An overview about derivatives markets and

instruments
Contents

• Introduction to derivatives
Derivatives

 In the last three decades derivatives have become increasingly important in finance.

 Futures and options are now traded actively on many exchanges throughout the world.

 Many different types of forward contracts, swaps, options and other derivatives are

regularly traded by financial institutions, fund managers and corporate treasures in

over-the-counter market.

 Anyone who works in finance needs to understand how derivatives work, how they

are used and how they are priced.

Definition of derivatives
 A derivative can be defined as a financial instrument whose value depends (or
drives form) the values of other, more basic, underlying variables or asset.

 Very often the variables underlying derivatives are the prices of traded assets.

 A stock option, for example, is a derivative whose value is dependent on the price
of a stock.

 Derivatives can be dependent on almost any variables, from the price of hogs to
the amount of snow falling at a certain ski resort.
Exchange-Traded markets

 A derivatives exchange is a market where individuals trade standardized contracts that have been defined
by the exchange.
 The Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and merchants together.

 Initially its main task was to standardize the quantities and qualities of the grain that were traded.

 Within a few years the first futures-types contract was developed. It was known as a to-arrive contract.

 Chicago Mercantile Exchange was established in 1919.

 The Chicago Board Options Exchange stated trading call option contracts on 16 stocks in 1973.
Electronic Markets

 Traditionally derivatives exchange have used what is known as the open outcry system.

 This involves traders physically meeting on the floor of the exchange, shouting, and

using a complicated set of hand signals to indicate the trades they would like to carry out.

 Exchange are increasingly replacing the open outcry system by electronic trading.

 This involves traders entering their desired trades at a keyboard and a computer being

used to match buyers and sellers.

Over-the-counter Markets

 The over-the-counter market is an important alternative to exchange and, measured

in terms of the total volume of trading, has become much larger than the exchange-
traded market.

 It is a telephone-and computer linked network of dealers.

 Trades are done over the phone and are usually between two financial institutions
or between a financial institutions and one of its clients.

 Financial institution often act as market makers for the more commonly traded
instruments.
Forward Contracts
 A relatively simple derivative is a forward contract. It is an agreement to buy or sell
an asset at a certain future time for a certain price.

 It can be contrasted with a spot contract, which is an agreement to buy or sell an

assets today.

 A forward contract is traded in the over-the-counter market-usually between two

financial institutions or between a financial institution and one of its clients.

 One of the parties to a forward contract assumes a long position and agrees to buy
the underlaying asset on a certain specified future date for a certain specified price.
Forward Contracts

 The other party assumes a short position and agrees to sell the assets on the same
date for the same price.

 Forward contracts on foreign exchange are very popular.

 Most large banks employ both sport and forward foreign-exchange traders.
Forward contract and Hedging
 Forward contracts can be used to hedge foreign currency risk.

 Suppose that, on July 20, 2007, the treasures of a US corporation knows that the corporation will
pay £1 million in 6 months (on January 20, 2008) and wants to hedge against exchange rate moves.

 The treasure can agree to buy £1 million 6 month forward contract at an exchange rate of 2.0489.

 The corporation then has a long forward contract on GBP. It has agreed that on January 20, 2008, it
will buy 1 million pound form the bank for $2.0489 million.

 The bank has a short forward contract on GBP. It has agreed that on January 20, 2008, it will sell £1
million for $2.0489 million.
Spot and forward quotes for the USD/GBP exchange rate
(2007)
Payoff form forward contracts

 What are the possible outcomes?

 The forward contract obligates the corporation to by £1 Million for $2,048,900.

 If the spot exchange rate rose to, say, 2.100, at the end of the 6 months, the forward contract would

be worth $51,100 ($2,100,000-$2,048,900) to the corporation.

 It would enable £1 million to be purchased at an exchange rate of 2.0489 rather than 2.1000.

 Similarly, if the sport ER fell to 1.9000 at the end of the 6 months, the forward contract would have

a negative value to the corporation of $148,900 ($19,000,000-$2,048,000) more than the market

price of the sterling.

Forward contract: Payoff for the long position

 In general, the payoff from a long position in a forward contract on one unit
of an asset is

 Where K is the delivery price and is the spot price of the asset at maturity of
the contract.
 This is because the holder of the contract is obligated to buy an asset worth
for K.
Forward Contract: Payoff for the short position

The payoff from a short position in a forward contract on one unit of an asset is:

The payoff can be positive or negative. Because it costs nothing to enter into a
forward contract, the payoff form the contract is also the trader’s total gain or loss
form the contract.
Payoff from forward contracts
Future contracts

 A futures contracts is an agreement between two parties to buy or sell an assets at

a certain time in the future for certain price.

 Unlike forward contracts, futures contracts are normally traded on an exchange.

 To make trading possible, the exchange specifies certain standardized features of

the contract.

 As the two parties to the contract do not necessarily know each other, the
exchange also provides a mechanism that gives the two parties a guarantee that
the contract well be honored.
Future contracts

 The largest exchanges on which future contracts are traded are the Chicago Board of
Trade (CBOT) and the Chicago Mercantile Exchange (CME).

 Commodities: gold, sugar, wool, copper, aluminum and tin.

 Financial assets: Stock indices, currencies and Treasure bonds.

 Future prices are regularly reported in the financial press.

 The price of the futures are determined by the supply and demand.

 If more traders want to go long than to go short position, the price goes up; if the reverse

is true, then the price goes down.

Options

 Options are traded both on exchange and in the over-the-counter market.

 There are two types of option:

 A call option gives the holder the right to buy the underlying asset by a certain date for a
certain price.

 A put option: gives the holder the right to sell the underlying assets by a certain date for a
certain price.

 The price in the contract is known as the exercise price or strike price; the date in the
contract is known as the expiration date or maturity.
Difference between Option and forward/future contract

An option gives the holder the right to do something. The holder does not have to
exercise this right.

This is what distinguishes option from forward and futures, where the holder is
obligated to buy or sell the underlying asset.

Where it costs nothing to enter into a forward or future contract, there is a cost to
acquiring an option.
Option strategy: call option scenario
 Suppose an investor instructs a broker to buy one April call option contract on
Intel with a strike price of $20.00.
 The broker will relay these instructions to a trader at the CBOE.
 This trader will then find another trader who wants to sell one April call contract
on Intel with a strike price of $20.00, and a price will be agreed.
 The price is $1.65
 This is the price for an option to buy one share. In the US, an option contract is a
contract to buy or sell 100 shares.
Therefore, the investor must arrange for $165 to be remitted to the exchange
through the broker.
The exchange will then arrange for this amount to be passed on to the party on the
other side of the transaction.
Option strategy: call option scenario

 The investor has obtained at a cost of $165 the right to buy 100 Intel shares for
$20.00 each.
 The party on the other side of the transaction has received $165 and has agreed to
sell 100 Intel shares for $20.00 per share if the investor choose to exercise the
option.
 If the price of Intel does not rise above $20.00 before April 21, 2007, the option is
not exercised and the investor loses $165.
 But the if the Intel share price does well and the option is exercised when it is
$30, the investors is able to but 100 shares at $20.00 per share when they are
worth $30 per share. This lead to a gain of $1000, or 835 when the initial cost of
the option are taken into account.
Option strategy
Option strategy: call put scenario

 Alternatively, the investor purchases April put option contract with a strike price
of $17.50.
 We see this would cost 100*0.725 = $72.50
 The investor would obtain right to sell 100 Intel shares for $17.50 per share prior
to April 21, 2007.
 If the Intel share price stays above $17.50, the option is not exercised and the
investors loses $72.50.
 But if the investor exercises when the stock price is $15, the investor makes a
gain of $250 by buying 100 Intel shares at $15 and selling them for $17.50.
 The net profit after the cost of the options is taken into account is $177.50 .
Net profit per share form call option and put option
Properties of the options

The price of a call option decreases as the strike price increase.

The price of a put option increases as the strike price increase.

Both types of options tend to become more valuable as their time to maturity
increases.

A put with a $25 strike price should be exercises immediately. That is why the
price is the same for all maturities.
Participants in the option markets

1) Buyer of calls
2) Sellers of calls
3) Buyers of puts
4) Sellers of puts

 Buyers are referred to as having long positions; sellers are preferred to as having
short positions.

 Selling an option is also known as writing the option.

Types of traders

 Hedgers: they use derivatives to reduce to risk that they face from potential
future movements in a market variables.

 Speculators: use them to bet on the future direction of a market variable.

 Arbitrageurs: take offsetting position in two or more instruments/markets to lock

in a profit.
Hedgers
 Suppose that it is July 20, 2007, and ImportCo, a company based in the US
knows that it will have to pay £10 million on October 20, 2007, for goods it has
purchased from a British supplier.
 The USD-GBP exchange rate quotes made by a firm is shown in the table.
Hedgers
 ImportCo could hedge its foreign exchange risk by buying pound form the
financial institution in the 3-month forward market at 2.0531.

 This would have the effect of fixing the price to be paid to the British exporter at
$20, 531,000.
Hedging using options

 Consider an investor who in May of a particular year own 1000 Microsoft shares.
The shar price is $28 per share.
 The investors is concerned about the a possible price decline in the next two
months and wants protection.
 The investor could buy ten July put option contracts on Microsoft with a strike
price of $27.50. This would give the investor the right to sell a total of 1000
shares for a price of $27.50.
 If the quoted option price is $1, then each option contract would cost 100*$1
=100 and total cost of hedging strategy would be 10*100 =1000.
Hedging using options

 The strategy costs $1000 but guarantees that shares can be sold for at least
$27.50 per share during the life of the option.

 If the market price of Microsoft fall below 27.50, the options will be exercised,
so that $27500 is realized for the entire holding.

 When the cost of the options is taken into account, the amount realized is $26500.
Value of Microsoft holding in 2 months
Comparison between forward contractions and option for
hedging

 Forward contracts are designed to neutralize risk by fixing the price that the
hedger will pay or receive for the underlying assets.

 Option contracts provide insurance.

 They offer a way for investors to protect themselves against adverse price
movements in the future while still allowing them to benefit form favorable price
movements.

 Unlike forwards, options involve the payment of an up-front fee.

Speculators

 Hedgers want to avoid exposure to adverse movements in the price of an assets,

speculator wish to take a position in the market. Eithter they are betting that the
price of the assets will go up or they are betting that it will go down.
Speculation using Futures

 US speculator who in Feb thinks that the British pound will strengthen
relative to the US dollar over the next 2 months and is prepared to back that
hunch to the tune of £250,000.
 First thing that speculator can do is purchase £25,000 in the sport market in
the hope that the sterling can be sold later at higher price.
 Second thing to take a long position in four April future contracts on
sterling (each contract is £62500).
Difference between spot and futures

 The first alternative of buying sterling requires an up-front investment $511,750

(=250,000*2.0470)

 Second alternative requires only a small amount of cash to be deposited by the

speculator in what is termed a “margin account”.

 The futures market allows the speculator to obtain leverage.

 With a relatively small outlay, the investor is able to take a large speculative
position.
Speculation using Spot and futures
Speculation using options

 Suppose that it is October and a speculator considers that a stock is likely to

increase in value over the next 2 months.

 The stock price is currently$20, and a 2-month call option with a $22.50 strike
price is currently selling for $1.

 Investors is willing to invest $2000

First option is purchase 100 share (100*20 = 2000)

Second option is to 2000 call option (20 call option is contracts)

Stock price $27

• The first strategy yield a profit of :

• 100*(27-20) = $700

• Second strategy yield a profit of:

• A call option on the stock with a strike price of $22.50 gives a payoff of $4.50. Total
payoff form the 2,000 options that are purchased under the second alternative is

• 2000*4.50 = 9000

• Net profit = 9000-2000 = $7000

Comparison of profit
Profit or loss form tow alternative strategies
Comparison between option and leverage
 Option like future provide a form of leverage.

 For a given investment, the use of options magnifies the financial consequences.

 Good outcomes become very good, while bad outcomes results in the whole initial
investment being lost.
 When a speculator uses futures, the potential loss as well as the potential gain is
vary large.
 When the options are used, no matter how bad things get, the speculator's loss is
limited to the amount paid for the options.
Arbitrageurs

 Arbitrage involves locking in a riskless profit by simultaneously entering into

transactions in two or more markets.

 A stock price at New York is traded at $200 and same stock is traded at London
stock exchange at £100 and exchange rate is $2.0300 per pound.

 An arbitrageur could simultaneously buy 100 shares of the stock in NY and sell
them in London

 100*[($2.03*100)-$200)] = $300
Next class: Mechanism of future markets
Reading material

 Chapter 1: Introduction
 John C. Hull (Seventh Edition) Option, Futures, and other Derivatives