Introduction

Chapter 1

Derivates- Definition
A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables. Very often the variables underlying derivatives are the prices of traded assets. A stock option, for example, is a derivative whose value is dependent on the price of a stock. Depending on the type of relationship they can broadly be classified into two categories: Linear Non-Linear instruments 2

Derivates- Definition
Linear Instruments (payoffs): refers to forward contracts, futures and swaps. These are obligations to exchange payments according to specified schedule. 2. Non-Linear Instruments (payoffs): refers to options, their value is non-linear function of the underlying assets.
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Derivates are financial contract traded in private over the counter (OTC) markets or on organized exchanges.
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Size of OTC and Exchange-Traded Markets

(Figure 1.1, Page 3)
550 500 450 400 350 300 250 200 150 100 50 0 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

Size of Market ($ trillion)

OTC Exchange

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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Ways 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

Foreign Exchange Quotes for GBP, July 20, 2007 (See page 4)
Bid 2.0558 2.0547 Offer 2.0562 2.0552

Spot 1-month forward

3-month forward
6-month forward

2.0526
2.0483

2.0531
2.0489

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

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

Example (page 4)
On July 20, 2007 the treasurer of a corporation enters into a long forward contract to buy 1 million in six months at an exchange rate of 2.0489 This obligates the corporation to pay $2,048,900 for 1 million on January 20, 2008 What are the possible outcomes?

Profit from a Long Forward Position

Profit

Price of Underlying at Maturity, ST

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Profit from a Short Forward Position

Profit

Price of Underlying at Maturity, ST

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Futures Contracts (page 6)

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

Chicago Board of Trade Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) 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$900/oz. in December (NYMEX) Sell 62,500 @ 2.0500 US$/ in March (CME) Sell 1,000 bbl. of oil @ US$120/bbl. in April (NYMEX)

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1. Gold: An Arbitrage Opportunity?

Suppose that: The spot price of gold is US$900 The 1-year forward price of gold is US$1,020 The 1-year US$ 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$900 - The 1-year forward price of gold is US$900 - The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?

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The Forward Price of Gold

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 = 900, T = 1, and r =0.05 so that F = 900(1+0.05) = 945
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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 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)

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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); See Table 1.2 page 7; Source: CBOE

Strike Price
15.00 17.50 20.00 22.50 25.00

Oct Call
4.650 2.300 0.575 0.075 0.025

Jan Call
4.950 2.775 1.175 0.375 0.125

Apr Call
5.150 3.150 1.650 0.725 0.275

Oct Put
0.025 0.125 0.875 2.950 5.450

Jan Put
0.150 0.475 1.375 3.100 5.450

Apr Put
0.275 0.725 1.700 3.300 5.450

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Exchanges Trading Options

Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) and many more (see list at end of book)

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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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Buy one Jan Call option contract at a Strike price of $20. What could be the possible outcomes?

Sell one Oct Put option contract at a Strike price of $22.50. What could be the possible outcomes?

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Four type of participants in the option market:

Buyers of calls Sellers of calls Buyers of puts Sellers of puts

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Types of Traders
Hedgers
Speculators Arbitrageurs
Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators

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Hedging Examples (pages 10-11)

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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Hedging being done using Forwards OR Option contracts- A Comparison

Forward contracts are designed to neutralize risk by fixing the price that hedger will pay or receive for the underlying assets. Option contract by contrast provide insurance.

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Value of Microsoft Shares with and without Hedging (Fig 1.4, page 11)
40,000 Value of Holding ($) 35,000
No Hedging

30,000

Hedging

25,000 Stock Price ($) 20,000 20 25 30 35 40

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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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Speculation being done using Future OR Option contracts- A Comparison

Future and options are similar instruments for speculators in that they both provide a way in which type of leverage can be obtained. Using future position the potential loss and potential loss is very large. When options are used, the speculators loss is limited to the amount paid for entering the option.

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Arbitrage Example
A stock price is quoted as 100 in London and $200 in New York The current exchange rate is 2.0300 What is the arbitrage opportunity?

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Questions:
It is May and a trader writes a September call option with a strike price of $20. the stock price is $18 and the option price is $2. Describe the traders cash flow if the option is held until September and the stock price is $25 at that time? A trader writes a December put option with a strike of price of $30. the price of option is $4. under what circumstances does a trader make a gain?

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