Topic 1 Introduction To Derivatives

Basics


This first lecture has four main goals:

1.

Introduce you to the notion of risk and the role of derivatives in managing risk.


Discuss some of the general terms such as short/long positions, bidbid-ask spread from finance that we need.

2.

Introduce you to three major classes of derivative securities.

  

Forwards Futures Options

3.

Introduce you to the basic viewpoint needed to analyze these securities. Introduce you to the major traders of these instruments.
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4.

Basics


Finance is the study of risk.

  

How to measure it How to reduce it How to allocate it

All finance problems ultimately boil down to three main questions:

  

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

The difficulty, of course, is that normally none of those questions have an easy answer.
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Basics


As you know from other classes, we can generally classify risk as being diversifiable or non-diversifiable: non

Diversifiable risk that is specific to a specific investment i.e. the risk that a single company s stock may go down (i.e. Enron). This is frequently called idiosyncratic risk. NonNon-diversifiable risk that is common to all investing in general and that cannot be reduced i.e. the risk that the entire stock market (or bond market, or real estate market) will crash. This is frequently called systematic risk. risk.

The market pays you for bearing non-diversifiable risk only nonfor bearing diversifiable risk.


not

In general the more non-diversifiable risk that you bear, the greater the nonexpected return to your investment(s). 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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Basics


In this sense, we can view the field of finance as being about two issues:
 

The elimination of diversifiable risk in portfolios; The allocation of systematic (non-diversifiable) risk to those (nonmembers of society that are most willing to bear it.

Indeed, it is really this second function the allocation of systematic risk that drives rates of return.


The expected rate of return is the price that the market pays investors for bearing systematic risk.

Basics


A derivative (or derivative security) is a financial instrument whose value depends upon the value of other, more basic, underlying variables. Some common examples include things such as stock options, futures, and forwards. It can also extend to something like a reimbursement program for college credit. Consider that if your firm reimburses 100% of costs for an A , 75% of costs for a B , 50% for a C and 0% for anything less.
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Basics


Your right 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. We also say that the value is contingent upon the grade you earn. Thus, your claim for reimbursement is a contingent claim. The terms contingent claims and derivatives are used interchangeably.

Basics


So why do we have derivatives and derivatives markets?



 

Because they somehow allow investors to better control the level of risk that they bear. They can help eliminate idiosyncratic risk. They can decrease or increase the level of systematic risk.

A First Example


There is a neat example from the bond-world of a bondderivative that is used to move non-diversifiable risk nonfrom one set of investors to another set that are, presumably, more willing to bear that risk. Disney wanted to open a theme park in Tokyo, but did not want to have the shareholders bear the risk of an earthquake destroying the park.


They financed the park through the issuance of earthquake bonds. If an earthquake of at least 7.5 hit within 10 km of the park, the bonds did not have to be repaid, and there was a sliding scale for smaller quakes and for larger ones that were located further away from the park.
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A First Example


Normally this could have been handled in the insurance (and re-insurance) markets, but there would have been retransaction costs involved. By placing the risk directly upon the bondholders Disney was able to avoid those transactions costs.


Presumably the bondholders of the Disney bonds are basically the same investors that would have been holding the stock or bonds of the insurance/reinsurance companies. Although the risk of earthquake is not diversifiable to the park, it could be to Disney shareholders, so this does beg the question of why buy the insurance at all.

This was not a free insurance. Disney paid LIBOR+310 on the bond. If the earthquake provision was not it there, they would have paid a lower rate.
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A First Example


This example illustrates an interesting notion that insurance contracts (for property insurance) are really derivatives! They allow the owner of the asset to sell the insured asset to the insurer in the event of a disaster. They are like put options (more on this later.)

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Basics


Positions In general if you are buying an asset 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 LONG the instrument. 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 SHORT the instrument.


In the stock and bond markets, if you short an asset, it means that you borrow it, sell the asset, and then later buy it back. In derivatives markets you generally do not have to borrow the instrument 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. Usually in derivatives markets the short is just the negative of the long position
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Basics


Commissions Virtually all transactions in the financial markets requires some form of commission payment.


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.) The larger the trade, the smaller the commission is in percentage terms.

BidBid-Ask spread Depending upon whether you are buying or selling an instrument, you will get different prices. If you wish to sell, you will get a BID quote, and if you wish to buy you will get an ASK quote.
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Basics


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. In general, however, the bid-ask spread is relatively bidconstant for a given customer/position. The spread is roughly a constant percentage of the transaction, regardless of the scale unlike the commission. Especially in options trading, the bid-ask spread is a bidmuch bigger transaction cost than the commission.
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Basics


Here are some example stock bid-ask spreads from bid8/22/2006:

  

IBM: ATT: Microsoft:

Bid Bid Bid

78.77 30.59 25.73

Ask Ask Ask

78.79 30.60 25.74

0.025% 0.033% 0.039%

Here are some example option bid-ask spreads (All with bidgood volume)
  

IBM Oct 85 Call: ATT Oct 15 Call: MSFT Oct 27.5 :

Bid Bid Bid

2.05 0.50 0.70

Ask 2.20 Ask 0.55 Ask 0.80.

7.3171% 10.000% 14.285%

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Basics


The point of the preceding slide is to demonstrate that the bid-ask spread can be a huge factor in determining bidthe profitability of a trade.


Many of those option positions require at least a 10% price movement before the trade is profitable.

Many trading strategies that you see people propose (and that are frequently demonstrated using real data) are based upon using the average of the bid-ask spread. bidThey usually lose their effectiveness when the bid-ask bidspread is considered.

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Basics


Market Efficiency We normally talk about financial markets as being efficient information processors.


Markets efficiently incorporate all publicly available information into financial asset prices. The mechanism through which this is done is by investors buying/selling based upon their discovery and analysis of new information. The limiting factor in this is the transaction costs associated with the market. For this reason, it is better to say that financial markets are efficient to within transactions costs. Some financial economists say that costs. financial markets are efficient to within the bid-ask spread. bidNow, to a large degree for this class we can ignore the bid-ask spread, bidbut there are some points where it will be particularly relevant, and we will consider it then.
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Basics


Before we begin to examine specific contracts, we need to consider two additional risks in the market:


Credit risk the risk that your trading partner might not honor their obligations.
  

Familiar risk to anybody that has traded on ebay! Generally exchanges serve to mitigate this risk. Can also be mitigated by escrow accounts.


Margin requirements are a form of escrow account.

Liquidity risk the risk that when you need to buy or sell an instrument you may not be able to find a counterparty.


Can be very common for outsiders in commodities markets.

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Basics


So now we are going to begin examining the basic instruments of derivatives. In particular we will look at (tonight):
  

Forwards Futures Options

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.


We will have a more in-detail examination of their properties, inand their pricing, in the weeks to come.

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Forward 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.
 

Forward contracts are normally not exchange traded. The party that agrees to buy the asset in the future is said to have the long position. The party that agrees to sell the asset in the future is said to have the short position. The specified future date for the exchange is known as the delivery (maturity) date. (maturity)

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Forward Contracts
The specified price for the sale is known as the delivery price, we will denote this as K.


Note 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 doesn t change, but the current spot (market) rate does. Thus, the contract gains (or loses) value over time.


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-ST). (K-

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Forward Contracts


Example:


Let s say that you entered into a forward contract to buy wheat at $4.00/bushel, with delivery in December (thus K=$3.64.) Let s 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. 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. 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. Indeed, we can determine your net payoff to the trade by applying the formula: payoff = ST K, since you gain an asset worth ST, but you have to pay $K for it. We can graph the payoff function:
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Forward Contracts
Payoff to Futures Position on Wheat Where the Delivery Price (K) is $4.00/Bushel
4 3 Payoff to Forwards 2 1 0 0 -1 -2 -3 -4 Wheat Market (Spot) Price, December 14 1 2 3 4 5 6 7 8

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Forward Contracts


Example:


In this example you were the long party, but what about the short party? They have agreed to sell wheat to you for $4.00/bushel on December 14. Their payoff is positive if the market price of wheat is less than $4.00/bushel they force you to pay more for the wheat than they could sell it for on the open market.


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.

Their payoff is negative, however, if the market price of wheat is greater than $4.00/bushel.


They could have sold the wheat for more than $4.00/bushel had they not agreed to sell it to you.

So their payoff function is the mirror image of your payoff function:

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Forward Contracts
Payoff to Short Futures Position on Wheat Where the Delivery Price (K) is $4.00/Bushel
4 3 Payoff to Forwards 2 1 0 0 -1 -2 -3 -4 Wheat Market (Spot) Price, December 14 1 2 3 4 5 6 7 8

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Forward Contracts


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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Forward Contracts
Long and Short Positions in a Forward Contract For Wheat at $4.00/Bushel
4 3 2 1 Payoff 0 0 -1 -2 -3 -4 Wheat Price 1 2 3 4 5 6 7 8

Short Position Long Position

Net Position

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Futures Contracts


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. Futures, 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. 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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Futures Contracts


The largest futures exchanges are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). Futures are traded on a wide range of commodities and financial assets. 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.


Harvest dates vary from year to year, transportation schedules change, etc.
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Futures Contracts


The exchange will usually place restrictions and conditions on futures. These include:
   

Daily price (change) limits. For commodities, grade requirements. Delivery method and place. How the contract is quoted.

Note however, that the basic payoffs are the same as for a forward contract.

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Options Contracts


Options on stocks were first traded in 1973. That was the year the famous Black-Scholes formula was Blackpublished, along with Merton s paper - a set of academic papers that literally started an industry. Options 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. There are two basic types of options:


A Call option is the right, but not the obligation, to buy the underlying asset by a certain date for a certain price. A Put option is the right, but not the obligation, to sell the underlying asset by a certain date for a certain price.


Note 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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Options Contracts
 

The date when the option expires is known as the exercise date, the expiration date, or the maturity date. The price at which the asset can be purchased or sold is known as the strike price. 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. An options contract is always costly to enter as the long party. The short party always is always paid to enter into the contract


Looking at the payoff diagrams you can see why

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Options Contracts


Let s say that you entered into a call option on IBM stock:


Today IBM is selling for roughly $78.80/share, so let s say you entered into a call option that would let you buy IBM stock in December at a price of $80/share. If in December the market price of IBM were greater than $80, you would exercise your option, and purchase the IBM share for $80. If, in December IBM 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.
 

Thus your payoff to the option is $0 if the IBM stock is less than $80 It is (ST-K) if IBM stock is worth more than $80

Thus, your payoff diagram is:

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Options Contracts
Long Call on IBM with Strike Price (K) = $80
80 60

Pa yoff

40 20 0 0 -20 IBM Terminal Stock Price

T

20

40

60

K =80

100

120

140

160

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Options Contracts
 

 

What if you had the short position? Well, after you enter into the contract, you have granted the option to the long-party. longIf they want to exercise the option, you have to do so. Of course, they will only exercise the option when it is in there best interest to do so that is, when the strike price is lower than the market price of the stock.


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. 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.

We can thus write your payoff as:

payoff = min(0,ST-K), which has a graph that looks like:
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Options Contracts
Short Call Position on IBM Stock with Strike Price (K) = $80
21.25

Pa yoff to Short Position

0 0 -21.25 20 40 60 80 100 120 140 160

-42.5

-63.75

-85 Ending Stock Price

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Options Contracts
 

This is obviously the mirror image of the long position. Notice, however, that at maturity, the short option position can NEVER have a positive payout the best that can happen is that they get $0.


This is why the short option party always demands an up-front uppayment it s the only payment they are going to receive. This payment is called the option premium or price.

Once again, the two positions net out to zero:

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Options Contracts
Long and Short Call Options on IBM with Strike Prices of $80
100 80 60 40 Payoff 20 0 -20 0 -40 -60 -80 -100 Ending Stock Price

Long Call Net Position

20 40 60 80 100 120 140 160

Short Call

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Options Contracts
 

Recall that a put option grants the long party the right to sell the underlying at price K. Returning to our IBM 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. The payoff to the holder of the long put position, therefore is simply payoff = max(0, K-ST) K-

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Options Contracts
Payoff to Long Put Option on IBM with Strike Price of $80
80 70 60 50 Pa yoff 40 30 20 10 0 -10 0 20 40 60 80 100 120 140 160

Ending Stock Price

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Options Contracts


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. Of course the long party will only do this when the stock price is less than the strike price. Thus, the payoff function for the short put position is: payoff = min(0, ST-K) And the payoff diagram looks like:

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Options Contracts
Short Put Option on IBM with Strike Price of $80

0 0 -21.25 Pa yoff 20 40 60 80 100 120 140 160

-42.5

-63.75

-85 Ending Stock Price

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Options Contracts


Since the short put party can never receive a positive payout at maturity, they demand a payment up-front upfrom the long party that is, they demand that the long party pay a premium to induce them to enter into the contract. Once again, the short and long positions net out to zero: when one party wins, the other loses.

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Options Contracts
Long and Short Put Options on IBM with Strike Prices of $80
100 80 60 40 Pa yoff 20 0 -20 0 -40 -60 -80 -100 Ending Stock Price 20 40 60 80 100 120 140 160

Long Position Net Position

Short Position

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Options Contracts


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. For a European call, the payoff to the option is:


Max(0,ST-K) Max(0,KMax(0,K-ST) Short call: -Max(0,ST-K) = Min(0,K-ST) Min(0,KShort put: -Max(0,K-ST) = Min(0,ST-K) Max(0,K-

For a European put it is



The short positions are just the negative of these:

 

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Options Contracts


Traders frequently refer to an option as being in the money , out of the money or at the money .


An in the money 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.
 

For a call option this means that St>K For a put option this means that St<K

An at the money option means one where the strike and exercise prices are the same. An out of the money option means one where the price of the underlying is such that if the option were exercised immediately, the option holder would NOT receive a payout.
 

For a call option this means that St<K For a put option this means that St>K.

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Options Contracts
Long Call on IBM with Strike Price (K) = $80
80 60

Pa yoff

40 20 0 0 -20 20 40 60

At the money Out of the money In the money

K = 80

100

120

140

160

IBM Terminal Stock Price

T

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Options Contracts


One interesting notion is to look at the payoff from just owning the stock its value is simply the value of the stock:

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Options Contracts
Payout Diagram for a Long Position in IBM Stock
180 160 140 120 Pa yoff 100 80 60 40 20 0 0 20 40 60 80 100 120 140 160 Ending Stock Price

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Options Contracts


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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Options Contracts
Payout Diagram for a Long Position in IBM Stock
200 150 Stock 100 Long Call Payoff 50 0 0 -50 Short Put -100 Ending Stock Price 20 40 60 80 100 120 140 160

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Options Contracts


Notice how the payoff to the options portfolio has the same shape and slope as the stock position just offset by some amount? This is hinting at one of the most important relationships in options theory Put-Call parity. PutIt may be easier to see this if we examine the aggregate position of the options portfolio:

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Options Contracts
Payout Diagram for a Long Position in IBM Stock
200 150 100 Payoff 50 0 0 -50 20 40 60 80 100 120 140 160

-100 Ending Stock Price

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Options Contracts


We will come back to put-call parity in a few weeks, but putit is well worth keeping this diagram in mind. So who trades options contracts? Generally there are three types of options traders:


Hedgers - these are firms that face a business risk. They wish to get rid of this uncertainty using a derivative. For example, an airline might use a derivatives contract to hedge the risk that jet fuel prices might change. 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. Arbitrageurs - They are looking for imperfections in the capital market.
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Financial Engineering


When we start examining the actual pricing of derivatives (next week), one of the fundamental ideas that we will use is the law of one price . Basically 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 regardless of the instruments contained in the portfolios.


This is only true to within transactions costs , i.e. the bid-ask bidspread on each individual instrument. Sometimes one portfolio will have such lower transactions costs that the law will only approximately hold.
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Financial Engineering


Financial 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. Financial engineering can be used to break apart a set of cash flows into component pieces that each have different risks and that can be sold to different investors.
 

Collateralized Bond Obligations do this for junk bonds. Collateralized Mortgage Obligations do this for residential mortgages.

Financial engineering can also be used to create cash flows streams that would otherwise be difficult to obtain.
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Financial Engineering
 

The Schwab/First Union equity-linked CD is a good equityexample of financial engineering. When it was issued (in 1999), the stock market was (and had been) incredibly hot for several years.


Many investors wanted to be in the market, but did not want to risk the market going down in value. As we will demonstrate, an investor could roll their own version of this, but in doing so would have incurred significant transaction costs.


The equity-linked CD was designed to meet this need. equity

Plus, many small investors (to whom this was targeted) probably could not get approval to trade options.

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Financial Engineering


The Contract:


An investor buys the CD (Certificate of Deposit) today, and then earns 70% of the simple rate of return on S&P 500 index over the next 5.5 years. If the S&P 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. Thus, the payoff to the CD was simply:
Index5.5 CDMaturity ! Investment * 1  max 0,  1 Index0

So let s 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).

58

Financial Engineering


In 5.5 years your payoff will be based upon the index level. Potential 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 (Note that on 12/30/2004 the S&P 500 was at 1211.92!)

The following chart demonstrates the payouts.

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Financial Engineering
Payoff to Equity Linked Swap
18000 16000 14000 12000 Payoff 10000 8000 6000 4000 2000 0 0 500 1000 1500 2000 2500 S&P 500 Level

60

Financial Engineering


Now, 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-sloping part is upwardnot as steep. This is our first indication that we may be able to decompose this into two simpler securities. 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.) The next graph demonstrates this position s payoff.
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Financial Engineering
Bond Plus Call Payoff
18000 16000 14000 12000 Payoff 10000 8000 6000 4000 2000 0 0 500 1000 1500 Index Value 2000 2500 3000 Option Payoff Bond Payoff Net

62

Financial Engineering


This position is ALSO identical to a position consisting of:

  

$10,000/1300 = 7.692 units of the index. $10,000/1300 = 7.692 put options on the index (K=1300) (-(1-.7)*$10,000/1300 = -2.30769) CALL options on the index. (1-

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.) The following chart shows this:
63

Financial Engineering
Long Index, Long Put, Short Call
25000 20000 15000 Payoff 10000 5000 0 0 -5000 Index 500 1000 1500 2000 2500 3000

Index Payoff Put Position Call Position Net

64

Financial Engineering


Now, all three of these should sell for the same price but there will be some differences because of transactions costs.


Really, this is why the Schwab equity-linked CD can work: investors equity(retail investors) are willing to turn to the prepackaged asset to avoid transaction costs (and to avoid timing difficulties with unwinding their position.)

Let s just think of this as a bond and .7 long call options for a moment. Clearly the call cannot be free, since the investor holds this option they must pay something for it. How much do they pay?


The interest that they could have earned on this money had they invested in a traditional CD. At that time 5.5 year CDs were yielding 6%, so the investor gives up $3,777 dollars in year 5.5 dollars.

($10, 000*1.065.5 )  10, 000 ! 3, 777

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Financial Engineering


The equity-linked CD is just one example of financial equityengineering 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. This has led to a real revolution in finance, and we will discuss this idea throughout the semester. We will return to options pricing later in the semester. Next, we turn our attention to the futures/forwards markets and pricing.
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