Options, Futures and other Derivatives

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Monday, Tuesday and Thursday
Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull

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YOU WILL NEED A CALCULATOR

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Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull

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WHAT DO YOU EXPECT TO LEARN IN THIS CLASS ?

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull

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INTRODUCTION

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull

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The Nature of Derivatives
A derivative is a financial instrument whose value depends on the values of other more basic underlying variables

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull

Hull . CDOs) Options. and Other Derivatives.1. 4th edition © 1999 by John C. Futures.6 Examples of Derivatives • • • • • Forward Contracts Options Futures Contracts Swaps Credit Derivatives (CDS .

and Other Derivatives.7 Derivatives Markets • Exchange Traded (futures. swaps. 4th edition © 1999 by John C.options) – standard products – trading floor – virtually no credit risk • Over-the-Counter (forwards.CDS) – non-standard products – telephone market – some credit risk Options. Futures.options. Hull .1.

1.8 20 4 2 0 S eo Mrk t ($ 2 iz f a e trillio ) n 20 0 10 8 10 6 10 4 OC T 10 2 Ech n e x ag 10 0 8 0 6 0 4 0 2 0 0 Ju -9 Options. 4th edition-0 1999 JuJohn C. Hull n 4 n 8 JuFutures.n 9 andn 0 Derivatives. JuOther Ju -0 Ju ©2 by n 3 Ju -0 -9 -0 n1 n -0 .

Futures. 4th edition © 1999 by John C. Hull .1. and Other Derivatives.9 Ways Derivatives are Used • To hedge risks • To reflect 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 Options.

4th edition © 1999 by John C. Futures.10 Forward Contracts • A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price) • It can be contrasted with a spot contract which is an agreement to buy or sell immediately Options. and Other Derivatives.1. Hull .

4th edition © 1999 by John C. Futures. and Other Derivatives.1.11 How a Forward Contract Works • The contract is an over-the-counter (OTC) agreement between 2 companies • The delivery price is usually chosen so that the initial value of the contract is zero • No money changes hands when contract is first negotiated and it is settled at maturity Options. Hull .

12 The Forward Price • The forward price for a contract is the delivery price that would be applicable to the contract if it were negotiated today • The forward price may be different for contracts of different maturities(depending on…?) % Options. 4th edition © 1999 by John C.1. and Other Derivatives. Hull . Futures.

then F = S (1+rt) F = S (1+r)t when < 1 year when > 1 year where r is the 1-year (domestic currency) risk-free rate of interest.05 x 1)]= $918. Hull .1. S=875.75 Options. and r=0. Futures.05 so that F = 875 [(1+(0. T=1. and Other Derivatives. In our examples. 4th edition © 1999 by John C.13 The Forward Price of Gold If the spot price of gold is S and the theoretical forward price for a contract deliverable in T years is F.

The 1-year US$ interest rate is 5% per annum • Is there an arbitrage opportunity? Options.1.The spot price of gold is US$875 .14 1. Gold: An Arbitrage Opportunity? • Suppose that: . and Other Derivatives.The 6-month forward price of gold trades at US$895 on the market . 4th edition © 1999 by John C. Futures. Hull .

and Other Derivatives.1. 4th edition © 1999 by John C.15 What is arbitrage ? A transaction that generates risk free profit Options. Hull . Futures.

05x0.88 Buy Future and Sell the Spot The theoretical price is not a price you can trade on Options.1.5) = $896. Hull . Futures. 4th edition © 1999 by John C. and Other Derivatives.16 The theoretical forward price is : 875 ( 1 + 0.

The 1-year forward price of gold is US$768 . Futures.The spot price of gold is US$750 .The 1-year US$ interest rate is 5% per annum • Is there an arbitrage opportunity? Options.17 2.1. Gold: Another Arbitrage Opportunity? • Suppose that: . Hull . and Other Derivatives. 4th edition © 1999 by John C.

Futures. there would Not be any arbitrage opportunities.1. 4th edition © 1999 by John C. Hull .18 What 2-year forward price would eliminate any arbitrage possibility? 750 ( 1 + 0. Options. and Other Derivatives.05)2 = $827 If the 2-year forward rate on gold is $827.

19 Terminology • The party that has agreed to buy has what is termed a long position (going LONG) • The party that has agreed to sell has what is termed a short position(going SHORT) Options. Futures. and Other Derivatives. 4th edition © 1999 by John C.1. Hull .

1. and Other Derivatives. Futures. THE PAYOFF FROM A LONG POSITION IN A FORWARD CONTRACT ON ONE UNIT OF AN ASSET IS F-S IN GENERAL. THE PAYOFF FROM A SHORT POSITION IN A FORWARD CONTRACT ON ONE UNIT OF AN ASSET IS S-F ( F IS THE DELIVERY OR FORWARD PRICE AND S IS THE SPOT PRICE) Options. 4th edition © 1999 by John C. Hull .20 IN GENERAL.

4th edition © 1999 by John C. and Other Derivatives.21 Example • On Sept 25. 2007 • What are the possible outcomes? Options. 2007 a trader enters into an agreement to buy €1 million in 3 months at an exchange rate of $1. Hull .472. Futures.1.4720 (F) • This obligates the trader to pay $1.000 for €1 million on December 25.

22 Profit from a Long Forward Position Profit K Price of Underlying at Maturity. Futures. and Other Derivatives. ST Options. 4th edition © 1999 by John C. Hull .1.

4th edition © 1999 by John C.1. and Other Derivatives. ST Options. Hull .23 Profit from a Short Forward Position Profit K Price of Underlying at Maturity. Futures.

4th edition © 1999 by John C. Futures.1. and Other Derivatives. Hull .24 THIS IS IT FOR FORWARDS OK? Options.

Hull .1. 4th edition © 1999 by John C.25 NOT OVER YET …. What can he do. A speculator thinks the dollar will go back up in the next 3 months. using the forward market? GOES LONG OR BUYS DOLLAR FORWARD Options. and Other Derivatives. Futures.

You decide to buy 3-months forward 1 Million euros.1.45 .1. 4th edition © 1999 by John C.1.02 * 1MM= $20 000 1.45 ? 1.470.$60 000 Options.47 = .47 for 1 €).47 = 0. Hull .0. and Other Derivatives.06*1MM = . What is his profit/loss if the Dollar/EURO rate goes to… You are buying €1 million that is selling $1. Futures.41 .000 1.26 THE DOLLAR/EURO RATE IS AT 1.47 TODAY (that is $1.41 ? 1.

27 WELCOME TO THE WORLD OF FUTURES Options. and Other Derivatives. 4th edition © 1999 by John C.1. Hull . Futures.

4th edition © 1999 by John C.1. Hull .28 AN ANXIOUS TRADER CHICAGO (CBOT) Options. and Other Derivatives. Futures.

Futures. Hull . and Other Derivatives. 4th edition © 1999 by John C.1.29 Futures Contracts • Agreement to buy or sell an asset for a certain price at a certain time • Similar to forward contract • Whereas a forward contract is traded OTC a futures contract is traded on an exchange Options.

) New York Cotton Exchange International Petroleum Exchange (IPE) LIFFE (London) TIFFE (Tokyo) and many more.. Hull .. 4th edition © 1999 by John C.30 Exchanges Trading Futures • • • • • • • Chicago Board of Trade (grains. Futures. and Other Derivatives. Options. bonds) Chicago Mercantile Exchange(curr.1.

1. 4th edition © 1999 by John C.31 1. Futures.The 1-year US$ interest rate is 5% per annum . Oil: An Arbitrage Opportunity? Suppose that: . and Other Derivatives. Hull .The quoted 1-year futures price of oil is US$ .The storage costs of oil are $2 per annum • Is there an arbitrage opportunity? Options.The spot price of oil is US$106 .

32 2. Hull . Oil: Another Arbitrage Opportunity? • Suppose that: . and Other Derivatives.The quoted 1-year futures price of oil is US$75 .The storage costs of oil are $2 per annum • Is there an arbitrage opportunity? Options. 4th edition © 1999 by John C.The spot price of oil is US$80 .The 1-year US$ interest rate is 5% per annum . Futures.1.

33 MORE IN-DEPTH ANALYSIS OF FUTURES NEXT WEEK . Futures.1.. Options. 4th edition © 1999 by John C. and Other Derivatives. Hull ..

34 Options • A call option is • A put option is an option to buy an option to sell a certain asset a certain asset by a certain by a certain date for a date for a certain price certain price (the strike (the strike price) price) Options. 4th edition © 1999 by John C. Hull . and Other Derivatives.1. Futures.

4th edition © 1999 by John C. and Other Derivatives.1. Hull . Futures.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) Options.

Hull .1.36 Difference betwen an option and a forward (or futures) contract ? Options. Futures. and Other Derivatives. 4th edition © 1999 by John C.

and Other Derivatives.37 Options vs Futures/Forwards • A futures/forward contract gives the holder the obligation to buy or sell at a certain price • An option gives the holder the right to buy or sell at a certain price Options.1. Hull . Futures. 4th edition © 1999 by John C.

1. option life = 2 months 30 Profit ($) 20 10 70 0 -5 80 90 100 Terminal stock price ($) 110 120 130 Options. Hull . 4th edition © 1999 by John C. strike price = $100.38 Long Call on IBM Profit from buying an IBM European call option: option price = $5. Futures. and Other Derivatives.

Futures. and Other Derivatives. 4th edition © 1999 by John C. Hull . strike price = $70. option life = 3 mths 30 Profit ($) 20 10 0 -7 40 50 60 70 80 Terminal stock price ($) 90 100 Options.39 Long Put on Exxon Profit from buying an Exxon European put option: option price = $7.1.

40 Short Call on IBM Profit from writing an IBM European call option: option price = $5. and Other Derivatives. by John C. strike price = $100. 4th edition © 1999 Options. Hull 110 120 130 70 80 90 100 Terminal stock price ($) .1. option life = 2 months Profit ($) 5 0 -10 -20 -30 Futures.

Hull .41 Short Put on Exxon Profit from writing an Exxon European put option: option price = $7. option life = 3 mths Profit ($) Terminal 7 40 50 60 stock price ($) 0 70 80 90 100 -10 -20 -30 Options. 4th edition © 1999 by John C.1. Futures. and Other Derivatives. strike price = $70.

ST = Price of asset at maturity Payoff Payoff X X Payoff X ST Payoff X ST ST ST Options.42 Payoffs from Options What is the Option Position in Each Case? X = Strike price. Futures. Hull . 4th edition © 1999 by John C.1. and Other Derivatives.

1. and Other Derivatives. Futures.43 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 (Barings case) Options. 4th edition © 1999 by John C. Hull .

The investor decides to hedge by buying/selling 5 puts ? buy Options. and Other Derivatives. Futures. A twomonth put with a strike price of $90 costs $2.1. 4th edition © 1999 by John C.44 Hedging Examples • A US company will pay £1 million for imports from Britain in 6 months and decides to hedge using a long/short long position in a forward contract ? • An investor owns 500 IBM shares currently worth $95 per share. Hull .

Hull . The current stock price is $78 and the price of a 3month call option with a strike of 80 is 3 (which means $300) • What are the alternative strategies? Options.1. 4th edition © 1999 by John C. Futures. and Other Derivatives.800 to invest feels that Exxon’s stock price will increase over the next 3 months.45 Speculation Example • An investor with $7.

and Other Derivatives.1. Hull . Futures.200 [(90-80)x2600]-7800 Options.46 OUTCOME STRATEGY BUY SHARES BUY CALL OPTIONS 70 (800) (7800) 90 1200 18. 4th edition © 1999 by John C.

90 dollars per pound • What is the arbitrage opportunity? Options.1.47 Arbitrage Example • A stock price is quoted as £100 in London and $200 in New York • The current exchange rate is 1. Futures. Hull . and Other Derivatives. 4th edition © 1999 by John C.

1. Futures. 4th edition © 1999 by John C.48 YOU BUY THE STOCK IN London at $190 DOLLARS AND YOU SELL IT IN NY AT $200 DOLLARS NET PROFIT = 10 DOLLARS/SHARE Options. Hull . and Other Derivatives.

Mutual funds must disclose investment policies. and Other Derivatives. speculation and arbitrage Options. Futures. 4th edition © 1999 by John C. • • Hedge funds are not subject to these constraints. Hull .Hedge Funds vs. limit use of leverage take no short positions. makes shares redeemable at any time.49 Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. Hedge funds use complex trading strategies are big users of derivatives for hedging. mutual funds • • – – – – 1.

Hull . 4th edition © 1999 by John C. Futures. and Other Derivatives.50 BREAK TIME ! Options.1.

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