Chapter 1

Introduction

1
What is a Derivative?
A derivative is an instrument (an agreement between
two parties (counterparties)) to transact an underlying
asset or an underlying reference price, interest rate
or index at a future date for an agreed upon price
(has different names depending on the derivative
contract).
The value of the derivative, thus, depends on, or is
derived from, the value of the underlying (another
asset).
Examples: futures, forwards, swaps, options,
exotics…

2
What is a Derivative?
The derivative market vs the spot (cash)
market
Derivative market Spot (cash) market
Price Forward, future, strike Spot price
(exercise) price
Payment On the expiry date of the Immediate (or some time
contract later using a credit
agreement)
Delivery On the expiry date Immediate
Obligation Depending on the type of Yes (always)
the derivative contact

3
Why Derivatives Are Important
Derivatives play a key role in allocating risks in the
economy by transferring risks between parties such that
each holds the risk it is better or more willing to bear
The underlying assets can be a financial asset such as
stocks, currencies, interest rates, debt instruments,
insurance payouts
Real assets like agricultural commodities metals and
sources of energy.
electricity prices, the weather, etc
Many financial transactions have embedded derivatives
The real options approach to assessing capital
investment decisions has become widely accepted
4
How Derivatives Are Traded
On organised exchanges such as the
Chicago Board Options Exchange (CBOE)
Open outcry system
(https://www.youtube.com/watch?v=aluuekJIhWI)
Electronic trading
In the over-the-counter (OTC) market where
traders working for banks, fund managers
and corporate treasurers etc. contact each
other directly over the phone usually and
execute transactions privately
5
The OTC Market Prior to 2008
Largely unregulated
Banks acted as market makers quoting bids and
offers (e.g. forward exchange rates quotes offered by
Barclays)
Master agreements usually defined how transactions
between two parties would be handled
But some transactions were cleared through central
counterparties (CCPs). A CCP stands between the
two sides to a transaction in the same way that an
exchange does.

6
Since 2008…
OTC market has become regulated. Objectives:
Reduce systemic risk (see Business Snapshot 1.2, page 5)
Reduce counterparty risk
Increase transparency to increase liquidity
In the U.S and some other countries, standardized OTC
products must be traded on swap execution facilities
(SEFs) which are electronic platforms similar to
exchanges
CCPs must be used to clear standardized transactions
between financial institutions in most countries
All trades must be reported to a central repository (to
enhance transparency).
7
Size of OTC and Exchange-Traded Markets
(Figure 1.1, Page 5)

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
Options, Futures, and Other Derivatives, 10th Edition,
Copyright © John C. Hull 2017 8
The Lehman Bankruptcy (Business
Snapshot 1.1)

Lehman’s filed for bankruptcy on September 15, 2008.

This was the biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives
markets and got into financial difficulties because it took
high risks and found it was unable to roll over its short
term funding
It had hundreds of thousands of transactions
outstanding with about 8,000 counterparties
Unwinding these transactions has been challenging for
both the Lehman liquidators and their counterparties

9
How Derivatives are Used
To hedge risks
To speculate or for price discovering
(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

10
Forward contracts
An agreement that obligates two parties to
exchange (buy or sell) an asset @ an agreed
upon prices (i.e. Forward price) @ an agreed
upon date (settlement date)
Traded on OTC and Tailor made (in terms of
the size and settlement date of the contract)
Forward contract on foreign exchange rates
are popular
large financial institutions post foreign
exchange rates quotes (e.g. Barclays)
11
Foreign Exchange Quotes for GBP, May
26, 2013 (See page 6)
Bid Offer
Spot 1.5541 1.5545

1-month forward 1.5538 1.5543

3-month forward 1.5533 1.5538

6-month forward 1.5526 1.5532

12
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)
No arbitrage principle
The forward price may be different for
contracts of different maturities (as
shown by the table)
Options, Futures, and Other Derivatives, 10th Edition,
Copyright © John C. Hull 2017 13
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

14
Example (pages 6-7)
On May 6, 2013, the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months at an
exchange rate of 1.5532
This obligates the corporation to pay
$1,553,200 (1.5532*1000000) for £1 million
on November 6, 2013
What are the possible outcomes?

15
Example (pages 6-7)
Position Payoff
Long Spot Price @ maturity – forward price (delivery price)
ST – K
Unlimited gain potential, theoretically
Limited loss potential (i.e. K only if ST is zero)
Short forward price (delivery price) – Spot Price @ maturity
K – ST
Limited gain potential (i.e. K only if ST is zero)
Unlimited loss potential, theoretically
The short position is inherently riskier

16
Example (pages 6-7)
If ST =1.60
Payoffs=ST – K
=[(1.60*1000000) – (1,553,200)]
=$46800
If ST =1.50
Payoffs=ST – K
=[(1.50*1000000) – (1,553,200)]
= – $53200
17
Profit from a Long Forward Position (K=
delivery price=forward price at time contract is entered into)

Profit

Price of Underlying at
K Maturity, ST

18
Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into)

Profit
K

Price of Underlying
K at Maturity, ST

19
Futures Contracts (page 8)
Agreement to buy or sell an asset for a
certain price (the future price) at a certain
time
Whereas a forward contract is traded OTC, a
futures contract is traded on an exchange
While these contracts are traded differently,
they both operate under the same essential
framework
The differences are enumerated in the
sequel
20
Futures vs forward Contracts
Forwards Futures

Agreement to buy or sell an Agreement to buy or sell an

underlying asset at a later date underlying asset at a later date

Traded OTC with customized Exchange traded with standardized

features features

Not guaranteed by a clearinghouse; Regulated, transparent, and traded

Limited regulation and reporting through a clearinghouse

Gains and losses settled at Daily settlement of gains and

maturity losses marked to market

21
Exchanges Trading Futures
CME Group (formed when Chicago
Mercantile Exchange and Chicago Board of
Trade merged)
InterContinental Exchange
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see list at end of book)

22
Examples of Futures Contracts
Agreement to:
Buy 100 oz. of gold @ US$1300/oz. in
December
Sell £62,500 @ 1.4500 US$/£ in March
Sell 1,000 bbl. of oil @ US$50/bbl. in April

23
Arbitrage
In well-functioning markets with low transaction costs and a free
flow of information, identical assets must sell for the same price.
This is referred to as the Law of One Price.
If identical assets do not sell at the same price, a trader could
buy the cheaper asset and sell it in the more expensive market,
earning a riskless profit. This is known as arbitrage (capturing
price differences on identical assets to earn a riskless profit).
The combined action of arbitrageurs continues until the prices of
identical assets converge.
Arbitrage is a relative valuation methodology. It tells us the
correct price of one asset or derivative relative to another asset
or derivative.

24
Arbitrage and Market Efficiency
The forces of arbitrage in financial markets assure us that:
the same asset cannot sell for different prices
nor can two equivalent combinations of assets that produce the
same results sell for different prices
Markets in which arbitrage opportunities are either nonexistent
or quickly eliminated are relatively efficient markets.
Efficient markets fairly compensate investors for risk.
Arbitrage opportunities give investors a return above the risk-
free rate without taking risk.
The abnormal returns generated by arbitrage are a violation of
market efficiency.

25
1. Gold: An Arbitrage
Opportunity?
Suppose that:
The current spot price of gold is US$1,200
The 1-year forward price of gold is US$1,300
The 1-year US$ interest rate is 5% per
annum
The convenience yield on gold equals
storage costs equals zero.
Is there an arbitrage opportunity?

26
1. Gold: An Arbitrage Opportunity? (fair
price calc)
The fair price is  F = S (1+r )T
IF F – S (1+r )T ≠0  then there exists an
arbitrage opportunity
F = S (1+r )T
1300 ≠ 1200(1+0.05) 1
1300 ≠1260
Therefore, the answer is Yes there is an arbitrage
opportunity. But, how can we formulate a trading
strategy to exploit it without having to commit an initial
investment and take risk?
 I will show you !!! 27
1. Gold: An Arbitrage
Opportunity? (trading strategy)
T=0 (now)
Borrow US$1,200 @ 5%
Buy @ spot price US$1,200
Sell it forward @ US$1,300
T=1 (in one year time)
Receive the proceeds US$1,300
Repay the loan with the interest US$1260
[1200+(0.05*1200)]
Earn a profit of US$40 (1300 – 1260)
28
Gold: An Arbitrage
Opportunity? (Cash flows)

T=1 T=0
+1300 1200
1260- )1.05*1200=( 1200-
40 0

29
2. Gold: Another Arbitrage
Opportunity?
Suppose that:
- The spot price of gold is US$1,200
- The 1-year forward price of gold is
US$1,200
- The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?

30
 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 = 1200, T = 1, and r =0.05
so that
F = 1200(1+0.05) = 1,260
Since F – S (1+r )T ≠0  then there exists an
arbitrage opportunity
31
Arbitrage Opportunity(trading
strategy)
T=0 (now)
Sell @ spot price US$1,200
Lend US$1,200 @ 5%
Buy the forward @ US$1,200
T=1 (in one year time)
Withdraw the deposit with the interest
US$1260 [1200+(0.05*1200)]
Buy it back @ 1200
Earn a profit of US$ 60 (1260 – 1200)
32
Gold: An Arbitrage
Opportunity? (Cash flows)

T=1 T=0
1260 )1.05*1200=( 1200
1200 - 1200-
60 0

Options, Futures, and Other Derivatives, 10th Edition,

Copyright © John C. Hull 2017 33
1. Oil: An Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$50
- The quoted 1-year futures price of oil is
US$60
- The 1-year US$ interest rate is 5% per
annum
- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

34
2. Oil: Another Arbitrage Opportunity?

Suppose that:
- The spot price of oil is US$50
- The quoted 1-year futures price of oil is
US$40
- The 1-year US$ interest rate is 5% per
annum
- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

35
Options
An option is a derivative contract in which one party,
the buyer, pays a sum of money to the other party,
the seller or writer, and receives the right to either
buy or sell an underlying asset at a fixed price either
on a specific expiration date or at any time prior to
the expiration date.
A call option is an option to buy a certain asset by
a certain date for a certain price (the strike or
exercise price)
A put option is an option to sell a certain asset by
a certain date for a certain price (the strike or
exercise price)
36
Options payoffs
Notations:
ST: the price of the underlying at the expiration date,T
X: the exercise or strike price of the option
Payoff to the call buyer: cT = Max(0,ST – X)
Payoff to the put buyer: pT = Max(0, X – ST)
Payoff to the call seller: – cT [i.e. – Max(0, ST – X)]
Payoff to the put seller: – pT = [i.e.– Max(0, X – ST)]

37
Options payoffs (show me the
money!)
For a call option
ST – X>0  in the money
ST – X<0  out of the money
ST = X  at the money
For a put option
X – ST >0  in the money
X – ST <0  out of the money
X=ST  at the money

38
Options profits
Notations:
c0: the price (premium) of the call option
p0: the price (premium) of the put option
Since option buyer must pay a price (or option
premium), the profit is computed by subtracting
the option premium from the option payoff.
Profit to the call buyer: Π = Max(0,ST – X) – c0
Profit to the put buyer: Π = Max(0,X – ST) – p0
39
American vs European Options
An American option can be exercised at any
time during its life
So we should note that Max(0,St – X), where time,
t is between 0 and T, is also the payoffs if the
owner decides to exercise the call option early
A European option can be exercised only at
maturity
i.e. only at time, T.

40
Google Call Option Prices from CBOE (May 8, 2013; Stock
Price is bid 871.23, offer 871.37); See Table 1.2 page 9

Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer

820 56.00 57.50 76.00 77.80 88.00 90.30

840 39.50 40.70 62.90 63.90 75.70 78.00

860 25.70 26.50 51.20 52.30 65.10 66.40

880 15.00 15.60 41.00 41.60 55.00 56.30

900 7.90 8.40 32.10 32.80 45.90 47.20

41
Google Put Option Prices from CBOE (May 8, 2013; Stock
Price is bid 871.23, offer 871.37); See Table 1.3 page 9

Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer

820 5.00 5.50 24.20 24.90 36.20 37.50

840 8.40 8.90 31.00 31.80 43.90 45.10

860 14.30 14.80 39.20 40.10 52.60 53.90

880 23.40 24.40 48.80 49.80 62.40 63.70

900 36.20 37.30 59.20 60.90 73.40 75.00

42
Properties of Options
The price of a call option decreases as the
strike price increases  the probability to
reach the strike becomes lower
while the price of a put option increases as
the strike price increases  the probability to
reach the strike becomes lower
Both types of option tend to become more
valuable as their time to maturity increases 
the higher the probability of favorable
outcome 43
Example (buy a Call option)
Suppose an investor instructs a broker to buy
one December call option contract on
Google with a strike price of $880.
Which table? The first
@ bid or offer? Offer
What is the offer price? $56.30
On how many shares is the option is written? 100
shares
How much the investor will pay? $5630
(=56.30*100) this amount will be remitted to the
seller of the option
44
Example ( buy a Call option)
the investor has obtained at a cost of $5,630
the right to buy 100 Google shares for $880
each.
There are two potential scenarios
If the share price of Google < 880, the option will
expire worthless
If the share price of Google > 880 say 1000, the
option can be excised i.e. buy the 100 shares
@$880 and sell them @1000 and earn a profit of
$12000 [($1000*100)-($880*100)] or after taken
the premium paid $6370 (12000-5630)
45
Example (sell a Put option)
Suppose an investor instructs a broker to sell
one September put option contract on
Google with a strike price of $840.
Which table? The second
@ bid or offer? Bid (because we are selling)
What is the bid price? $31
On how many shares is the option written? 100
shares
How much the investor will pay? Nothing!! He will
receive $3100 (=31*100) this amount will be
remitted to the seller of the option
46
Example (sell a Put option)
There are two potential scenarios
the share price of Google >840, the option will
expire worthless
If the share price of Google < $840 say $800, the
option can be excised i.e. buy the 100 shares
@$840 and sell them @$800 and incur a loss of
$4000 [($800*100)-($840*100)] or after taken the
premium received -$900 (3100-4000)

47
Profits from buying a Call and
selling a Put

48
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

49
Types of Traders
Hedgers: use derivatives to control or
eliminate a financial exposure
Futures and forward contracts lock-in the price of
the underlying asset and not allow for any upside
potential
Options hedge negative price movements and
allow for upside potential since they have
asymmetric payoffs

50
Types of Traders
Speculators: use derivatives to bet on the
market
Futures require a small initial investment in the
form of an initial margin requirement
Because futures unlike option have symmetrical
payoffs, they can result in large gains or large
losses
They main motivation for using derivatives in
speculation is the limited initial outlay which create
significant leverage
51
Types of Traders
Arbitrageurs: seek to earn a riskless profit
through the discovery of mispriced securities
Riskless profits is earned by entering into
equivalent offsetting positions in one or more
markets (no initial investment is required).
Arbitrage opportunities do not last long as the act
of arbitrage brings prices back into equilibrium
quickly.

52
Hedging Examples (pages 11-13)
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

53
Value of Microsoft Shares with and
without Hedging (Fig 1.4, page 13)
40,000 Value of Holding ($)

35,000

No Hedging
30,000 Hedging

25,000

Stock Price ($)

20,000
20 22 24 26 28 30 32 34 36 38

54
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?

55
Arbitrage Example
A stock price is quoted as £100 in London
and $150 in New York
The current exchange rate is 1.5300
What is the arbitrage opportunity?

56
Dangers
Traders can switch from being hedgers to
speculators or from being arbitrageurs to
speculators
It is important to set up controls to ensure that
trades are using derivatives in for their
intended purpose
Soc Gen (see Business Snapshot 1.4 on
page 18) is an example of what can go wrong
High leverage
57
High leverage Example
Relatively small price changes in the underlying
asset price can cause large swings in the
counterparty equity. But how?
E.g. One heating oil futures contract is written
on 42000 gallons of heating oil @ a futures
price of $1/gallon
What is the value of the commodity that we
control (notional value)? $42000($1*42000
gallon)
58
High leverage Example
-A 1 cent increase in the futures price leads to
change in the value of the futures contract of
$420 ($0.01*42000 gallons)
-How much is the as a percentage of the value
of the contract? 1%(420/42000)
-But where is the problem?! It is because of the
small initial outlay in the form of a margin
requirement of $5000 in this case

59
High leverage Example
So the 1% change in the price of heating oil, the
margin (our equity) changes by 8.4% but how?

That is very large change which means that

leverage amplify the changes in the underlying
asset—it is favorable in this case but prices can
move in either directions up or down…

60
Hedge Funds (see Business Snapshot 1.3, page 12)
Hedge funds are not subject to the same rules as
mutual funds and cannot offer their securities
publicly.
Mutual funds must
disclose investment policies,
make shares redeemable at any time,
limit use of leverage
Hedge funds are not subject to these constraints.
Hedge funds use complex trading strategies are big
users of derivatives for hedging, speculation and
arbitrage

61
Types of Hedge Funds
Long/Short Equities
Convertible Arbitrage
Distressed Securities
Emerging Markets
Global Macro
Merger Arbitrage

62