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Introduction
Chapter 1
1
Chapter Outline
1.1 Exchange-traded markets
1.2 Over-the-counter markets
1.3 Forward contracts
1.4 Futures contracts
1.5 Options
1.6 Types of traders
1.7 Other derivatives
2
The Nature of Derivatives
A derivative is an instrument whose
value depends on (derives from) the
values of other more basic underlying
variables
3
Examples of Derivatives
•
•
•
•
Forward Contracts
Futures Contracts
Swaps
Options
4
Ways 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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1.1 Exchange-traded markets
• Traditionally exchanges have used the
open-outcry system, but increasingly they
are switching to electronic trading
Contracts are standard there is virtually no
credit risk
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1.2 Over-the-counter markets
• A computer- and telephone-linked network
of dealers at financial institutions,
corporations, and fund managers
• Contracts can be non-standard and there is
some small amount of credit risk
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1.3 Forward Contracts
• A forward contract specifies that a certain
commodity will be exchanged for another at
a specified time in the future at prices
specified today.
– Its not an option: both parties are expected to hold up
their end of the deal.
– If you have ever ordered a textbook that was not in
stock, you have entered into a forward contract.
• It can be contrasted with a spot contract which is
an agreement to buy or sell immediately
• Forwards are traded in the OTC market
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Foreign Exchange Rates Thursday, November 1, 2001
U.S. $ equiv.
Country
Thursday
Currency per U.S. $
Wednesday
Thursday
Wednesday
Britain (Pound)
1.4631
1.4540
0.6835
0.6878
1 Month Forward
1.4608
1.4516
0.6846
0.6889
3 Months Forward
1.4560
1.4466
0.6868
0.6913
6 Months Forward
1.4493
1.4400
0.6900
0.6944
Canada (Dollar)
0.6267
0.6294
1.5957
1.5888
1 Month Forward
0.6264
0.6291
1.5964
1.5895
3 Months Forward
0.6262
0.6289
1.5969
1.5901
6 Months Forward
0.6259
0.6286
1.5976
1.5908
France (Franc)
0.1376
0.1372
7.2662
7.2896
0.1375
0.1370
7.2746
Clearly
the
market
participants
expect
3 Months Forward
0.1372
0.1367
7.2906
will be worth
in
6 Months Forward that the yen
0.1368
0.1364 MORE
7.3091
Germany (Mark)
0.4616
0.4601
2.1665
dollars
in
six
months.
1 Month Forward
0.4610
0.4596
2.1690
7.2981
3 Months Forward
0.4600
0.4585
2.1738
2.1809
6 Months Forward
0.4589
0.4574
2.1793
2.1864
Japan (Yen)
0.008197
0.008168
122.00
122.43
1 Month Forward
0.008212
0.008184
121.78
122.19
3 Months Forward
0.008241
0.008213
121.34
6 Months Forward
0.008283
0.008252
120.73
1 Month Forward
7.3143
7.3328
2.1735
2.1760
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121.76
121.18
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
10
Foreign Exchange Rates Thursday, November 1, 2001
U.S. $ equiv.
Country
Thursday
Currency per U.S. $
Wednesday
Thursday
Wednesday
Britain (Pound)
1.4631
1.4540
0.6835
0.6878
1 Month Forward
1.4608
1.4516
0.6846
0.6889
3 Months Forward
1.4560
1.4466
0.6868
0.6913
6 Months Forward
1.4493
1.4400
0.6900
0.6944
Canada (Dollar)
0.6267
0.6294
1.5957
1.5888
1 Month Forward
0.6264
0.6291
1.5964
1.5895
3 Months Forward
0.6262
0.6289
1.5969
1.5901
6 Months Forward
0.6259
0.6286
1.5976
1.5908
France (Franc)
0.1376
0.1372
7.2662
7.2896
0.1375
0.1370
7.2746
Clearly
the
market
participants
expect
3 Months Forward
0.1372
0.1367
7.2906
will be worth
dollars
6 Months Forward that the GBP
0.1368
0.1364 less in
7.3091
Germany (Mark)
0.4616
0.4601
2.1665
in
six
months.
1 Month Forward
0.4610
0.4596
2.1690
7.2981
3 Months Forward
0.4600
0.4585
2.1738
2.1809
6 Months Forward
0.4589
0.4574
2.1793
2.1864
Japan (Yen)
0.008197
0.008168
122.00
122.43
1 Month Forward
0.008212
0.008184
121.78
122.19
3 Months Forward
0.008241
0.008213
121.34
6 Months Forward
0.008283
0.008252
120.73
1 Month Forward
7.3143
7.3328
2.1735
2.1760
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121.76
121.18
Terminology: The Long and the Short of it
• IF YOU BENEFIT FROM A RISE IN
THE PRICE OF THE UNDERLYING
COMMODITY, YOU ARE LONG.
• IF YOU BENEFIT FROM A FALL IN
THE PRICE OF THE UNDERLYING
COMMODITY, YOU ARE SHORT.
12
Terminology: The Long and the Short of it
• The party that has agreed to buy (IN
THE FUTURE) has what is termed a
long position
• The party that has agreed to sell has
what is termed a short position
13
Example (page 3)
• On August 16, 2002 the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months at
an exchange rate of 1.4359
• This obligates the corporation to pay
$1,435,900 for £1 million on February 16,
2003
• What are the possible outcomes?
14
Profit from a
Long Forward Position
Profit
K
Price of Underlying
at Maturity, ST
15
Profit from a
Short Forward Position
Profit
K
Price of Underlying
at Maturity, ST
16
Futures Contracts: Preliminaries
• A futures contract is like a forward contract:
– It specifies that a certain commodity will be exchanged
for another at a specified time in the future at prices
specified today.
• A futures contract is different from a forward:
– Futures are standardized contracts trading on organized
exchanges with daily resettlement (“marking to market”)
through a clearinghouse.
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Futures Contracts: Preliminaries
• Standardizing Features:
– Contract Size
– Delivery Month
• Daily resettlement
– Minimizes the chance of default
• Initial Margin
– About 4% of contract value, cash or T-bills held
in a street name at your brokerage.
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Selected Futures Contracts
Contract
Agricultural
Contract Size
Exchange
Corn
Wheat
Cocoa
OJ
Metals & Petroleum
Copper
Gold
Unleaded gasoline
Financial
British Pound
Japanese Yen
Eurodollar
5,000 bushels
5,000 bushels
10 metric tons
15,000 lbs.
Chicago BOT
Chicago & KC
CSCE
CTN
25,000 lbs.
100 troy oz.
42,000 gal.
CMX
CMX
NYM
£62,500
¥12.5 million
$1 million
IMM
IMM
LIFFE
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Futures Markets
• The Chicago Mercantile Exchange
(CME) is by far the largest.
• Others include:
– The Philadelphia Board of Trade (PBOT)
– The MidAmerica Commodities Exchange
– The Tokyo International Financial Futures
Exchange
– The London International Financial Futures
Exchange
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1.5 Options Contracts: Preliminaries
• An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an
asset on (or perhaps before) a given date, at prices
agreed upon today.
• Calls versus Puts
– Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset at
some time in the future, at prices agreed upon today.
When exercising a call option, you “call in” the asset.
– Put options gives the holder the right, but not the
obligation, to sell a given quantity of an asset at some
time in the future, at prices agreed upon today. When
exercising a put, you “put” the asset to someone.
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Options Contracts: Preliminaries
• Exercising the Option
– The act of buying or selling the underlying asset through the
option contract.
• Strike Price or Exercise Price
– Refers to the fixed price in the option contract at which the
holder can buy or sell the underlying asset.
• Expiry
– The maturity date of the option is referred to as the
expiration date, or the expiry.
• European versus American options
– European options can be exercised only at expiry.
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– American options can be exercised at any time up to expiry.
Options Contracts: Preliminaries
• In-the-Money
– The exercise price is less than the spot price of
the underlying asset.
• At-the-Money
– The exercise price is equal to the spot price of
the underlying asset.
• Out-of-the-Money
– The exercise price is more than the spot price of
the underlying asset.
23
Options Contracts: Preliminaries
• Intrinsic Value
– The difference between the exercise price of the option
and the spot price of the underlying asset.
• Speculative Value
– The difference between the option premium and the
intrinsic value of the option.
Option
Premium
=
Intrinsic
Value
+ Speculative
Value
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Call Options
• Call options gives the holder the
right, but not the obligation, to buy a
given quantity of some asset on or
before some time in the future, at
prices agreed upon today.
• When exercising a call option, you
“call in” the asset.
25
Basic Call Option Pricing Relationships at Expiry
• At expiry, an American call option is worth
the same as a European option with the same
characteristics.
• If the call is in-the-money, it is worth ST - E.
• If the call is out-of-the-money, it is worthless.
CT = Max[ST - E, 0]
• Where
ST is the value of the stock at expiry (time T)
E is the exercise price.
CT is the value of the call at expiry
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Call Option Payoffs
60
Option payoffs ($)
40
Buy a call
20
0
0
10
20
30
40
50
60
70
80
90
100
Stock price ($)
-20
-40
-60
Exercise price = $50
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Call Option Payoffs
60
Option payoffs ($)
40
20
0
-20
0
10
20
30
40
50
60
70
80
90
100
Stock price ($)
Write a call
-40
-60
Exercise price = $50
28
Call Option Profits
60
Option profits ($)
40
Buy a call
20
0
-20
0
10
20
30
40
50
60
70
80
90
100
Stock price ($)
Write a call
-40
-60
Exercise price = $50; option premium = $10
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Put Options
• Put options gives the holder the
right, but not the obligation, to sell a
given quantity of an asset on or
before some time in the future, at
prices agreed upon today.
• When exercising a put, you “put” the
asset to someone.
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Basic Put Option Pricing Relationships at Expiry
• At expiry, an American put option is
worth the same as a European
option with the same characteristics.
• If the put is in-the-money, it is
worth E - ST.
• If the put is out-of-the-money, it is
worthless.
PT = Max[E - ST, 0]
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Put Option Payoffs
60
Option payoffs ($)
40
Buy a put
20
0
0
10
20
30
40
50
60
70 80
90
100
Stock price ($)
-20
-40
-60
Exercise price = $50
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Put Option Payoffs
60
Option payoffs ($)
40
20
0
0
10
20
30
40
50
60
70 80
90
100
Stock price ($)
-20
-40
write a put
-60
Exercise price = $50
33
Option profits ($)
Put Option Profits
60
40
20
10
0
-10
-20
Write a put
0
10
20
30
Stock price ($)
40
50
60
70 80
Buy a put
90
100
-40
-60
Exercise price = $50; option premium = $10
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($)
profits ($)
Option profitsOption
Selling Options
• The seller (or writer)
60 of an option has an
obligation.
• The purchaser of an
option has an option.
40
20
10
0
-10
-20
Buy a call
Write a put
0
10
20
30
Stock price ($)
40
50
60
70 80
Buy a put
90
100
Write a call
-40
-60
35
Exchanges Trading Options
•
•
•
•
•
•
•
Chicago Board Options Exchange
American Stock Exchange
Philadelphia Stock Exchange
Pacific Stock Exchange
European Options Exchange
Australian Options Market
and many more (see list at end of book)
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1.6 Types of Traders
• Hedgers
• Speculators
• Arbitrageurs
Some of the large trading losses in
derivatives occurred because individuals
who had a mandate to hedge risks switched
to being speculators
37
Hedging Examples (page 11)
• 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 Microsoft shares
currently worth $73 per share. A two-month
put with a strike price of $65 costs $2.50.
The investor decides to hedge by buying 10
contracts
38
Speculation Example
• An investor with $4,000 to invest feels that
Cisco’s 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 25 is $1
• What are the alternative strategies?
39
Arbitrage Example (pages 12-13)
• A stock price is quoted as £100 in London
and $172 in New York
• The current exchange rate is 1.7500
• What is the arbitrage opportunity?
40
Hedging
• Two counterparties with offsetting risks can
eliminate risk.
– For example, if a wheat farmer and a flour mill enter
into a forward contract, they can eliminate the risk each
other faces regarding the future price of wheat.
• Hedgers can also transfer price risk to
speculators and speculators absorb price
risk from hedgers.
• Speculating: Long vs. Short
41
Hedging and Speculating Example
You speculate that copper will go up in price,
so you go long 10 copper contracts for
delivery in 3 months. A contract is 25,000
pounds in cents per pound and is at $0.70
per pound or $17,500 per contract.
If futures prices rise by 5 cents, you will gain:
Gain = 25,000 × .05 × 10 = $12,500
If prices decrease by 5 cents, your loss is:
Loss = 25,000 × -.05 × 10 = -$12,500
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Hedging: How many contacts?
You are a farmer and you will harvest 50,000 bushels
of corn in 3 months. You want to hedge against a
price decrease. Corn is quoted in cents per bushel at
5,000 bushels per contract. It is currently at $2.30
cents for a contract 3 months out and the spot price
is $2.05.
To hedge you will sell 10 corn futures contracts:
50,000 bushels
 10 contracts
5,000 bushels per contract
Now you can quit worrying about the price of corn
and get back to worrying about the weather.
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Hedging in Interest Rate Futures
• A mortgage lender who has agreed to loan
money in the future at prices set today can
hedge by selling those mortgages forward.
• It may be difficult to find a counterparty in
the forward who wants the precise mix of
risk, maturity, and size.
• It’s likely to be easier and cheaper to use
interest rate futures contracts however.
44
Actual Use of Derivatives
• Because derivatives don’t appear on the
balance sheet, they are present a challenge
to financial economists who which to
observe their use.
• Survey results appear to support the notion
of widespread use of derivatives among
large publicly traded firms.
• Foreign currency and interest rate
derivatives are the most frequently used.
45