FRM Part 1

Book 3 - Financial Markets and Products

Chapter 4

INTRODUCTION - Options, Futures, and Other Derivatives

 Learning Objectives
After completing this reading you should be
able to:
 Describe the over-the-counter market, distinguish it from trading on an exchange,
and evaluate its advantages and disadvantages.
 Differentiate between options, forwards, and futures contracts.
 Identify and calculate option and forward contract payoffs.
 Calculate and compare the payoffs from hedging strategies involving forward
contracts and options.
 Calculate and compare the payoffs from speculative strategies involving futures
and options.
 Calculate an arbitrage payoff and describe how arbitrage opportunities are
temporary.
 Describe some of the risks that can arise from the use of derivatives.
 Differentiate among the broad categories of traders: hedgers, speculators, and
arbitrageurs.
 Over-the-counter Trading vs.
Exchange Trading
Over-the counter market:
 Decentralized trading platform, without a central physical location, where
market participants use a host of communication channels to trade with
one another without a formal set of regulations.
o The communication channels commonly used include telephone,
email, and computers.
 In an OTC market, it’s possible for two participants to exchange
products/securities privately without others being aware of the terms,
including the price.
 OTC markets are much less transparent than exchange trading.
 Stocks traded in an OTC market could belong to a small company that’s
yet to satisfy the conditions for listing on the exchange.
 The OTC market is also popular for large trades.
Over-the-counter Trading vs.
Exchange Trading
Advantages Disadvantages

Fewer
restrictions Increased
and credit risk
regulations

Freedom to
Less
negotiate
transparency
deals

Cost-effective
for
corporations
 Options, Futures, and Forwards
An options contract:
 An agreement between two parties to transact on an underlying
security at a predetermined price called the strike price prior to some
date called the expiration date.
 The option gives the holder a right but not the obligation to buy/sell the
underlying at an agreed upon date at the strike price.
 A call option gives the holder the right but not the obligation to buy the
underlying asset at the strike price prior to the expiration date.
o The call option holder is betting that the price of the underlying will
rise.
 A put option, on the other hand, gives the holder the right but not the
obligation to sell the underlying asset at the strike price prior to the
expiration date.
o The put option holder is betting that the price of the underlying will
decrease.
 Options, Futures, and Forwards
A forward contract:
 A non-standardized contract between two parties that specifies the
price and the quantity of an asset to be delivered in the future.
o They are traded in the OTC market.
 One party takes the long position and agrees to buy the underlying asset
at a specified price on the specified date, while the other party takes the
short position and agrees to sell the asset on that same date at that same
price.

A futures contract:
 A standardized, legally-binding agreement between two parties that
specifies the price at which to trade a given asset (commodity or financial
instrument) at a specified future date.
o Futures contracts can be traded on exchanges (CME, CBOE, etc.)
 Options, Futures, and Forwards
 Futures contracts differ from forwards in several other aspects:
o Clearinghouse - The clearinghouse is an interposed party between
the buyer and the seller which ensures the performance of the contract.
In essence, futures contracts have no credit risk.
o Marking to market - Since the clearinghouse must monitor the credit
risk between the buyer and the seller, it performs daily marking to
market. This is the settlement of the gains and losses on the contract
on a daily basis. It avoids the accumulation of large losses over time.
o Margins - Daily settlements may not provide a buffer strong enough to
avoid future losses. For this reason, each party is required to post
collateral that can be seized in the event of default. The initial
margin must be posted when initiating the contract. If the equity in the
account falls below the maintenance margin, the relevant party is
required to provide additional funds to cover the initial margin.
Example >>
 Options, Futures, and
Forwards
Example
 An investor enters into a long position in a coffee futures contract
(KCN20) at $520.50 per bag.
o Each futures contract controls 100 bags.
o The initial margin is $5,200 and the maintenance margin is $4,700.
o At the close of trading on the first day, the futures price drops to
$512.
 What is the investor required to do at the end of the first trading day?
Solution
 Loss on position = ($520.50 – $512) × 100 = $850
 New margin = $5,200 – $ 850 = $4,350
 Because this is below the maintenance margin of $4,700, an additional
payment of $850 must be made to bring back the equity to the initial
margin of $5,200.
 Calculating Option and
Forward Contract Payoffs
Call Option Payoff:
 To the buyer

𝑪𝑪𝑻𝑻 = 𝒎𝒎𝒎𝒎𝒎𝒎(𝟎𝟎, 𝑺𝑺𝑺𝑺 − 𝑿𝑿)

 Where:
o CT = call option payoff
o ST = stock price at maturity
o X = strike price
o To the seller, payoff = − CT
o The price paid for the call, C0 is also called the call premium.

o Profit to call option buyer = CT − C0

o Profit to the option seller = C0 − CT
 Calculating Option and
Forward Contract Payoffs
Put Option Payoff:
 To the buyer

𝑷𝑷𝑻𝑻 = 𝒎𝒎𝒎𝒎𝒎𝒎(𝟎𝟎, 𝑿𝑿 − 𝑺𝑺𝑺𝑺)

 Where:
o PT = put option payoff
o ST = stock price at maturity
o X = strike price
o To the seller, payoff = − PT
o The price paid for the call, P0 is also called the call premium.

o Profit to call option buyer = PT − P0

o Profit to the option seller = P0 − PT
 Calculating Option and
Forward Contract Payoffs
Forward Contract Payoff:
 The payoff to the long position is given by:

𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 = 𝑺𝑺𝑺𝑺 − 𝑲𝑲
 Where:
o ST = spot price at maturity
o K = delivery price
o The payoff to the short position = K − ST
 How Hedging Works
 The use derivatives like futures and options to reduce or eliminate
financial exposure.
o An investor with a long position in an asset can hedge the exposure
by entering into a short futures contract or by buying a put option.
o An investor with a short position in an asset can hedge the exposure
by entering into a long futures contract or by buying a call option.
 A forward contract helps the hedger to lock in the price of the underlying
security.
o Forward contracts do not need any investment at onset.
 The hedger gives up any movement that may have had positive or
negative results if they left the position unhedged.
Example >>
 How Hedging Works
Example
 Suppose a U.S. based company is scheduled to receive £10 million in
six months.
 The current exchange rate stands at 1.32 $/£ .
 The management is worried that the pound might depreciate against
the dollar, so it decides to hedge the exchange risk with a forward
contract at 1.3 $ / £.
 With the forward, the company will be guaranteed to receive $13
million.
o Suppose the company does not hedge the position and the
exchange rate in six months turns out to be 1.25 $/£, then the
company would receive $12,500,000.
o Suppose further that the company does hedge the position at 1.3
$/£ and the rate turns out to be 1.35 $ / £. In this case, the company
will still receive $13 million but will be forced to give up the extra
$500,000 it would have received if it didn’t hedge the position.
 Payoffs from Speculative Strategies Involving
Futures Contracts
 Speculative trading refers trading without the intention of obtaining the
underlying commodity.
o Speculators basically make bets on the market, unlike hedgers
whose priority is to eliminate exposures.
 Speculators are motivated by the leverage that comes with futures
contracts in which no initial investment is required.
o All that’s needed is the initial margin required by the
clearinghouse/exchange.
o The margin is no more than a percentage of the notional value of
the underlying.
 The gains or losses associated with futures can be quite large, and
payoffs are symmetrical.
 Speculators trade in futures with the intention of reselling these contracts
before maturity.
 Payoffs from Speculative Strategies Involving
Options Contracts
 For options, speculators only need to part with the option’s price at the
onset, which is often just a few dollars for 100 shares worth of the
underlying.
 Options have asymmetrical payoffs. Going long on options can bring in
significant gains, but losses are limited to the option’s price paid.
o Note that it’s the exact opposite for being short a call option, where
the payoff is limited and the losses are unlimited.
 Arbitrage Payoffs
 Arbitrage opportunities exist when prices of similar assets are set at
different levels.
 An arbitrageur attempts to make a risk-free profit by buying the asset in
the cheaper market and simultaneously selling it in the overpriced market.

Example
 Suppose ABC stock is trading at $200 on exchange A and $198 on
exchange B.
 If you buy one ABC stock on exchange B and simultaneously sell it on
exchange A, you can make a risk-free profit of $2 without any outlay of
cash.
 However, arbitrage opportunities are normally short-lived because of the
nature of efficient markets.
Risks in Derivative Trading
Market risk

• There are no guarantees the market price will move in favor of

the derivative trader.

Counterparty risk

• The risk that the buyer, seller, or dealer will default on the
contract.
• Particularly prevalent in OTC markets.
Liquidity risk

• The bid-ask spreads could be so large as to represent a

substantial cost.
Operational risk

• The risk that a trader with instructions to use derivatives as a

hedging tool will be tempted to take speculative positions, or hit
the wrong button!
 Exam Tips
Bid-ask spread
 The bid price is the “quoted bid,” or the highest price, which a dealer is
willing to pay to purchase a security.
 The offer price is the price at which the security is offered for sale, also
known as the “asking price.”
 The bid-ask spread represents the difference between the offer price
and the bid price.

European vs. American options

 All European options can only be exercised at maturity.
 American options, on the other hand, may be exercised any time
between issue date and expiration.
 Book 3 - Financial Markets and Products
Chapter 4
INTRODUCTION - Options, Futures, and Other Derivatives
Learning Objectives Recap:
 Describe the over-the-counter market, distinguish it from trading on an exchange, and evaluate its
advantages and disadvantages.
 Differentiate between options, forwards, and futures contracts.
 Identify and calculate option and forward contract payoffs.
 Calculate and compare the payoffs from hedging strategies involving forward contracts and
options.
 Calculate and compare the payoffs from speculative strategies involving futures and options.
 Calculate an arbitrage payoff and describe how arbitrage opportunities are temporary.
 Describe some of the risks that can arise from the use of derivatives.
 Differentiate among the broad categories of traders: hedgers, speculators, and arbitrageurs.