Derivatives Workshop

Actuarial Society October 30, 2007

Agenda

Intro to Derivatives Buying/Short-selling Forwards Options Swaps

What are Derivatives?

A financial instrument that has a value determined by price of something else A contract whose value depends on what something else is worth
Futures Swaps

Options Insurance

Why use Derivatives?

Risk management

Hedging

Speculation Reduced transaction costs Regulatory arbitrage

Buying an Asset - Long Position

Offer price (ask price) Bid price Bid-ask spread Commission (flat or percentage)

Example

Bid price = $50; Ask price = $50.25 Commission = $1/transaction How much does it cost to buy 100 shares, then immediately sell it? Cost = $50.25*100 - $50*100 + $2 = $27

Short-Selling

Borrow now Sell now Buy later (covering the short position) Return later Lease rate of asset payments that must be made before repaying asset

Why Short-sell?

Speculation Financing Hedging

Example

Stock price now = $50 Stock price one year from now = $49.50 Commission = $1/transaction How much can you make short selling 100 shares? Profit = $50*100-$49.50*100-$2 = $48

Forward Contracts

Sets terms now for the buying or selling of an asset at specified time in future
Specifies quantity and type of asset Sets price to be paid (forward price) Obligates seller to sell and buyer to buy

Settles on expiration date

Forward Contracts

Forward price -- price to be paid Spot price -- market price now Underlying asset -- asset on which contract is based Buyer = long; Seller = short
Long position makes money when price Short position makes money when price

Payoffs in Forward Contract

Payoff to long forward (buyer) = Spot price at expiration - forward price

Agreed to buy at fixed (forward) price

Payoff to short forward (seller) = Forward price - spot price at expiration

Agreed to sell at fixed price

Call Options

Contract where buyer has the right but no obligation to buy

Seller is obligated to sell, if the buyer chooses to exercise the option

Since seller cannot make money, buyer must pay premium for option

Forwards have no premium

Call Options

Strike price - amount buyer pays for the asset Exercise - act of paying strike price to receive the asset Expiration - when option must be exercised, or become worthless European style - only exercise on x-date Bermudan style - during specified periods American style - entire life of option

Payoff of Call Option - Long

Buyer is not obligated to exercise -- will only do so if payoff is greater than 0 Purchased call payoff = max[0, spot price at x-date - strike price]

Must pay premium to seller

Profit = payoff - future value of premium

Payoff of Call Option - Short

Opposite to payoff/profit of buyer Written call payoff = -max[0, spot price at x-date - strike price]

Only profits from premium

Profit = - payoff + future value of premium

Put Options

Contract where seller has the right but no obligation to sell

Buyer is obligated to buy, if the seller chooses to exercise the option

Since buyer cannot make money, seller must pay premium for option Seller of asset = buyer of put option

Insurance Strategies

Buying put option floor (min sale price) Buying call option cap (max price) Covered writing writing option with corresponding long position Naked writing no position in asset

Covered writing

Covered call
Same as selling a put Asset whose price is unlikely to change

Covered put

Same as writing a call

Synthetic Forwards
BUY CALL & SELL PUT

FORWARD CONTRACT

Must pay net option premium Pay strike price

Zero premium Pay forward price

Put-Call Parity

No arbitrage Net cost of index must be same whether through options or forward contract Call (K,T) Put(K,T) = PV(F0,T K)

Spreads Only calls/only puts

Bull: buy call, sell call with higher strike price Bear: buy higher strike price, sell lower Box: synthetic long forward and synthetic short forward at different prices Ratio spread: buy m calls and sell n calls at different strike prices

Can have zero premium (only pay if you need the insurance)

Collars

Buy put, sell call with higher strike Collar width difference between call and put strikes Similar to short forward contract

Straddles

Buying call and put with same strike price Profits from volatility in both directions Premiums are costly (paying twice)

Strangle

Same as straddle, but buy out-of-the-money options Premiums will be lower Stock price needs to be more volatile in order to make profit

Written Straddle

Sell call and put with same strike price Profits when volatility is low Potential unlimited loss from stock price changes in either direction

Butterfly Spreads

Insures against losses from a written straddle Out-of-the-money put provides insurance on the downside Out-of-the-money call provides insurance on the upside

Swaps

Contract for exchange of payments over time Forward is single-payment swap Multiple forwards, but as single transaction