Derivatives

MART - University of San Carlos

Presentation
November 12, 2009

Table of Contents
1. 2. 3. 4. 5. 6. Derivative Markets & Instruments Forward Markets & Contracts Futures Markets & Contracts Options Markets & Contracts Swap Markets & Contracts Risk Management Applications of Option Strategies

1.

Derivative Markets & Instruments

What is a derivative?


A derivative is a financial instrument which return is based on the return of some other underlying asset Exchange-traded vs. over-the-counter/OTC
Exchange-traded - Standard terms and features - Traded on an organized trading facility Over-the-counter - Any transaction created by two parties anywhere else

Forward commitments vs. contingent claims

Forward commitment


Forward commitment: agreement to engage in a transaction at a later date at a price established at the start Two types of forward commitment:
Exchange-traded --> futures OTC --> forward contracts and swaps

Forward


Forward contract: an agreement that the buyer will buy from the seller an underlying asset at a future date at a price established at the start The contracts are customized Each party is subject to default risk Private and largely unregulated market

Futures


Futures contract: an exchange-traded forward contract The contracts are standardized The exchange, through a clearinghouse, guarantees the delivery to both parties by way of daily settlement --> hence eliminates the default risk Somewhat easier to offset a transaction

Swap


Swap: an agreement to exchange a series of future cash flows Not only single payment like forward Also private in nature, hence face a default risk Common examples are interest rate and currency swaps

Contingent claims


Contingent claims: derivatives in which the payoffs occur if a specific event happens, no obligation to engage in the future transactions. An option is an instrument that gives a party a right (and not an obligation) to buy/sell from the other party at a fixed price over a period of time
A call: a right to buy A put: a right to sell

More about option



 

Option = a right, can be bought and sold Owning an option represents the right to do something (which is either to buy or to sell) The owner of an option has the flexibility, but at a price Option price/premium: the price of the right Option buyer has the right, option seller has the obligation

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Still on option


  

Exercise price: the fixed price at which the underlying can be bought or sold Exercise price is only used when the option owner is exercising the option, if not then the option will expire unexercised There are exchange-traded and OTC options Low transaction cost Options sometimes are embedded in other instruments (such as bonds and ABS)

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Two layer


The option itself: has buyer/seller, price, type of option, period to exercise The underlying asset: type of asset, price (exercise price)

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Purposes and criticism



Purposes of derivatives
Price discovery Risk management

Criticisms
Complex so improper (or lack of knowledge) could cost a large financial loss Mistakenly characterized as a form of legalized gambling

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Arbitrage
Arbitrage: a situation/process to profit at no risk with no commitment of money Arbitrageurs move will correct any price discrepancies --> hence promoting market efficiency In other words, prices are set to eliminate arbitrage profits

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Pop Quiz 1.1

A customized agreement to purchase a certain T-bond next Thursday for $1,000 is: A. A swap B. An option C. A futures contract D. A forward commitment

This non-standardized type of contract is a forward commitment

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2.

Forward Markets & Contracts

Forward contract
  

Buyer = Long, Seller = Short No money changes hands at the start Two possible settlements
Delivery: long pays the price and short delivers the asset Cash settlement: long and short just pay the net cash value of the position on the delivery date

Cash-settled forward is also called nondeliverable forwards (NDFs), e.g.: forward contract on index Default: only from the party that owes the greater amount

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Forward contract termination



Make an opposite or reverse transaction/position with the same expiration date The choice of the counterparty for the reverse transaction
Different from the first transaction: expose to credit risk from 2 different counterparties, but probably with a better return Same as the first transaction: eliminate credit risk for both sides

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The players


End user a party with a risk management problem, e.g.: corporations, nonprofit organizations or governments Dealer a party that matches the long and the short, either an end user or another dealer For individual transaction, dealer might be exposed to a credit risk, but a good and prudent dealer should eliminate such risk on its overall transaction portfolio

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Equity forward contracts



A contract to purchase or sell an individual stock, a stock portfolio or a stock index in a later date at an agreed price Putting aside the transaction costs, there is no difference doing forward contracts for several stocks individually and a single forward contract on a stock portfolio Forward on stock index uses the index as the contract price Forward on index is not a perfect hedge to a portfolio, but might be more practical and lower in transaction costs Unless specifically stated, equity forwards usually exclude dividends

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Forward contracts on bonds



How bonds differ from stocks:

Some have coupons, which are similar to dividends to stock Have a maturity, so forward contracts must expire before the maturity date Some have special features, like calls and convertibility Carry the default risk

Zero-coupon bonds (e.g.: T-bills): price quotation using the discount rate, and not the bond price Coupon-bearing bonds (e.g.: T-bonds): price quotation using the yield, instead of the price Convention: 1 year = 360 days

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Example


A 60-day forward contract on a 180-day T-bill is quoted at 4%. The price of $1 par is $1 4% x (180/360) = $0.98 There are 2 time periods:
Forward contract period: 60 days Maturity of the T-bill: 180 days
60 days Forward contract starting date Forward contract delivery date Buyer receives the 180-day T-bill 180 days Maturity date of 180-day T-bill Buyer gets $1 on T-bill maturity

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Eurodollar market
  

There is a large market for time deposits in various currencies issued by large creditworthy banks Primary market is in London Eurodollar = a dollar time deposit outside US, the primary time deposit instrument in this market Eurodollar time deposits are issued when banks borrow dollars from other banks LIBOR: London Interbank Offer Rate, the lending interest rate for Eurodollar time deposit among banks in London Eurodollar time deposits use add-on interest instead of discounting method like bonds (like usual TDs)

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Other currencies TDs



Eurosterling: Poundsterling-denominated TDs outside UK Euroyen: Yen-denominated TDs outside Japan For Euro-denominated TDs:
EuroLIBOR: compiled in London by British Bankers Assctn Euribor: compiled in Frankfurt, published by ECB

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Forward rate agreement (FRA)

 

FRAs are contracts with interest payment (interest rate) as the underlying Like bonds, there will be 2 time periods:
Time period of the FRA or the forward contract itself Time period of the underlying

Example: a 90-day FRA of 180-day LIBOR (also written as 3 x 9 FRA) There are also 2 different interest rates of the underlying:
At the start of the FRA = the agreed price for the FRA At the expiration of the FRA a factor to calculate the settlement
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Example
  

A 90-day FRA on a 180-day LIBOR is quoted at 5.5% At expiration date, the rate for 180-day LIBOR is 6% Since the interest of 180-day LIBOR will be paid in arrear (i.e.: 180 days later from the FRA expiration date), so we must calculate the present value of such interest payment Assuming the principal/notional amount is US$10m
Settlement value Notional amount (Rate at expiration Fwd rate) (Days in underlying/360) 1 + Rate at expiration (Days in underlying/360)

(6% 5.5%) (180/360) US$10mn 1 + 6% (180/360) = US$24,272

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Formula de-composition
(Rate at expiration Fwd rate) (Days in underlying/360) 1 + Rate at expiration (Days in underlying/360) 1 1 + Rate at expiration (Days in underlying/360) (Rate at expiration Fwd rate) (Days in underlying/360) Present value formula Remember: PV = FV/(1 + i)n 90 days FRA start date Price/rate for 180-day LIBOR is 5.5% X =

The difference (or profit/loss) due to the different rates (read: price) between FRA start date & its expiration date 180 days Maturity of 180-day LIBOR TD + interest

FRA expiration date Delivery of 180-day LIBOR time deposit, with spot price of 180day LIBOR is 6%

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Currency forward contract



To minimize or eliminate the currency fluctuation risk by locking the exchange rate to buy/sell a certain currency for other currency Example: a US company, anticipating to get Euro (meaning, it will long or short US$), could enter into a forward contract to be long in US$ (buying US$ with ) or short in (selling for US$) Settlement could be by delivery or cash-settled

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Pop Quiz 2.1

The short in a deliverable forward contract: A. Has no default risk B. Receives payment at contract initiation C. Is obligated to deliver the specified asset D. Makes a cash payment to long at settlement
The short in a forward contract is obligated to deliver the specified asset at the contract price on the settlement date. There is typically no payment made at contract initiation, and either party may have default risk if there is any probability that the counterparty may not perform under the terms of the contract.

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Pop Quiz 2.2

Which of the following statements regarding a LIBOR-based FRA is true? A. The short will settle the contract by making a loan B. FRAs can be based on interest rates for 30, 60 or 90-day periods C. The contract rate will change with LIBOR over the term of the agreement D. If LIBOR increases unexpectedly over the contract term, the long will be required to make cash payment at settlement
A LIBOR based contract can be based on LIBOR for various terms. They are settled in cash and the contact rate is fixed for the life of the contract. The long will receive a payment when LIBOR is higher than the contract rate at settlement
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3.

Futures Markets & Contracts

Institutional features of future contracts

  

Public, traded on an exchange Regulated Standardized terms and conditions by the exchange:
Types of underlying to be traded Expiration dates and how far the expirations go Contract size and price quotation unit Trading hour, location, and pit or electronic trading

Clearinghouse provides a guarantee against credit losses, by way of daily settlement or marking to market mechanism through margin maintenance

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Characteristics of future contracts

    

Standardized terms and conditions Has the liquidity for the secondary market Protected by the existence of a clearinghouse Need to maintain margin (both for buyer and seller) Fungible: the ability to offset a position (Offsetting: to re-enter the market with an opposite/reverse position, doesnt matter on who will be the counterparty)

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Margin
 

In stock market, margin means loan, i.e.: to reduce investors own money to buy the securities The investor pays only part of the value, and borrows the balance of the transaction value
Margin percentage = Investors own equity Market value of the stock/securities


 

In futures market, margin means deposit or collateral, i.e.: money to be put in opening a futures position Both buyer and seller must deposit their margin No borrowing occurs

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Still on margin
Regulator Quotation Initial margin Margin call


Stock market Federal Percentage Up to maintenance level

Futures market Clearinghouse Dollar terms Lower compare to stock Up to initial level

Given the low margin requirement for futures, it has a bigger leverage magnitude Example: stock market margin in US is 50%, while futures margins are usually <10% of the futures price

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Futures Trade
  

Buyer and Seller on each side Future exchange selects the contracts that will trade Asset, Amount of Asset and settlement/delivery are standardized Delivery Price for the contract is the Equilibrium Price at that point in time which depends on supply Mechanism of supply and demand determines equilibrium is open outcry at a particular location on the exchange floor called pit Each trade is reported so the equilibrium price is known to all trader

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Futures Position prior to Expiration

 

Reverse or Offsetting trade Similar to exiting a forward contract prior to expiration With futures, other side of your position is held by the clearinghouse If making an exact opposite trade to the current position, the clearinghouse will net the positions out, leaving a zero balance.

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Different types of margin

 

Initial margin: money to be deposited when a futures transaction is initiated Maintenance margin: the minimum money balance to be maintained before the clearinghouse calls the traders to deposit funds up to the initial margin Settlement price: an average of final few trades of the day as determined by the clearinghouse (to avoid market manipulation towards the closing hour) Variation margin: additional money to bring the balance up to the initial margin requirement

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Marking to market
 

Conversion of paper gains/losses to actual gains/losses Long 20 contracts, initial margin $5, maintenance margin $2

Day Beginning Funds Settlement Price Gain or Ending (1) Balance (2) Deposited (3) Price (4) Change (5) Loss (6) Balance (7) 0 82 1 84 2 78 3 73 4 79 5 82 6 84 Total

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The other side of the transaction



Short 20 contracts, initial margin $5, maintenance margin $2

Day Beginning Funds Settlement Price Gain or Ending (1) Balance (2) Deposited (3) Price (4) Change (5) Loss (6) Balance (7) 0 82 1 84 2 78 3 73 4 79 5 82 6 84 Total
Profit/loss = (End price Beginning price) x # of contract

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Limits in the futures market



Price limits: limits on the price change in one trading day Limit move: when price freezes at one of the limits Limit up: when the price is stuck at the upper limit Limit down: when the price is stuck at the lower limit Locked limit: if a transaction cannot take place because the price would be beyond the limits
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Closing of a futures transaction

2 days before expiration (futures price = 50) 1 day before expiration (settlement price = 52) Expiration (settlement price = 53)

Buy futures at 50: Pay nothing

Mark to market profit/loss: 52 50 = 2

Cash Settlement: Receive 53 52 = 1 or Physical Delivery: Pay 52, receive asset worth 53 or Closeout: Sell contract at 53 Mark to market profit/loss: 53 52 = 1

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Delivery option


Delivery option: the right to decide on delivery aspects The short holds the sole right to make decisions about what, when and where to deliver Exchange for physicals (EFP): alternative delivery procedure mutually agreed by the long and short, outside the exchanges normal delivery procedures.

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Closing and Terminating a Futures Position

Closing Out A Futures Position When a trader goes long or short on a position, he can close his position prior to expiration by executing a reversing transaction that is exactly the same as his original trade. The clearing house views the trader as holding a long and short position that offset each other, causing the trader's position to be flat. This is the same as having no position at all.
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Example: Closing a Futures Position

You have entered a long position in 30 December S& P 250 contracts, in August. Come September, you decide that you want to close your position before the contract expires. To accomplish this, you must short, or sell the 30 December S & P 250 contract. The clearing house sees your position as flat because you are now long and short the same amount and type of contract.
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Terminating Futures Contracts

1. Close-Out (offset) at Expiration - If a trader holds a long position, she can go short the same contract with regards to the terms of the original trade and vice versa for the short position trader. Prices may differ because of market conditions. 2. Delivery - Here, the long position keeps the position open at the end of trading on the expiration date. This requires the long holder to accept delivery of the underlying asset and pay the short position the settlement price from the previous day.
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Terminating Futures Contracts

3. Equivalent Cash Settlement - Some contracts are designated as cash-settle contracts. At expiration, the trader keeps his position open. When the contract expires, the margin account is marked to market and the gain is posted in the account. The reason that a gain is posted is because in most cases the trader would close out the position prior to expiration if it is a loser.

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Terminating Futures Contracts

4. Exchange-for-Physicals These are used for futures participants. Here the long and short holders arrange alternative delivery procedures. For example, if the exchange requires the physical delivery of the asset in Chicago, the parties may agree to make settlement outside of the required area, say Pittsburgh. The parties will have to report to the Chicago Board of Trade that the transaction was settled outside the normal procedures. This is satisfactory to the exchange.
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Futures exchange member



Exchange members have the privilege to transact

Floor traders = locals, or Brokers = futures commissions merchants (FCM)

Three styles of locals

Scalper: brief holding period, try to profit from bid/ask spread Day trader: closes all positions at the end of the day Position trader: holds positions open overnight

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Treasury bill futures

 

 

   

Underlying: 90-day $1,000,000 US Treasury bill Price quotation: IMM Index (International Monetary Market) = 100 Rate Actual futures price = $1mn x [1 Rate x (90/360)] Example: Rate = 6.25, IMM = 100 6.25 = 93.75, Price = $1mn x [1 (6.25% x (90/360))] = $984,375 Conversion: 1 basis point of IMM Index = $25 in price Minimum tick size: one-half basis point, or $12.5 Less important and actively traded than Eurodollar futures Settlement: cash

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Eurodollar futures
 

  

 

Underlying: $1,000,000 notional principal of 90-day Eurodollars Price quotation: IMM Index (International Monetary Market) = 100 Rate Actual futures price = $1mn x [1 Rate x (90/360)] Minimum tick size: one basis point, or $25 Interest on Eurodollar time deposits is computed on an add-on basis to the notional principal The expirations go out about 10 years Settlement: cash

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Eurodollar Futures
3-month Eurodollar futures contracts trade with delivery months of March, June, September, and December up to 10 years into the future. This means that in 2006 an investor can use Eurodollar futures to lock in an interest rate for 3-month periods that are as far into future as 2016. The interest rate underlying the Eurodollar futures contract is the Eurodollar interest rate applicable to a 90-day period beginning on the 3rd Wednesday of the delivery month. A Eurodollar futures contract is settled in cash on the 2nd London business day before the 3rd Wednesday of the month. The face value of a Eurodollar future contract is $1000000.
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Eurodollar Futures


  

Eurodollar futures work the same as T-bill contracts except the rate is based on LIBOR. Price quotes and actual price is determined the in the same way as for T-bills. Settles in cash One of most active contracts in the markets Instead of add-on interest, (for example a 100 @ 10% for a year and the bank would owe $110 dollars), the rate is subtracted from 100, just as it is with T-bills With T-bills the investor would receive $1 million per contract, while in the Eurodollar futures market the firm would pay 1 million euros
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Treasury bonds futures

  

  

Underlying: US Treasury bonds with any coupon but with a maturity of at least 15 years Hypothetical deliverable bond has a 6% coupon Actual deliverable bonds with coupon greater/less than 6% will be adjusted by the conversion factor Conversion factor: price of a $1.0 par bond with a coupon and maturity equal to the actual deliverable bond, with 6% yield Short will look for the cheapest-to-deliver bond Price quotation: points and 32nds, e.g.: 98 18/32 = 98.5625 Settlement: actual delivery through Feds wire system

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Treasury Bond Contracts



A contract based on the delivery of a U.S. Treasury bond with any coupon and at least 15 years to maturity. There are many different bonds that fit the above description. To give some type of standardization, the markets use a conversion factor to achieve a hypothetical bond with a 6% coupon.

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Because bond prices do not move in a linear fashion, there is a chance to use arbitrage to capitalize on the deviance of a bond when compared to the 6% standardized bond. To do this, traders look for the cheapest to deliver bond (CTD). This is the least expensive underlying product that can be delivered upon expiry to satisfy the requirements of a derivative contract. This helps minimize the slippage between the conversation factor and the actual price.
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The CTD bond is always changing because prices and yields are always changing. A contract covers $100,000 par value of U.S. Treasuries. Contract expires March, June, September and December

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Stock index futures

         

One of the most successful types of futures contracts Underlying: stock index, e.g.: S&P 500 Stock Index Price quotation: same magnitude order as the index itself Actual price: price quotation x a multiplier Example: for S&P 500 futures, the multiplier is $250 Settlement: cash Dow Jones Industrials = $10 Nasdaq = $100 FTSE 100 (footsie) Germany s DAX 30 Japan Nikkei 225 Frances CAC 40

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Stock Index Contracts



Investors trading index options are essentially betting on the overall movement of the stock market as represented by a basket of stocks. Options on the S&P 500 are some of the most actively traded options in the world. Quoted in terms equal to the index itself. For example if the S&P 500 is trading at 1050 the one-month contract may be at 1060. Each contract has a multiplier. For the S&P 500, it is 250. The actual price in the above point would equal 1060*250 = $265,000.
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Stock Index Contracts



 

S&P 500 contracts expire in March, June, September and December and can have maturity dates as far away as two years. Settlement is in cash. The FTSE 100 and Japan's Nikkei 225 are other types of indexes upon which stock index contracts are based.

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Currency futures
 

 

 

The first financial futures contracts Underlying: foreign currencies, with different contract size for each currency. E.g.: for euro is Euro125,000 Price quotation: depends on the currency Example: for euro, price quotation is in US$/euro Futures price of $0.8555, contract price = $106,937.50 Settlement: actual delivery through book entry Yen =Y12,500,000 and is quoted without two zeroes that ordinarily preceded the price. Ex. 0.8205) 12,500,000 (0.008205) = $102,562.50
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Currency Contracts


Currency contracts function in the same way as forward contracts for currency. They are typically much smaller than forward contracts. Each contract has a stated size and quotation unit. Future price for euros = 0.92, which leads to a contract price of 125,000(this is the contract size)(.92) = 115,000 Calls for actual delivery through book entry of the underlying currency.
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Pop Quiz 3.1

The daily process of adjusting margin in a futures account is called: A. Initial margin B. Variation margin C. Marking to market D. Maintenance margin
Variation margin is the funds that must be deposited when marking to market draws the margin balance below the maintenance margin.

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Pop Quiz 3.2

A trader buys (takes a long position) in a Eurodollar futures contract ($1 million face value) at 98.14 and closes out at a price of 98.27. On this contract the trader has: A. Lost $325 B. Gained $325 C. Lost $1,300 D. Gained $1,300
The price quoted as 1 annualized discount in %. Remember that the gains and losses on T-bill and Eurodollar futures are $25 per basis point of the price quote. The price is up 13 ticks, and 13 x $25 is a gain of $325 for a long position.

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4.

Option Markets & Contracts

Features of option contracts



Option price = option premium = premium = the price to be paid by the option buyer for the right to exercise Exercise price = strike price = strike = the price at which the option holder can buy/sell the underlying To exercise = exercising the option = when the option holder uses the right to buy/sell the underlying Expiration date or time to expiration
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Exercise styles


European-style exercise or European option: the option that can be exercised only on its expiration day American-style exercise or American option: the option that can be exercise on any day through the expiration day The default risk is unilateral (unlike in forward contracts) because only the short can default

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Moneyness, Payoff, Intrinsic Value & Time Value



Moneyness: relationship between the price of underlying and the exercise price
In-the-money: exercising the option will produce cash inflow > cash outflow Out-of-the-money: exercising the option will produce cash inflow < cash outflow At-the-money: when underlying price = exercise price

 

Payoff: value of an option at its expiration Intrinsic Value is the amount: 1) by which the option is in the money, and 2) the option holder would receive if the option were exercised. Time Value of an option is the amount by which the option premium exceeds the intrinsic value (speculative value). Option value = intrinsic value + time value
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Exchange-Trade & OTC Options

Exchange-Traded or Listed Options  Regulated, standardized, liquid, and back by the Options Clearing Corp. for Chicago Board Options Exchange Transactions Over-the-counter (OTC) options  All but disappeared with the growth of the organized exchanges in the 1970s. There presently exists and active market in OTC options on currencies, swaps, and equities, for institutional buyers.  Unregulated, consists of custom options, involves counterparty risk, facilitated by dealers.

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Types of options
       

Stock options or equity options Index options Bond options Interest rate options Currency options Options on futures Commodity options Other types of options

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Stock options
Exercise Price July Calls October Calls July Puts October Puts 15.00 2.35 3.30 0.90 1.85 17.50 1.00 2.15 2.15 3.20


Options on Sun Microsystems on 13 June, share price is $16.25 Pricing Principles

Call options have a lower premium the higher the exercise price Put options have a lower premium the lower the exercise price Both call and put options are cheaper the shorter the time to expiration

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Index options
 

A stock index is practically a collection of stocks The exchange determines an index contract multiplier Example: S&P 500 Index is European style and settles in cash, with multiplier of 250 If the last closing index is 1241.60 A call option expiring in 1-mo with exercise price of $1250 is selling for $28 At expiration: If the index > 1250 exercise the option. If not, let the option expires
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Bond options
   

 

Primarily traded in the OTC markets Mostly for government bonds The option could be American or European style Its expiration day must be significantly before the maturity date of the bond Could be actual delivery or cash-settled Example: A call option on a US T-bond for $5mn face value with an exercise price of $0.98 per $1.00 par

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Interest rate options

 

The price is the interest rate, so exercise price becomes exercise rate Interest rate call: an option where the holder has the right to make a known interest payment and receive an unknown interest payment Interest rate put: an option where the holder has the right to make an unknown interest payment and receive a known interest payment Settled in cash, mostly European style

Holder/Long Right Seller/Short Obligation Interest rate call Pay known, receive unknown Pay unknown, receive known Interest rate put Pay unknown, receive known Pay known, receive unknown

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Interest rate options vs. FRA

 

FRA is a commitment, interest rate option is a right FRA pays at expiration (discounted), interest rate option pays at the maturity of the interest (no discounting) Example: An option expiring in 90 days on 180-day LIBOR with exercise rate of 5.5% and notional amount of $10mn At expiration, 180-day LIBOR is 6% Payoff to holder = $10mn x (6% - 5.5%)(180/360) = $25,000

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Payoff of interest rate options



For interest rate calls

Notional x Max(0,Underlying rate at expiration Exercise rate) Days in underlying rate 360

For interest rate puts

Notional x Max(0,Exercise rate Underlying rate at expiration) Days in underlying rate 360


Notation note: Max(a,b) = the maximum of a or b

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Interest rate cap and floor



Interest rate cap (floor) is a series of call (put) options on an interest rate, each expiring at the date of floating rate reset, with each has the same exercise rate Each component of cap (floor) is called a caplet (floorlet) Interest rate collar is a combination of:
A long cap and a short floor, or A short cap and a long floor

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Currency options
 

Allows the holder to buy (sell) an underlying currency at a fixed exercise exchange rate Example: An call option on 50mn at $0.90/ At expiration:
> $0.90/ Exercise the option < $0.90/ Buy at market rate



< 1.1111/$ Sell $45m at 1.1111/$

> 1.1111/$ Sell enough $ to get 50mn

Call option on 50mn at $0.90/ = Put option on $45mn (50mn x $0.90/) at 1.111/$ (1/($0.90/))

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Options on futures


A call (put) option on a futures gives the holder the right to enter into a long (short) futures contract at a fixed futures price If call (put) option is exercised, the exchange will assign the option seller with the short (long) futures contract

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Notations
       

S0, ST = underlying price at time 0 (today) and T X = exercise price r = risk-free rate T = time to expiration = # of days 365 c0, cT = price of European call today & at expiration C0, CT = price of American call today & at expiration p0, pT = price of European put today & at expiration P0, PT = price of American put today & at expiration

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Payoff values
 

Payoff: value of an option at its expiration Intrinsic value = exercise value: what the option is worth to exercise based on current conditions Time value = speculative value: the difference between the option market price and its intrinsic value. Time value = 0 at expiration
Option value = intrinsic value + time value

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Value at expiration


At expiration, a call option is worth either zero or the difference between the underlying price and the exercise price, whichever is greater cT = CT = Max(0, ST X) At expiration, a put option is worth either zero or the difference between the exercise price and the underlying price, whichever is greater pT = PT = Max(0, X ST)

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Payoff diagrams, X = 50
Long call
Value 0 0

Long put

50

50

Short call
0 0

Short put

50

50
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Min & Max Values of American & European Options



Minima. Theoretically, no option will sell for less than intrinsic value and no option can take on a negative value. Thus, Ct > 0, ct > 0, Pt > 0, and pt > 0 Max values for calls. The maximum value of either an American or European call option at any time is the time-t share price of the underlying stock. Thus, C0 < S0 and c0 < S0

Max values for puts. The price of an American put option cannot be more than the strike price. For European puts, since they cannot be exercised prior to expiration, the maximum value is the PV of the exercise price discounted at the RFR. Thus, P0 < X and p0 < X/(1 + r)T
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Lower Bounds for European Options



To determine the lower bounds for European options, we examine the value of a portfolio in which the option is combined with a long or short position in the stock and a pure discount bond.
Option European call American call European put American put Minimum Value ct > Max[0, S t X / (1 + r) ] Ct > Max[0, S t X / (1 + r) ] pt > Max[0, X / (1 + r)
T-t T-t T-t

Maximum Value St St X / (1 + r) X
T-t

St]

Pt > Max[0, X St]

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Lowest possible price



Call options
European: c0 u Max(0, S0 X/(1+r)T) American: C0 u Max(0, S0 X) u c0 Because Max(0, S0 X/(1+r)T) u Max(0, S0 X) and C0 u c0, so: C0 u Max(0, S0 X/(1+r)T)

Put options
European: p0 u Max(0, X/(1+r)T S0) American: P0 u Max(0, X S0)

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Example
 

   

A call and a put expires in 73 days, the underlying price is 53 and risk-free rate is 5% Calculate the lower bounds of European/American calls for exercise prices of 50 and 55 Calculate the lower bounds of European and American puts for exercise prices of 50 and 55 T= S0 = r= X=

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Difference in exercise prices

 

Assume: X1 e X2 For call options: c0(X1) u c0(X2); C0(X1) u C0(X2)

Call option with higher exercise price can not have a greater value than the one with a lower exercise price

For put options: p0(X1) e p0(X2); P0(X1) e P0(X2)

Put option with lower exercise price can not have a greater value than the one with a higher exercise price

Generally, the higher the exercise price, the lower the call price and the higher the put price
Exercise Price July Calls October Calls July Puts October Puts 15.00 2.35 3.30 0.90 1.85 17.50 1.00 2.15 2.15 3.20
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Difference in time to expiration

 

Assume: T1 e T2 (option with T1 expires earlier) For call options: c0(T1) e c0(T2); C0(T1) e C0(T2)
The longer-term call is worth no less than the shorter-term call

For put options:

European: p0(T1) can be e or u than p0(T2) American: P0(T1) e P0(T2) Exercise Price July Calls October Calls July Puts October Puts 15.00 2.35 3.30 0.90 1.85 17.50 1.00 2.15 2.15 3.20

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Put-call parity
 

  

Derived from a fiduciary call and a protective put Fiduciary call = a European call + a risk-free bond. The bond matures at the calls expiration date with face value = exercise value Protective put = a European put + underlying asset At expiration, the value of FC = the value of PP So, the current value must be equal to avoid arbitrage current value of FC = current value of PP c0 + X/(1 + r)T = p0 + S0

90

Synthetics
     

From put-call parity: c0 + X/(1 + r)T = p0 + S0 Synthetic call: c0 = p0 + S0 X/(1 + r)T Synthetic put: p0 = c0 + X/(1 + r)T S0 Synthetic underlying: S0 = c0 + X/(1 + r)T p0 Synthetic bond: X/(1 + r)T = p0 + S0 c0 Notation:
+: long/buy, or lending money by buying (for bond) : short/sell, or borrowing money by issuing (for bond)

91

Arbitrage
 

If put-call parity equation is violated, then buy the lower combination and sell the higher one Example: A call option with X = 100, expiring in half a year (T = 0.5). Risk-free rate = 10%. The call is priced at $7.50 and the put at $4.25. The underlying price is $99. FC = c0 + X/(1 + r)T = 7.5 + 100/1.10.5 = 102.85 PP = p0 + S0 = 4.25 + 99 = 103.25 So, buy FC and sell PP netted $0.40 Sell PP = PP = (p0 + S0) = p0 S0

92

Early exercise


For call options

If the underlying makes no cash payments, C0 = c0 With the underlying makes cash payments during the life of the option, early exercise can be worthwhile and C0 can be higher than c0

For put options

Because of time value of money and bankruptcy possibility, there is always a possibility of early exercise So, American puts are nearly always worth more than the European puts: P0 > p0
93

Effect of cash flows on underlying



Some underlying have cash flows (dividends, interest, carrying costs) Remove the PV of the cash flows from the underlying price Lower bounds of European options are: c0 u Max(0, [S0 PV(CF,0,T)] X/(1+r)T) p0 u Max(0, X/(1+r)T [S0 PV(CF,0,T)]) Put-call parity: c0 + X/(1 + r)T = p0 + [S0 PV(CF,0,T)]
94

Effect of interest rate & volatility



The higher the interest rate

Call option prices are higher, and Put option prices are lower

The higher the volatility

Increase call and put option prices, because it increases the possible upside and downside values of the underlying

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Pop Quiz 4.1

Which of the following statements about moneyness is FALSE? When: A. S-X is>0, a call option is in the money B. S-X = 0, a call option is at the money C. S=X, a put option is at the money D. S>X, a put option is in the money

A put option is out of the money when S>X and in the money when X>S.

96

Pop Quiz 4.2

A $40 call on a stock trading at $43 is priced at $5. The time value of the option is: A. $2 B. $3 C. $5 D. $8

The intrinsic value is S-X = $43-$40=$3. So the time value is $5$3=$2.

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Pop Quiz 4.3

Which of the following will increase the value of a put option? A. An increase in Rf B. An increase in volatility C. A decrease in the exercise price D. A decrease in time to expiration

Increased volatility of the underlying asset increases both put values and call values

98

5.

Swap Markets & Contracts

Characteristics of swap contracts

 

  

  

A swap is a series of payments On the initiation (except on currency swaps), no exchange of money Settlement date = payment date Settlement period = time between settlement dates Netting: parties exchange the net amount owed (except for currency swaps due to different currency) Generally settled in cash Termination date = date of the final payment Almost exclusively OTC market

100

Termination of a swap


 

Settle with the counterparty, selling/buying the swap at the market value Entering a new swap with opposing position Sell the swap to another counterparty (not commonly used) Using a swaption (an option to enter a swap agreement)

101

Currency swaps


   

Each party makes interest payments to the other in different currencies Exchange the notional/principal at the initiation Make periodic payment on the interest Exchange back the notional at the termination Example: to lower the cost of borrowing in a cross-border transaction by utilizing each partys borrowing credibility domestically

102

Example


 

A US company is expanding in Europe and needs 9M. It issues $10M US bonds and enters into a currency swap with a German company for 9mn Exchange rate = 0.90/$ Interest rates p.a.:
US$-denominated loan Euro-denominated loan US company European company 8% 9% 6% 5%

  

Assume: annual interest payment Interest on US$ loan = $10M x 8% = $800T Interest on loan = 9M x 5% = 450T

103

Currency swap diagram



On the initiation date

$10M
Bondholders US-Co DE-Co

$10M


9M

On interest payment date(s)

$800T
Bondholders US-Co DE-Co

$800T


On termination date
Bondholders

=$500T or 450T 5%
$10M
US-Co DE-Co

$10M

9M
104

Cash flows


From the US companys point-of-view

9M $800T $800T $10.8M

In

Out

$10M Initiation date

450T Interest payment dates

450T

9.45M Termination date

105

Interest rate swaps



  

Plain vanilla swap: one party pays a fixed rate and the other pays a floating rate, in the same currency No need to exchange the notional principals Interest payments are netted Example: A bank pays its depositors with floating rates while receives loan payments from its borrowers with fixed rates exposed to interest rate increase. So, the bank enters into a swap agreement to minimize the exposure/risk
106

Interest Rate Swap Case Analysis

Bank XYZ enters into a $1,000,000 quarterly-pay plain vanilla interest rate swap as the fixed-rate payer at a fixed rate of 6% based on a 360-day year. The floatingrate payer agrees to pay 90-day LIBOR plus a 1 percent margin; 90-day LIBOR is currently 4 percent. 90- day LIBOR rates are: 4.5% 90 days from now 5.0% 180 days from now 5.5% 270 days from now 6.0% 360 days from now Calculate the amounts Bank A pays or receives 90, 270 and 360 days from now.
107

Interest Rate Swap Case Analysis

Payment 90 days from now depends on current LIBOR plus fixed rate and 1% margin. Fixed-rate payer pays: [0.06(90/360) (0.04 + 0.01) (90/360)] x 1,000,000 = $ 2,500 270 days from now the payment is based on LIBOR 180 days from now, which is 5% plus 1% margin = floating-rate of 6%, which is equal to the fixed rate, so there is no net 3rd quarterly payment. Banks payment 360 days from now is: [0.06(90/360) (0.055 + 0.01) (90/360)] x 1,000,000 = -$1,250 Floating-rate payment exceeds the fixed-rate payment, Bank A will receive $1,250 at the 4th payment date.
108

Plain Vanilla Swap Structure

Float

Borrowers

Bank

Depositors

Fixed Float Fixed

Swap counterpart

109

Equity swaps


Swaps where the variable rate is the return on a stock or stock index Example: a mutual fund enters an equity swap with a dealer where:
The dealer pays a fixed rate, and The mutual fund pays the return of a certain stock index (if the return is negative, the dealer will pay the mutual fund)

110

Equity Swap Payments Case Analysis



Mr. Isaac enters into a 2-yr $10 M quarterly swap as the fixed payer and will receive the index return on the S&P 500. The fixed rate is 8% and the index is currently @ 986. At the end of the next three quarters the index level is: 1030, 968, and 989. Calculate the net payment for each of the next three qtrs., Identify direction of the payment.

111

Equity Swap Payments Case Analysis



% change in the index each quarter, Q, is: Q1 = 4.46%, Q2 = -6.02%, and Q3 = 2.17%. The index return payer (IR) will receive 0.08/4 = 2% each quarter and pay the index return,

Q1: IR payer pays 4.46% - 2.00% = 2.46% or $246,000. Q2: IR payer receives 6.02% + 2.00% = 8.02% or $802,000. Q3: IR payer pays 2.17% - 2.00% = 0.17% or $17,000.

112

Pop Quiz 5.1

Which of the following statements is FALSE? A. In a currency swap, the notional principal is actually swapped twice, once in the beginning of the swap and again at the termination of the swap B. The time frame of a swap is called its tenor C. Swap are a zero sum game D. In a currency swap, only net interest payments are made In a currency swap, payments are not netted because they are made in different currencies. Full interest payments are made, and the notional principal is also exchanged.

113

Pop Quiz 5.2

Which of the following statements is not an advantage of swaps? Swaps: A. Give the traders privacy B. Have little or no regulation C. Minimize default risk D. Have customized contracts Swaps do not minimize default risk. Swaps are agreements between 2 or more parties, and there are no guarantees that one of the parties will not default. Note that swaps do give traders privacy and , being private transactions, have little or no regulation and off the ability to customize contracts to specific needs.

114

Pop Quiz 5.3

In an equity swap: A. Settlement is made only at swap termination B. Shares are exchanged for the notional principal C. Returns on 2 equities are swapped, at each settlement date D. Returns on an index can be swapped for fixed-rate payments

Equity swaps involve one party paying the return or total return on a stock or index periodically in exchange for a fixed return.

115

6.

Risk Management Applications

Simple stock strategies

Buy Stock
Profit 50

Sell Short Stock

-50 50 50 Stock price at End of Holding Period (ST)

117

Calls


A call selling for $7 with the exercise price of $100

V0, VT = value of the position at time 0 and T = profit from transaction = VT V0

Long call
Profit 0 -7 Value at Expiration Profit 7 0

Short call
Profit

Value at Expiration 100 107 100 107 Value of Underlying at Expiration (ST)
   

Profit = = cT c0 Breakeven = X + c0 = 107 Max profit = g Max loss = c0 = 7

   

Profit = = cT + c0 Breakeven = X + c0 = 107 Max profit = c0 = 7 Max loss = g

118

Puts


A put selling for $4 with the exercise price of $60

V0, VT = value of the position at time 0 and T = profit from transaction = VT V0

Profit 60 56 0

Long put
Value at Expiration 0 -56 Profit 56 60 -60 Profit

Short put

Value at Expiration

56 60 Value of Underlying at Expiration (ST)

   

   

Profit = = pT p0 Breakeven = X p0 = 56 Max profit = X p0 = 56 Max loss = p0 = 4

Profit = = pT + p0 Breakeven = X p0 = 56 Max profit = p0 = 4 Max loss = X p0 = 56

119

Covered calls
  

A covered call = own underlying + sell/short a call V0 = S0 c0 ST if ST e X, or VT = ST Max(0, ST X) = X if ST > X ST S0 + c0 if ST e X, or = VT V0 = X S0 + c0 if ST > X Maximum profit = X S0 + c0 Maximum loss (if ST = 0) = S0 + c0 Breakeven = S0 c0

  

120

Covered calls diagram



A stock selling for $20 (S0). A call on such stock with an exercise price of $28 (X) selling for $5 (c0).

Profit


13 5 0 8


Maximum profit = X S0 + c0 = 28 20 + 5 = 13 Maximum loss = S0 + c0 = -20 + 5 = -15 Breakeven = S0 c0 = 20 5 = 15

-15 -20 15 20 28 33

121

Protective puts
  

A protective put = own underlying + buy/long a put V0 = S0 + p0 if ST e X, or VT = ST + Max(0, X ST) = X ST if ST > X X S0 p0 if ST e X, or = VT V0 = ST S0 p0 if ST > X Maximum profit = g Maximum loss = S0 + p0 X Breakeven = S0 + p0

  

122

Protective puts diagram



A stock selling for $20 (S0). A put on such stock with an exercise price of $17 (X) selling for $5 (p0).

Profit


12 0 -8 -20 -5

Maximum profit = g Maximum loss = S0 + p0 X = 20 + 5 17 = 8 Breakeven = S0 + p0 = 20 + 5 = 25

17 12 20

25

123

Pop Quiz 6.1

Which of the following is the riskiest single-option transaction? A. Buying a call B. Writing a call C. Buying a put D. Writing a put

When buying either a call or a put, the loss is limited to the premium. When writing puts, your loss is limited to the strike price of the stock if the stock falls to zero (however, you keep the premium). When writing an uncovered call, the stock could go up infinitely, and you would be forced to buy the stock in the open market and deliver at the strike price potential losses are unlimited
124

Pop Quiz 6.2

A put with a strike price of $75 sells for $10. Which of the following statements is false? The greatest: A. Profit the writer of the put option can make is $10 B. Profit the buyer of a put option can make is $65 C. Loss the writer of a put option can have is $75 D. Loss to the buyer of a put is $10 The greatest loss the put writer can have is the strike price premium = $65

125