Options, Futures, and Other Derivatives, 6

th
Edition, Copyright John C. Hull 2005
1.1
Introduction
Chapter 1
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.2
Derivatives

A derivative security is a inancial contract

!hose value is derived ro" the value o
so"ething else, such as a stoc# price, a
co""odity price, an e$change rate, an
interest rate, or even an inde$ o prices.
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.!
The Nature of Derivatives

A derivative is an instru"ent !hose

value depends on the values o other
"ore %asic underlying varia%les

&hese contracts are legally %inding

agree"ents, "ade on the trading screen
o stoc# e$changes, to %uy or sell an
asset in uture.
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
."
'
A derivative is a inancial
instru"ent, or contract, %et!een
t!o parties that derived its value
ro" so"e other underlying asset
or underlying reerence price,
interest rates or inde$.
'
A derivative %y itsel does not
constitute o!nership, instead it is
a pro"ise to convey o!nership.
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.5
Examples of Derivatives
'
(utures Contracts
'
(or!ard Contracts
'
)!aps
'
*ptions
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.6
Derivatives: Types & Classification

&hese are traded %oth on esta%lished

e$changes +li#e ,)E, Chicago %oard o
option e$change- and *&C "ar#et.

*&C "ar#et is usually a telephone and

co"puter lin#ed net!or# o
dealers.%ro#ers spread ar a!ay
geographically and orders are placed and
e$ecuted electronically or over phone.
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.#
Financial Derivatives
Forwards
Futures options complex
Co""odity
)toc# inde$
inancial
Co""odity
)toc#
(utures
)toc# inde$
)!aps
(or!ard rate
agree"ent
Credit derivatives
E$otic options
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.$
Derivatives Markets

E$change traded

/erivatives traded on the regulated e$changes are highly

standardised.

&he parties o the contracts do not decide the ter"s o

utures.option contracts0 they "erely accept the ter"s o
contracts standardised %y the e$change

Over-the-counter (OTC)

A co"puter1 and telephone1lin#ed net!or# o dealers at

inancial institutions, corporations, and und "anagers

Contracts can %e non1standard and there is so"e s"all a"ount

o credit ris#
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.%
Sie of !TC and Exchan"e Markets
#$i"ure %&%' (a"e )*

&our'e( )an* +or ,nternational &ettle-ents. Chart sho.s total prin'ipal a-ounts
+or O/C -ar*et and value o+ underlying assets +or e0'hange -ar*et
0
20
20
60
30
100
120
120
160
130
200
220
220
Jun143 Jun144 Jun100 Jun101 Jun102 Jun105 Jun102
)i6e o 7ar#et +8
trillion-
*&C
E$change
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.0
+ays Derivatives are ,sed

&o hedge ris#s

&o speculate +ta#e a vie! on the

uture direction o the "ar#et-

&o loc# in an ar%itrage proit

&o change the nature o a lia%ility

&o change the nature o an

invest"ent !ithout incurring the costs
o selling one portolio and %uying
another
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.
$or-ard Contracts

(or!ard contracts are si"ilar to utures

e$cept that they trade in the over1the1
counter "ar#et

(or!ard contracts are particularly popular

on currencies and interest rates
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.2
$orei"n Exchan"e .uotes for /0(
1une )' 233) #See pa"e 4*
9id *er
)pot 1.6231 1.6235
11"onth or!ard 1.6223 1.6255
51"onth or!ard 1.613: 1.6142
61"onth or!ard 1.6042 1.6100
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.!
$or-ard (rice

&he or!ard price or a contract is the

delivery price that !ould %e applica%le
to the contract i !ere negotiated
today +i.e., it is the delivery price that
!ould "a#e the contract !orth e$actly
6ero-

&he or!ard price "ay %e dierent or

contracts o dierent "aturities
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
."
Terminolo"y

&he party that has agreed to %uy

has !hat is ter"ed a long position

&he party that has agreed to sell

has !hat is ter"ed a short position
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.5
Example #pa"e 4*

*n June 5, 2005 the treasurer o a

corporation enters into a long or!ard
contract to %uy ;1 "illion in si$ "onths at
an e$change rate o 1.6100

&his o%ligates the corporation to pay

81,610,000 or ;1 "illion on /ece"%er 5,
2005

<hat are the possi%le outco"es=

Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.6
(rofit from a
5on" $or-ard (osition
>roit
>rice o ?nderlying
at 7aturity, S
T
K
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.#
(rofit from a
Short $or-ard (osition
>roit
>rice o ?nderlying
at 7aturity, S
T
K
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.$
$utures Contracts #pa"e 6*

Agree"ent to %uy or sell an asset or a

certain price at a certain ti"e

)i"ilar to or!ard contract

<hereas a or!ard contract is traded

*&C, a utures contract is traded on an
e$change
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.%
Exchan"es Tradin" $utures

Chicago 9oard o &rade

Chicago 7ercantile E$change

@A((E +@ondon-

Eure$ +Europe-

97B( +)ao >aulo, 9ra6il-

&A((E +&o#yo-

and "any "ore +see list at end o %oo#-

Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.20
Examples of $utures Contracts
Agree"ent toC

%uy 100 o6. o gold D ?)8200.o6. in

/ece"%er +,E7EF-

sell ;62,500 D 1.5000 ?)8.; in

7arch +C7E-

sell 1,000 %%l. o oil D ?)820.%%l. in

April +,E7EF-
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.2
%& /old: 7n 7r8itra"e
!pportunity9
)uppose thatC
&he spot price o gold is ?)8500
&he 11year or!ard price o gold is
?)8520
&he 11year ?)8 interest rate is 5G
per annu"
As there an ar%itrage opportunity=

Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.22
2& /old: 7nother 7r8itra"e
!pportunity9
)uppose thatC
1
&he spot price o gold is
?)8500
1
&he 11year or!ard price o gold
is ?)8500
1
&he 11year ?)8 interest rate is
5G per annu"
As there an ar%itrage opportunity=
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.2!
The $or-ard (rice of /old
A the spot price o gold is S and the or!ard
price or a contract delivera%le in T years is F,
then
F = S +1Hr -
T
!here r is the 11year +do"estic currency- ris#1
ree rate o interest.
An our e$a"ples, S I 500, T I 1, and r I0.05 so
that
F I 500+1H0.05- I 515
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.2"
%& !il: 7n 7r8itra"e
!pportunity9
)uppose thatC
1
&he spot price o oil is ?)814
1
&he Juoted 11year utures price o
oil is ?)825
1
&he 11year ?)8 interest rate is
5G per annu"
1
&he storage costs o oil are 2G
per annu"
As there an ar%itrage opportunity=
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.25
2& !il: 7nother 7r8itra"e
!pportunity9
)uppose thatC
1
&he spot price o oil is ?)814
1
&he Juoted 11year utures price o
oil is ?)816
1
&he 11year ?)8 interest rate is
5G per annu"
1
&he storage costs o oil are 2G
per annu"
As there an ar%itrage opportunity=
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.26
!ptions

A call option is an option to %uy a

certain asset %y a certain date or a
certain price +the stri#e price-

A put option is an option to sell a

certain asset %y a certain date or a
certain price +the stri#e price-
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.2#
7merican vs European !ptions

An A"erican option can %e e$ercised at

any ti"e during its lie

A European option can %e e$ercised only

at "aturity
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.2$
Intel !ption (rices #May 2:' 233);
Stock (rice<23&=)*; See Ta8le %&2 pa"e >

)tri#e
>rice
June
Call
July
Call
*ct
Call
June
>ut
July
>ut
*ct
>ut
20.00 1.25 1.60 2.20 0.25 0.35 1.50
22.50 0.20 0.25 1.15 1.35 2.20 2.35
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.2%
Exchan"es Tradin" !ptions

Chicago 9oard *ptions E$change

A"erican )toc# E$change

>hiladelphia )toc# E$change

>aciic E$change

@A((E +@ondon-

Eure$ +Europe-

and "any "ore +see list at end o %oo#-

Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.!0
!ptions vs $utures?$or-ards

A utures.or!ard contract gives the holder

the o%ligation to %uy or sell at a certain
price

An option gives the holder the right to %uy

or sell at a certain price
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.!
Types of Traders
1
Hedgers
1
&pe'ulators
1
2r3itrageurs
&o-e o+ the largest trading losses in derivatives have
o''urred 3e'ause individuals .ho had a -andate to 3e
hedgers or ar3itrageurs s.it'hed to 3eing spe'ulators
4&ee +or e0a-ple )arings )an*, )usiness &napshot .2,
page 55
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.!2
@ed"in" Examples #pa"es %3A%%*

A ?) co"pany !ill pay ;10 "illion or

i"ports ro" 9ritain in 5 "onths and
decides to hedge using a long position
in a or!ard contract

An investor o!ns 1,000 7icrosot

shares currently !orth 823 per share. A
t!o1"onth put !ith a stri#e price o
82:.50 costs 81. &he investor decides
to hedge %y %uying 10 contracts
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.!!
Balue of Microsoft Shares -ith
and -ithout @ed"in" #$i" %&4' pa"e %%*
20,000
25,000
50,000
55,000
20,000
20 25 50 55 20
Stock rice (!)
"alue o#
$oldin% (!)
,o Hedging
Hedging
Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.!"
Speculation Example

An investor !ith 82,000 to invest eels

that A"a6on.co"Ks stoc# price !ill
increase over the ne$t 2 "onths. &he
current stoc# price is 820 and the price
o a 21"onth call option !ith a stri#e o
25 is 82

<hat are the alternative strategies=

Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.!5
7r8itra"e Example

A stoc# price is Juoted as ;100 in

@ondon and 81:2 in ,e! Eor#

&he current e$change rate is 1.:500

<hat is the ar%itrage opportunity=

Options, Futures, and Other Derivatives, 6th Edition,
Copyright John C. Hull 2005
.!6
@ed"e $unds #see 0usiness Snapshot %&%' pa"e :*

Hedge unds are not su%Lect to the sa"e rules as

"utual unds and cannot oer their securities pu%licly.

7utual unds "ust

disclose invest"ent policies,

"a#es shares redee"a%le at any ti"e,

li"it use o leverage

ta#e no short positions.

Hedge unds are not su%Lect to these constraints.

Hedge unds use co"ple$ trading strategies are %ig

users o derivatives or hedging, speculation and
ar%itrage