sell)
Spot 1.4407 1.4411
1-month forward 1.4408 1.4413
3-month forward 1.4410 1.4415

6-month forward 1.4416 1.4422

What do quotes mean?
• Bid is the price that the financial institution (usually bank) is willing to buy British Pound.
Thus, Spot Bid Quote of 1.4407 means that the bank will pay 1.4407 US Dollar for buying
1 British Pound.
• Offer/Ask is the price that the financial institution (usually bank) is willing to sell British
Pound. Thus, Spot Offer Quote of 1.4411 means that the bank will ask or sell 1 British
Pound for 1.4411 US Dollar.
• Spread is the difference between the Offer and Bid price and is also the profit of the
bank from the currency transaction (1.4407 – 1.4411 in Spot)
• Spread will get larger if the bank does not want to hold a large stock of the currency in
transaction. For eg. In September 25,2008, Bid price for USD/ South African rand is
8.1425 and Offer price is 8.1580
Why is spread larger between US Dollar and South African Rand?
•Because South African Rand is not a very liquid (highly traded ) currency as US Dollar
or British Pound. Banks demand higher liquidity premium in Rand transactions.
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Example (page 5)
On May 24, 2010 the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months at an
exchange rate of 1.4422
This obligates the corporation to pay
$1,442,200 for £1 million on November 24,
2010
What are the possible outcomes?

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Profit from a Long Forward
Position (K= delivery price, ST= price of asset at
contract maturity

Profit

Price of Underlying at
K Maturity, ST

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Profit from a Short Forward
Position (K= delivery price=forward price at time
contract is entered into)

Profit

Price of Underlying
K at Maturity, ST

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Futures Contracts (page 7)
Agreement to buy or sell an asset for a
certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC,
a futures contract is traded on an exchange

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Exchanges Trading Futures
CME Group (formerly Chicago Mercantile
Exchange and Chicago Board of Trade)
NYSE Euronext
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see list at end of book)

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Examples of Futures Contracts
Agreement to:
Buy 100 oz. of gold @ US$1400/oz. in
December
Sell £62,500 @ 1.4500 US$/£ in March
Sell 1,000 bbl. of oil @ US$90/bbl. in April

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1. Gold: An Arbitrage
Opportunity?
Suppose that:
The spot price of gold is US$1,400
The 1-year forward price of gold is US$1,500
The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?

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2. Gold: Another Arbitrage
Opportunity?
Suppose that:
- The spot price of gold is US$1,400
- The 1-year forward price of gold is
US$1,400
- The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?

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 The Forward Price of Gold
(ignores the gold lease rate)

If the spot price of gold is S and the forward

price for 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 = 1400, T = 1, and r =0.05
so that
F = 1400(1+0.05) = 1470

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1. Oil: An Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$95
- The quoted 1-year futures price of oil is
US$125
- The 1-year US$ interest rate is 5% per
annum
- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

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2. Oil: Another Arbitrage
Opportunity?
Suppose that:
- The spot price of oil is US$95
- 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?
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Options
A call option gives the holder the right to buy
a certain asset by a certain date for a certain
price (the strike price)
A put option gives the holder the right to sell a
certain asset by a certain date for a certain
price (the strike price)

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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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Intel Option Prices (Sept 12, 2006; Stock Price=19.56);
Source: CBOE

Strike Oct Jan Apr Oct Jan Apr

Price Call Call Call Put Put Put
15.00 4.650 4.950 5.150 0.025 0.150 0.275

17.50 2.300 2.775 3.150 0.125 0.475 0.725

20.00 0.575 1.175 1.650 0.875 1.375 1.700

22.50 0.075 0.375 0.725 2.950 3.100 3.300

25.00 0.025 0.125 0.275 5.450 5.450 5.450

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Options vs Futures/Forwards
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

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Types of Traders
Hedgers
Speculators
Arbitrageurs

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Hedging Examples (pages 10-12)
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)

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Speculation Example
An investor with $2,000 to invest feels that
a 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 22.50 is $1
What are the alternative strategies?

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Arbitrage Example
A stock price is quoted as £100 in London
and $140 in New York
The current exchange rate is 1.4300
What is the arbitrage opportunity?

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