Topic 1

Introduction to Financial
Engineering (Derivatives)

Options, Futures, and Other Derivatives, 11th Edition,

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What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options,
exotics…

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Why Derivatives Are Important
Derivatives play a key role in transferring risks in the
economy
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity prices, insurance payouts, the weather, etc
Many financial transactions have embedded
derivatives
The real options approach to assessing capital
investment decisions has become widely accepted

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How Derivatives Are Traded
On exchanges such as the Chicago Board
Options Exchange (CBOE)
In the over-the-counter (OTC) market where
traders working for banks, fund managers
and corporate treasurers contact each other
directly

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The OTC Market Prior to 2008
Largely unregulated
Banks acted as market makers quoting bids and asks
Master agreements usually defined how transactions
between two parties would be handled
But some transactions were cleared through central
counterparties (CCPs). A CCP stands between the
two sides to a transaction in the same way that an
exchange does

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Since 2008…
OTC market has become regulated. Objectives:
Reduce systemic risk (see Business Snapshot 1.2)
Increase transparency
In the U.S and some other countries, standardized OTC
products must be traded on swap execution facilities
(SEFs) which are electronic platforms similar to
exchanges
CCPs must be used to clear standardized transactions
between financial institutions in most countries
All trades must be reported to a central repository

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Size of OTC and Exchange-Traded Markets
(Figure 1.1)
800
Size of Market
700
($ trillion)

600

500

400

300
OTC
Ex-
200 change

100

0
-9 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9
un n -9 n -0 n -0 n -0 n -0 n -0 n -0 n -0 n -0 n -0 n -0 n -1 n -1 n -1 n -1 n -1 n -1 n -1 n -1 n -1 n -1
J Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
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The Lehman Bankruptcy (Business
Snapshot 1.1)

Lehman’s filed for bankruptcy on September 15, 2008.

This was the biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives
markets and got into financial difficulties because it took
high risks and found it was unable to roll over its short
term funding
It had hundreds of thousands of transactions
outstanding with about 8,000 counterparties
Unwinding these transactions has been challenging for
both the Lehman liquidators and their counterparties

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How 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
without incurring the costs of selling
one portfolio and buying another

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Foreign Exchange Quotes for GBP, May
21, 2020 (Table 1.1)
Bid Ask
Spot 1.2217 1.2220

1-month forward 1.2218 1.2222

3-month forward 1.2220 1.2225

6-month forward 1.2224 1.2230

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Forward Price
The forward price for a contract is the
delivery price that would be applicable to
the contract if were negotiated today
(i.e., it is the delivery price that would
make the contract worth exactly zero)
The forward price may be different for
contracts of different maturities (as
shown by the table)

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Terminology
The party that has agreed to buy
has what is termed a long position
The party that has agreed to sell
has what is termed a short position

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Example
On May 21, 2020, the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months at an
exchange rate of 1.2230
This obligates the corporation to pay
$1,223,000 for £1 million on November 21,
2020
What are the possible outcomes?

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Profit from a Long Forward Position (K=
delivery price=forward price at time contract is entered into)

Profit

Price of Underlying
K at Maturity, ST

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Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into)

Profit

Price of
K Underlying
at Maturity,
ST

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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

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Exchanges Trading Futures
CME Group (formed when Chicago
Mercantile Exchange and Chicago Board of
Trade merged)
InterContinental Exchange
B3 (Brazil)
Tokyo Financial Exchange (Tokyo)
and many more (see list at end of book)

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Examples of Futures Contracts
Agreement to:
Buy 100 oz. of gold @ US$1800/oz. in
December
Sell £62,500 @ 1.2500 US$/£ in March
Sell 1,000 bbl. of oil @ US$40/bbl. in April

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The Forward Price of a Non-
Dividend Paying Stock

If the spot price is S and the forward price for a

contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-free rate
of interest.
In our examples, S = 60, T = 1, and r =0.05 so that
F = 60(1+0.05) = 63

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1. An Arbitrage Opportunity?

Suppose that:
The price of a non-dividend-paying stock is
$60
The 1-year forward price of the stock is $65
The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?

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2. Another Arbitrage Opportunity?
Suppose that:
The price of a non-dividend-paying stock is
$60
The 1-year forward price of the stock is $58
The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?

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1. Oil: An Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$50
- The quoted 1-year futures price of oil is
US$60
- The 1-year US$ interest rate is 5% per
annum
- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

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2. Oil: Another Arbitrage Opportunity?

Suppose that:
- The spot price of oil is US$50
- The quoted 1-year futures price of oil is
US$40
- The 1-year US$ interest rate is 5% per
annum
- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

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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)

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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

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Apple Call Option Prices from CBOE (May 21, 2020); Stock
Price is bid 316.23, ask 316.50 (Table 1.2)

Strike Jun 2020 Jun 2020 Sep 2020 Sep 2020 Dec 2020 Dec 2020
Price Bid Ask Bid Ask Bid Ask

290 29.80 30.85 39.35 40.40 46.20 47.60

300 21.55 22.40 32.50 33.90 40.00 41.15

310 14.35 15.30 26.35 27.25 34.25 35.65

320 8.65 9.00 20.45 21.70 28.65 29.75

330 4.20 5.00 15.85 16.25 23.90 24.75

340 1.90 2.12 11.35 12.00 19.50 20.30

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Apple Put Option Prices from CBOE (May 21, 2020); Stock
Price is bid 316.23, ask 316.50 (Table 1.3)

Strike Jun 2020 Jun 2020 Sep 2020 Sep 2020 Dec 2020 Dec 2020
Price Bid Ask Bid Ask Bid Ask

290 3.00 3.30 12.70 13.65 20.05 21.30

300 4.80 5.20 15.85 16.85 23.60 24.90

310 7.15 7.85 19.75 20.50 28.00 28.95

320 11.25 12.05 24.05 24.80 32.45 33.35

330 17.10 17.85 28.75 29.85 37.45 38.40

340 24.40 25.45 34.45 35.65 42.95 44.05

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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 (not
obligation) to buy or sell at a certain price

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Types of Traders
Hedgers – use derivatives to reduce risks
that they face from potential future
movements in market.
Speculators – use derivatives to bet on the
future direction of market.
Arbitrageurs – take offsetting positions in
two or more instruments (could be derivatives
and other investment tools such as stock
investment, bonds etc…) to lock in profit.
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Hedging Examples
A US company will pay £10 million for
imports from Britain in 3 months and
decides to hedge using a long position in a
forward contract
An investor owns 1,000 shares currently
worth $28 per share. A two-month put with a
strike price of $27.50 costs $1. The investor
decides to hedge by buying 10 contracts

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Value of Shares with and without
Hedging (Figure 1.4)
40,000 Value of Holding ($)

35,000

No Hedging
30,000 Hedging

25,000

Stock Price ($)

20,000
20 22 24 26 28 30 32 34 36 38

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Speculation Example
An investor with $2,000 to invest feels that
a stock price will increase over the next 2
months. The current stock price is $20 and
the price of a 2-month call option with a
strike of 22.50 is $1
What are the alternative strategies?

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Arbitrage Example
A stock price is quoted as £100 in London
and $120 in New York
The current exchange rate is 1.2300
What is the arbitrage opportunity?

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