Derivatives (ECONM3017)

Lecture One: An Introduction

Nick Taylor
nick.taylor@bristol.ac.uk

University of Bristol

Derivatives Lecture One 1 / 22

Table of contents

1 Learning Outcomes
2 General Information
3 Forward Contracts
4 Futures Contracts
5 Swaps
6 Options
7 Trader Types
8 Summary
9 Reading

Derivatives Lecture One 2 / 22

Learning Outcomes

At the end of this lecture you will be able to:

1 Define a derivative.
2 Distinguish between derivative types and markets.
3 Understand basic derivative-related terminology.
4 Classify the users of derivatives, and motivate their reasons for using
derivatives.

Derivatives Lecture One 3 / 22

General Information

Definition
A derivative security (also known as a contingent claim) is a security
whose value is contingent (dependent) on the value of another (more
basic) underlying asset.

Derivatives Lecture One 4 / 22

General Information (cont.)

Market Types
Exchange-traded markets, and over-the-counter (OTC) markets.
Trading Mechanisms
Open-outcry, and electronic trading.
Main Derivative Securities
Forwards/futures, swaps, and options.
Main Derivative Uses
Hedging, speculation (leverage), and arbitrage.

Derivatives Lecture One 5 / 22

Forward Contracts

Definition
A forward contract is an agreement between two parties to buy or sell a
specified amount of a specified asset at a specified future date for a
specified price, where both parties are obliged to honour the contract. All
forward contracts are traded OTC.

Derivatives Lecture One 6 / 22

Forward Contracts (cont.)

Key Terminology
Long Position: the party who agrees to buy the specified asset holds a
long position.
Short Position: the party who agrees to sell the specified asset holds a
short position.
Notation
K is the delivery price
ST is the spot price (of the underlying asset) at the maturity of the
contract.
Payoffs
Long position payoff is: ST K ;
Short position payoff is: K ST ;

Derivatives Lecture One 7 / 22

Forward Contracts (cont.)

Payoffs (cont.)
Payoff 6

-
K ST

Long Position

Derivatives Lecture One 8 / 22

Futures Contracts

Definition
A futures contract is an agreement between two parties to buy or sell a
specified amount of a specified asset at a specified future date for a
specified price, where both parties are obliged to honour the contract.

Note that unlike a forward contract a

futures contract is normally traded on
an exchange. The exchange specifies
certain standardised features of the
contract and also provides a
mechanism which gives the two
parties a guarantee that the contract
will be honoured.

Derivatives Lecture One 9 / 22

Futures Contracts (cont.)

Payoffs
As with forward contracts.
Main Markets
The main markets around the world are: the Chicago Board of Trade
(CBOT, www.cbot.com); the Chicago Mercantile Exchange (CME,
www.cme.com); Euronext (www.euronext.com); Eurex
(www.eurexchange.com); Bolsa de Mercadorias & Futuros
(www.bmf.com.br); the Tokyo International Financial Futures Exchange
(www.tiffe.or.jp); the Singapore International Monetary Exchange
(www.sgx.com); and the Sydney Futures Exchange (www.sfe.com.au).

Derivatives Lecture One 10 / 22

Swaps

Definition
A swap is an agreement between two parties (companies) to exchange
cash flows in the future. (All swaps are traded OTC).

Derivatives Lecture One 11 / 22

Swaps (cont.)

Types
Interest Rate Swaps: a company agrees to pay cash flows equal to
interest at a predetermined fixed rate on a notional principal for a
number of years, in exchange for interest at a floating rate on the same
notional principal for the same period of time.
Currency Swaps: a company exchanges principal and interest payments
on one currency for principal and interest payments in another.
Credit Default Swaps: a company makes regular payments until a
default occurs. At this point, the company obtains the right to sell
bonds issued by the company at face value.

Derivatives Lecture One 12 / 22

Options

Definition
A European Call Option gives the owner the right (not the obligation) to
buy a given number of a specified underlying asset at a specified price
(exercise or strike price) at the expiration date (at maturity).

Definition
A European Put Option gives the owner the right (not the obligation) to
sell a given number of a specified underlying asset at a specified price
(exercise or strike price) at the expiration date (at maturity).

In the case of American options the

owner can exercise at any time prior
to maturity. For all these options, the
option price (or premium) is paid
upon entering the contract.

Derivatives Lecture One 13 / 22

Options (cont.)

Notation
K is the (pre-specified) strike price.
ST is the spot price (of the underlying asset) at the maturity of the
contract.
Payoffs
Long call position payoff is: max(ST K , 0);
Short call position payoff is: max(ST K , 0) = min(K ST , 0);
Long put position payoff is: max(K ST , 0);
Short put position payoff is: max(K ST , 0) = min(ST K , 0);

Derivatives Lecture One 14 / 22

Options (cont.)

Payoffs (cont.)

Payoff 6 Payoff 6

- K -
K ST @ ST
@
@
@
@
@
Long Position in Call Option Short Position in Call Option

Derivatives Lecture One 15 / 22

Options (cont.)

Payoffs (cont.)

Payoff 6 Payoff 6
@
@
@
@
@
@ - K -
K ST ST

Long Position in Put Option Short Position in Put Option

Derivatives Lecture One 16 / 22

Options (cont.)

Main Markets
The main stock options markets are: the Chicago Board Options Exchange
(www.cboe.com); the Philadelphia Stock Exchange (www.phlx.com); the
American Stock Exchange (www.amex.com); the International Securities
Exchange (www.iseoptions.com); the Boston Options Exchange
(www.bostonoptions.com); Eurex (www.eurexchange.com); and Euronext
(www.euronext.com).
Note that a large number options
contracts are OTC traded (primarily
foreign exchange options and exotic
options).

Derivatives Lecture One 17 / 22

Trader Types

Hedgers
These traders try to reduce their exposure to risk. This can be achieved via
forward (or futures) contracts or options.

Example
An investor owns 1000 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.

Derivatives Lecture One 18 / 22

Trader Types (cont.)

Speculators
These traders take a position in the market, betting that the asset price will
go up or down.

Example
An investor with $2000 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. Two strategies are considered: the first
involves buying 100 shares, and the second involves buying 2000 call options.
Stock Price in 2 months
Action $15 $27
Buy 100 Shares $500 $700
Buy 2000 Call Options $2000 $7000

Derivatives Lecture One 19 / 22

Trader Types (cont.)

Arbitrageurs
These traders lock into riskless profit by simultaneously entering into
transactions in two or more markets.
Example
Suppose the spot price of gold is $900, the 1-year forward price of gold is $900,
and the 1-year US interest rate is 5% per annum. This presents an arbitrage
opportunity.
Terminal Value
Action Initial Value ST 900 ST > 900
Short Gold 900 ST ST
Long Forward 0 ST 900 ST 900
Lend 900 900e 0.05 900e 0.05
Total 0 900e 0.05 900 > 0 900e 0.05 900 > 0

Derivatives Lecture One 20 / 22

Summary

Derivative Types
Forwards, futures, swaps, and options.
Trader Types
Hedgers, speculators, and arbitrageurs.
Some Terminology
Long v. short positions, etc.

Derivatives Lecture One 21 / 22

Reading

Essential Reading
Chapters 1 and 2, Hull (2015).
Recommended Reading
Hull, J, 2014, The changing landscape for derivatives, SSRN Working Paper.

Derivatives Lecture One 22 / 22