Chapter 1

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Introduction to
Derivatives

Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 2

Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 3

Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 4
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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
A derivative instrument is a contract between two parties that
specifies conditions (especially the dates, resulting values of the
underlying variables, and notional amounts) under which
payments are to be made between the parties. Ex, An SBI stock
option is a derivative because its value depends on the price of
SBI stock
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Forward Price
1. The forward price for a contract is the delivery
price that would be applicable to the contract if
were negotiated today
2. The forward price may be different for contracts
of different maturities
3. The party that has agreed to buy has what is
termed a long position
4. The party that has agreed to sell has what is
termed a short position
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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? If pound appreciate to 2.05 or
depreciate to 2.039
If you plan to grow 500 bushels of wheat next year, you could sell your
wheat for whatever the price is when you harvest it, or you could lock
in a price now by selling a forward contract that obligates you to sell
500 bushels of wheat to, say, Mr A after the harvest for a fixed price.
By locking in the price now, you eliminate the risk of falling wheat
prices. On the other hand, if prices rise later, you will get only what
your contract entitles you to.
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Profit from a
Long Forward Position
Profit
Price of Underlying
at Maturity, S
T
K
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Profit from a
Short Forward Position
Profit
Price of Underlying
at Maturity, S
T
K
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Futures Contracts
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.
Maturity date, contract size ,strike price all
are fixed in advance.

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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)
NSE/BSE(India)

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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)
Buyers of Call
Sellers of Call
Buyers of Put
Sellers of Put

Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 14
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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

Stock Price
Strike Price
Value of Option
Contract Lot
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Exchanges Trading Options
Chicago Board Options Exchange
American Stock Exchange-NASDAQ
Philadelphia Stock Exchange
Pacific Exchange
LIFFE (London)
Eurex (Europe)
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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
Facts: 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 using future
Company A: must pay 1 million pound in Sept for
imports from Britain
Company B: will receive 3 million pound in Sept
from Exports to Britain
Quotes:
Current exchange Rate $1.6920= 1pound
September Future price $ 1.6850= 1 pound
Size of Future contract: pound 62,500

Company A hedging strategy?
Company B hedging strategy?

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Hedging using options
An investor owns 500 IBM shares and wants
protection against possible decline in the share
price over the next two months.
Quotes:
Current IBM share= $52
IBM October 50 put= $4
Size of Put: 100 shares

The Investors strategy if price fall below or above
52?
Outcome?

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Speculation using future
An investor feels that sterling with strengthen
relative to the US dollar over the next two months
and would like to take a speculative position
Quotes:
Current exchange Rate $1.6470= 1pound
April Future price $ 1.6410= 1 pound
Size of Future contract: pound 62,500

Investor speculative strategy if exchange rate is
1.7000 or 1.6000?
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Speculation using options
A speculator with $7,800 to invest thinks that the
price of Exxon will increase in the next three
months and has obtained the following quotes:
Quotes:
Current stock price= $78
Exxon December call with an $80 strike price =
$3
The speculator has $ 7800 to invest

Investor speculative strategy of price $90 or $70?

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Arbitration
A stock is traded on both the New York Stock
Exchange and LSE.
Quotes:
New York SE= $172 per share
LSE = pound 100 per share
Value of 1 pound= $1.7500

Investor arbitrage strategy?
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Welcome to Derivatives