Introduction To Derivatives

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 uasics
Ú ñinance is the study of risk.
Ú How to measure it
Ú How to reduce it
Ú How to allocate it

Ú All finance problems ultimately boil down to three main

questions:
Ú What are the cash flows, and when do they occur?
Ú Who gets the cash flows?
Ú What is the appropriate discount rate for those cash flows?

Ú The difficulty, of course, is that normally none of those

questions have an easy answer.

 uasics
Ú We can generally classify risk as being diversifiable or non-
non-
diversifiable:
Ú Diversifiable ƛ risk that is specific to a specific investment ƛ i.e. the risk
that a single companyƞs stock may go down (i.e. Enron). This is
frequently called m m
m m

Ú ^on--diversifiable ƛ risk that is common to all investing in general and
^on
that cannot be reduced ƛ i.e. the risk that the entire stock market (or
bond market, or real estate market) will crash. This is frequently called
 m m
..
 m m

Ú The market Ơpaysơ you for bearing non-

non-diversifiable risk only ƛ not
for bearing diversifiable risk.
Ú In general the more non-
non-diversifiable risk that you bear, the greater the
expected return to your investment(s).
Ú Many investors fail to properly diversify, and as a result bear more risk
than they have to in order to earn a given level of expected return.

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 uasics
Ú In this sense, we can view the field of finance as being
about two issues:
Ú The elimination of diversifiable risk in portfolios;
Ú The 
m
 of systematic (non-
(non-diversifiable) risk to those
members of society that are most willing to bear it.

Ú Indeed, it is really this second function ƛ the allocation

of systematic risk ƛ that drives rates of return.
Ú The expected rate of return is the Ơpriceơ that the market pays
investors for bearing systematic risk.

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 What is Risk?
Ú The concept of risk is simple.
simple. It is the potential for
change in the price or value of some asset or
commodity.. The meaning of risk is not restricted just to
commodity
the potential for loss.
loss. There is upside risk and there is
downside risk as well.
well.
 What is a { 
Ú To ue cautious or to protect against loss.
loss.
Ú In financial parlance, hedging is the act of reducing uncertainty
about future price movements in a commodity, financial
security or foreign currency .
Ú Thus a hedge is a way of insuring an investment against risk.
risk.
 uasics
Ú A derivative (or derivative security) is a financial
instrument whose value depends upon the value of
other, more basic, underlying variables.

Ú Some common examples include things such as stock

options, futures, and forwards.

-
 uasics

Ú It can also extend to something like a reimbursement

program for college credit. Consider that if your firm
reimburses 100% of costs for an ƠAơ, 75% of costs for a
Ơuơ, 50% for a ƠCơ and 0% for anything less.

Ú Your Ơrightơ to claim this reimbursement, then is tied to

the grade you earn. The value of that reimbursement
plan, therefore, is derived from the grade you earn.

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 uasics
Ú So why do we have derivatives and derivatives markets?

Ú uecause they somehow allow investors to better control the level

of risk that they bear.
Ú They can help eliminate idiosyncratic/peculiar risk.
Ú They can decrease or increase the level of systematic risk.

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 What do derivatives do?
† Derivatives attempt either to mm m  
 arising
from adverse price movements of the underlying asset

† ´r m m  
m arising out of favorable price

fluctuation.. Since derivatives derive their value from the
fluctuation
underlying asset they are called as derivatives.
derivatives.
 Types of Derivatives
(UA: Underlying Asset)
† uased on the underlying assets derivatives are classified
into.

† ñinancial Derivatives (UA: ñin asset)

† Commodity Derivatives (UA: gold etc)
† Index Derivative (uSE sensex)
 How are derivatives used?
Ú Derivatives are basically m
mm instruments
instruments..
Hedging is the most important aspect of derivatives and
also their basic economic purpose.
purpose.

Ú Derivatives can be compared to an insurance policy.

policy. As
one pays premium in advance to an insurance company
in protection against a specific event, similarly the
derivative products have a payoff contingent upon the
occurrence of some event for which he pays premium in
advance..
advance
 uasics
Ú âositions ƛ In general if you are buying an asset ƛ be it
a physical stock or bond, or the right to determine
whether or not you will acquire the asset in the future
(such as through an option or futures contract) you are
said to be ƠL´^ ơ the instrument.
Ú If you are giving up the asset, or giving up the right to
determine whether or not you will own the asset in the
future, you are said to be ƠSH´RTơ the instrument.
Ú In the stock and bond markets, if you Ơshortơ an asset, it means
that you borrow it, sell the asset, and then later buy it back.
Ú In derivatives markets you generally do not have to borrow the
instrument ƛ you can simply take a position (such as writing an
option) that will require you to give up the asset or
determination of ownership of the asset.
Ú Usually in derivatives markets the Ơshortơ is just the negative of
the Ơlongơ position
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 uasics
Ú Commissions ƛ Virtually all transactions in the financial
markets requires some form of commission payment.
Ú The size of the commission depends upon the relative position of
the trader: retail traders pay the most, institutional traders pay
less, market makers pay the least (but still pay to the
exchanges.)
Ú The larger the trade, the smaller the commission is in
percentage terms.
Ú uid-Ask spread ƛ Depending upon whether you are
uid-
buying or selling an instrument, you will get different
prices. If you wish to sell, you will get a ƠuIDơ quote,
and if you wish to buy you will get an ƠASKơ quote.

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 uasics
Ú The difference between the bid and the ask can vary
depending upon whether you are a retail, institutional, or
broker trader; it can also vary if you are placing very
large trades.
Ú In general, however, the bid-
bid-ask spread is relatively
constant for a given customer/position.
Ú The spread is roughly a constant percentage of the
transaction, regardless of the scale ƛ unlike the
commission.
Ú Especially in options trading, the bid-
bid-ask spread is a
much bigger transaction cost than the commission.

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 uasics
Ú Here are some example stock bid-
bid-ask spreads from
8/22/2006:
Ú IuM: uid ƛ 78.77 Ask ƛ 78.79 0.025%
Ú ATT: uid ƛ 30.59 Ask ƛ 30.60 0.033%
Ú Microsoft: uid ƛ 25.73 Ask ƛ 25.74 0.039%
Ú Here are some example option bid-
bid-ask spreads (All with
good volume)
Ú IuM ´ct 85 Call: uid ƛ 2.05 Ask ƛ 2.20 7.3171%
Ú ATT ´ct 15 Call: uid ƛ 0.50 Ask ƛ0.55 10.000%
Ú MSñT ´ct 27.5 : uid ƛ 0.70 Ask ƛ0.80. 14.285%

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 uasics
Ú The point of the preceding slide is to demonstrate that
the bid-
bid-ask spread can be a huge factor in determining
the profitability of a trade.
Ú Many of those option positions require at least a 10% price
movement before the trade is profitable.
Ú Many Ơtrading strategiesơ that you see people propose
(and that are frequently demonstrated using Ơrealơ data)
are based upon using the average of the bid-
bid-ask spread.
They usually lose their effectiveness when the bid-
bid-ask
spread is considered.

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 uasics
Ú Market Efficiency ƛ We normally talk about financial markets as
being efficient information processors.
Ú Markets efficiently incorporate all publicly available information into
financial asset prices.
Ú The mechanism through which this is done is by investors
buying/selling based upon their discovery and analysis of new
information.
Ú The limiting factor in this is the transaction costs associated with the
market.
Ú ñor this reason, it is better to say that financial markets are efficient 
m
 

     .. Some financial economists say that
financial markets are efficient to within the bid-
bid-ask spread.
Ú ^ow, to a large degree for this class we can ignore the bid-bid-ask spread,
but there are some points where it will be particularly relevant, and we
will consider it then.

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 uasics
Ú uefore we begin to examine specific contracts, we need
to consider two additional risks in the market:
Ú Credit risk ƛ the risk that your trading partner might not honor
their obligations.
Ú ñamiliar risk to anybody that has traded on ebay!
Ú enerally exchanges serve to mitigate this risk.
Ú Can also be mitigated by escrow accounts.
Ú Margin requirements are a form of escrow account.
Ú Liquidity risk ƛ the risk that when you need to buy or sell an
instrument you may not be able to find a counterparty.
Ú Can be very common for Ơoutsidersơ in commodities markets.

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 uasics
Ú So now we are going to begin examining the basic
instruments of derivatives. In particular we will look at
(tonight):
Ú ñorwards
Ú ñutures
Ú ´ptions
Ú The purpose of our discussion tonight is to simply
provide a basic understanding of the structure of the
instruments and the basic reasons they might exist.
Ú We will have a more in-in-detail examination of their properties,
and their pricing, in the weeks to come.


 ñorward Contracts
A forward contract is an agreement between two parties to
buy or sell an asset at a certain future time for a certain
future price.
Ú ñorward contracts are normally not exchange traded.
Ú The party that agrees to buy the asset in the future is said to
have the long position.
Ú The party that agrees to sell the asset in the future is said to
have the short position.
Ú The specified future date for the exchange is known as the
delivery (maturity
(maturity)) date.

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 ñorward Contracts
The specified price for the sale is known as the delivery
price, we will denote this as K.
Ú ^ote that K is set such that at initiation of the contract the value
of the forward contract is 0. Thus, by design, no cash changes
hands at time 0. The mechanics of how to do this we cover in
later lectures.
As time progresses the delivery price doesnƞt change, but
the current spot (market) rate does. Thus, the contract
gains (or loses) value over time.
Ú Consider the situation at the maturity date of the contract. If
the spot price is higher than the delivery price, the long party
can buy at K and immediately sell at the spot price ST, making a
profit of (ST-K), whereas the short position could have sold the
asset for ST, but is obligated to sell for K, earning a profit
(negative) of (K-
(K-ST).


 ñorward Contracts
Ú Example:
Ú Letƞs say that you entered into a forward contract to buy wheat
at $4.00/bushel, with delivery in December (thus K=$3.64.)
Ú Letƞs say that the delivery date was December 14 and that on
December 14th the market price of wheat is unlikely to be
exactly $4.00/bushel, but that is the price at which you have
agreed (via the forward contract) to buy your wheat.
Ú If the market price is greater than $4.00/bushel, you are
pleased, because you are able to buy an asset for less than its
market price.
Ú If, however, the market price is less than $4.00/bushel, you are
not pleased because you are paying more than the market price
for the wheat.
Ú Indeed, we can determine your net payoff to the trade by
applying the formula: payoff = ST ƛ K, since you gain an asset
worth ST, but you have to pay $K for it.
Ú We can graph the payoff function:
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 ñorward Contracts
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 ñorward Contracts
Ú Example:
Ú In this example you were the long party, but what about the
short party?
Ú They have agreed to sell wheat to you for $4.00/bushel on
December 14.
Ú Their payoff is positive if the market price of wheat is less than
$4.00/bushel ƛ they force you to pay more for the wheat than
they could sell it for on the open market.
Ú Indeed, you could assume that what they do is buy it on the open
market and then immediately deliver it to you in the forward
contract.
Ú Their payoff is negative, however, if the market price of wheat is
greater than $4.00/bushel.
Ú They could have sold the wheat for more than $4.00/bushel had
they not agreed to sell it to you.
Ú So their payoff function is the mirror image of your payoff
function:

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 ñorward Contracts
Ú Clearly the short position is just the mirror image of the
long position, and, taken together the two positions
cancel each other out:

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Short âosition



Long âosition





  
   
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^et
âosition
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 ñutures Contracts
Ú A futures contract is similar to a forward contract in that it
is an agreement between two parties to buy or sell an
asset at a certain time for a certain price. ñutures,
however, are usually exchange traded and, to facilitate
trading, are usually standardized contracts. This results in
more institutional detail than is the case with forwards.

Ú The long and short party usually do not deal with each
other directly or even know each other for that matter.
The exchange acts as a clearinghouse. As far as the two
sides are concerned they are entering into contracts with
the exchange. In fact, the exchange guarantees
performance of the contract regardless of whether the
other party fails.
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 ñutures Contracts
Ú The largest futures exchanges are the Chicago uoard of
Trade (Cu´T) and the Chicago Mercantile Exchange
(CME).

Ú ñutures are traded on a wide range of commodities and

financial assets.

Ú Usually an exact delivery date is not specified, but rather

a delivery range is specified. The short position has the
option to choose when delivery is made. This is done to
accommodate physical delivery issues.
Ú Harvest dates vary from year to year, transportation schedules
change, etc.

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 ñutures Contracts
Ú The exchange will usually place restrictions and conditions
on futures. These include:
Ú Daily price (change) limits.
Ú ñor commodities, grade requirements.
Ú Delivery method and place.
Ú How the contract is quoted.

Ú ^ote however, that the basic payoffs are the same as for a
forward contract.

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 ´ptions Contracts
Ú ´ptions on stocks were first traded in 1973. That was
the year the famous ulack
ulack--Scholes formula was
published, along with Mertonƞs paper - a set of
academic papers that literally started an industry.
Ú ´ptions exist on virtually anything. Tonight we are
going to focus on general options terminology for
stocks. We will get into other types of options later in
the class.
Ú There are two basic types of options:
Ú A Call option is the right, but not the obligation, to buy the
underlying asset by a certain date for a certain price.
Ú A âut option is the right, but not the obligation, to sell the
underlying asset by a certain date for a certain price.
Ú ^ote that unlike a forward or futures contract, the holder of the
options contract does not have to do anything - they have the
option to do it or not.

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 ´ptions Contracts
Ú The date when the option expires is known as the
exercise date, the expiration date, or the maturity date.
Ú The price at which the asset can be purchased or sold is
known as the strike price.
Ú If an option is said to be European, it means that the
holder of the option can buy or sell (depending on if it is
a call or a put) only on the maturity date. If the option is
said to be an American style option, the holder can
exercise on any date up to and including the exercise
date.
Ú An options contract is always costly to enter as the long
party. The short party always is always paid to enter into
the contract
Ú Looking at the payoff diagrams you can see whyƦ

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 ´ptions Contracts
Ú Letƞs say that you entered into a call option on IuM
stock:
Ú Today IuM is selling for roughly $78.80/share, so letƞs say you
entered into a call option that would let you buy IuM stock in
December at a price of $80/share.
Ú If in December the market price of IuM were greater than $80,
you would exercise your option, and purchase the IuM share for
$80.
Ú If, in December IuM stock were selling for less than $80/share,
you could buy the stock for less by buying it in the open market,
so you would not exercise your option.
Ú Thus your payoff to the option is $0 if the IuM stock is less than $80
Ú It is (ST-K) if IuM stock is worth more than $80
Ú Thus, your payoff diagram is:

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 ´ptions Contracts
Ú What if you had the short position?
Ú Well, after you enter into the contract, you have  the
option to the long-
long-party.
Ú If they want to exercise the option, you have to do so.
Ú ´f course, they will only exercise the option when it is in there
best interest to do so ƛ that is, when the strike price is lower
than the market price of the stock.
Ú So if the stock price is less than the strike price (ST<K), then the
long party will just buy the stock in the market, and so the option
will expire, and you will receive $0 at maturity.
Ú If the stock price is more than the strike price (ST>K), however,
then the long party will exercise their option and you will have to
sell them an asset that is worth ST for $K.
Ú We can thus write your payoff as:
payoff = min(0,ST-K),
which has a graph that looks like:

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 ´ptions Contracts
Ú This is obviously the mirror image of the long position.
Ú ^otice, however, that at maturity, the short option
position can ^EVER have a positive payout ƛ the best
that can happen is that they get $0.
Ú This is why the short option party always demands an up-
up-front
payment ƛ itƞs the only payment they are going to receive. This
payment is called the option  m or price.

Ú ´nce again, the two positions Ơnet outơ to zero:

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 ´ptions Contracts
Ú Recall that a put option grants the long party the right to
sell the underlying at price K.
Ú Returning to our IuM example, if K=80, the long party
will only elect to exercise the option if the price of the
stock in the market is less than $80, otherwise they
would just sell it in the market.
Ú The payoff to the holder of the long put position,
therefore is simply
payoff = max(0, K-K-ST)

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 ´ptions Contracts
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 ´ptions Contracts
Ú The short position again has granted the option to the
long position. The short has to buy the stock at price K,
when the long party wants them to do so. ´f course the
long party will only do this when the stock price is less
than the strike price.
Ú Thus, the payoff function for the short put position is:
payoff = min(0, ST-K)

Ú And the payoff diagram looks like:

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 ´ptions Contracts
Ú Since the short put party can never receive a positive
payout at maturity, they demand a payment up-up-front
from the long party ƛ that is, they demand that the long
party pay a  m to induce them to enter into the
contract.

Ú ´nce again, the short and long positions net out to zero:
when one party wins, the other loses.

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 ´ptions Contracts
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 ´ptions Contracts
Ú The standard options contract is for 100 units of the
underlying. Thus if the option is selling for $5, you
would have to enter into a contract for 100 of the
underlying stock, and thus the cost of entering would
be $500.
Ú ñor a European call, the payoff to the option is:
Ú Max(0,ST-K)
Ú ñor a European put it is
Ú Max(0,K--ST)
Max(0,K
Ú The short positions are just the negative of these:
Ú Short call: -Max(0,ST-K) = Min(0,K-
Min(0,K-ST)
Ú Short put: -Max(0,K-
Max(0,K-ST) = Min(0,ST-K)

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 ´ptions Contracts
Ú Traders frequently refer to an option as being Ơin the
moneyơ, Ơout of the moneyơ or Ơat the moneyơ.
Ú An Ơin the moneyơ option means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would receive a payout.
Ú ñor a call option this means that St>K
Ú ñor a put option this means that St<K
Ú An Ơat the moneyơ option means one where the strike and
exercise prices are the same.
Ú An Ơout of the moneyơ option means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would ^´T receive a payout.
Ú ñor a call option this means that St<K
Ú ñor a put option this means that St>K.

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 ´ptions Contracts
Ú ´ne interesting notion is to look at the payoff from just
owning the stock ƛ its value is simply the value of the
stock:

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 ´ptions Contracts
Ú What is interesting is if we compare the payout from a
portfolio containing a short put and a long call with the
payout from just owning the stock:

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 ´ptions Contracts
Ú ^otice how the payoff to the options portfolio has the
same shape and slope as the stock position ƛ just offset
by some amount?

Ú This is hinting at one of the most important relationships

in options theory ƛ âut
âut--Call parity.

Ú It may be easier to see this if we examine the aggregate

position of the options portfolio:

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 ´ptions Contracts
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 ´ptions Contracts
Ú We will come back to put-
put-call parity in a few weeks, but
it is well worth keeping this diagram in mind.

Ú So who trades options contracts? enerally there are

three types of options traders:
Ú Hedgers - these are firms that face a business risk. They wish
to get rid of this uncertainty using a derivative. ñor example, an
airline might use a derivatives contract to hedge the risk that jet
fuel prices might change.
Ú Speculators - They want to take a bet (position) in the market
and simply want to be in place to capture expected up or down
movements.
Ú Arbitrageurs - They are looking for imperfections in the capital
market.
 ñinancial Engineering
Ú When we start examining the actual pricing of
derivatives (next week), one of the fundamental ideas
that we will use is the Ơlaw of one priceơ.
Ú uasically this says that if two portfolios offer the same
cash flows in all potential states of the world, then the
two portfolios must sell for the same price in the market
ƛ regardless of the instruments contained in the
portfolios.
Ú This is only true to Ơwithin transactions costsơ, i.e. the bid-
bid-ask
spread on each individual instrument.
Ú Sometimes one portfolio will have such lower transactions costs
that the law will only approximately hold.

 ñinancial Engineering
Ú ñinancial engineering is the notion that you can use a
combination of assets and financial derivatives to
construct cash flow streams that would otherwise be
difficult or impossible to obtain.
Ú ñinancial engineering can be used to Ơbreak apartơ a set
of cash flows into component pieces that each have
different risks and that can be sold to different investors.
Ú Collateralized uond ´bligations do this for Ơjunkơ bonds.
Ú Collateralized Mortgage ´bligations do this for residential
mortgages.
Ú ñinancial engineering can also be used to create cash
flows streams that would otherwise be difficult to obtain.

-
 ñinancial Engineering
Ú The Schwab/ñirst Union equity-
equity-linked CD is a good
example of financial engineering.
Ú When it was issued (in 1999), the stock market was
(and had been) incredibly Ơhotơ for several years.
Ú Many investors wanted to be in the market, but did not want to
risk the market going down in value.
Ú The equity-
equity-linked CD was designed to meet this need.
Ú As we will demonstrate, an investor could Ơroll their ownơ
version of this, but in doing so would have incurred significant
transaction costs.
Ú âlus, many small investors (to whom this was targeted) probably
could not get approval to trade options.

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 ñinancial Engineering
Ú The Contract:
Ú An investor buys the CD (Certificate of Deposit) today, and then earns
70% of the simple rate of return on S&â 500 index over the next 5.5
years.
Ú If the S&â index ended up below the initial index level (so that the
appreciation was negative), then the investor received their full initial
investment back, but nothing else.
Ú Thus, the payoff to the CD was simply:

Ã

* * 
º

   
 
    
   





Ú So letƞs say that you invested $10,000, and that in June of 1999 the
index was 1300 (so that you were, in essence, buying $10,000/1,300 or
7.69 units of the index).

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 ñinancial Engineering
Ú In 5.5 years your payoff will be based upon the index
level. âotential index levels and payoffs include:
Index Simple Rate of Return Cash Received
1000 - 23.07% $10,000
1200 - 7.69% $10,000
1300 0.00% $10,000
1400 7.69% $10,538
1500 15.38% $11,076
2000 53.85% $13,769
(^ote that on 12/30/2004 the S&â 500 was at 1211.92!)
Ú The following chart demonstrates the payouts.


 ñinancial Engineering
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 ñinancial Engineering
Ú ^ow, the first thing about that chart that you should
notice is that it looks an awful lot like the shape of a call
option, although the slope of the upward-
upward-sloping part is
not as steep.
Ú This is our first indication that we may be able to
decompose this into two simpler securities.
Ú Indeed, one way of decomposing this security would be
to assume that we bought a bond that paid $10,000 at
time 5.5, and that we bought 5.38 call options with a
strike of 1300 (70% of 10,000/1300.)
Ú The next graph demonstrates this positionƞs payoff.


 ñinancial Engineering
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 ñinancial Engineering
Ú This position is ALS´ identical to a position consisting of:
Ú $10,000/1300 = 7.692 units of the index.
Ú $10,000/1300 = 7.692 put options on the index (K=1300)
Ú (-(1
(1--.7)*$10,000/1300 = -2.30769) CALL options on the index.

Ú The reason for the short call options is because the CD

only gives us 70% of the return on the index, so we
have to sell back some of that return via the call option
(note that we will earn a premium for this.)

Ú The following chart shows this:

Ñ
 ñinancial Engineering
ù
+
 ) ù
   

üüü

üüüü

üüü
 




 

üüüü
 
 


üüü

ü
ü üü üüü üü üüü üü
üüü
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 ñinancial Engineering
Ú ^ow, all three of these 
 sell for the same price ƛ but there
will be some differences because of transactions costs.
Ú Really, this is why the Schwab equity-
equity-linked CD can work: investors
(retail investors) are willing to turn to the Ơprepackagedơ asset to
avoid transaction costs (and to avoid timing difficulties with
unwinding their position.)
Ú Letƞs just think of this as a bond and .7 long call options for a
moment.
Ú Clearly the call cannot be free, since the investor holds this
option they must pay something for it. How much do they pay?
Ú The interest that they could have earned on this money had they
invested in a traditional CD.
Ú At that time 5.5 year CDs were yielding 6%, so the investor Ơgives
upơ $3,777 dollars in year 5.5 dollars.

 





* *  ß 







 ñinancial Engineering
Ú The equity-
equity-linked CD is just one example of financial
engineering ƛ the notion that investors are really just
purchasing potential future cash flows and that any two
sets of identical potential future cash flows must sell for
the same price.

Ú This has led to a real revolution in finance, and we will

discuss this idea throughout the semester.

Ú We will return to options pricing later in the semester.

^ext, we turn our attention to the futures/forwards
markets and pricing.

-