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Financial Markets Education Derivative Fundamentals

April 2003

DRAFT

Preface
Learning about Derivatives is a never-ending adventure. There is always more to know, from valuation to risk management, to the enormous variety of financial products built using derivatives. Where to start? As the Cheshire Cat said: "It depends on where you are going." This piece was written to aid those who want to understand derivatives in some depth because they are going to be involved in some way in the derivatives markets. Particularly this is intended for people who work in an investment banking environment such as we have at UBS. This includes traders, salespeople, researchers, risk managers as well as operations and financial control professionals. Many of them will go on to more advanced courses. This book is intended to give them a solid foundation without leaning heavily on advanced maths. Financial Markets Education, a group within the investment banking business of UBS, produced this work to support the courses we offer to the staff of the bank. We are also making it available to our clients, with the hope that it will help them as well in understanding the nature and use of derivatives. No claim to originality is made the material contained here is the product of many years of discussions and experiences gained while working with the derivative traders, salespeople and risk managers in UBS and its predecessor organisations. Please let us know of any errors you might find in the book. London February 2003

Financial Markets Education


Europe Joe Troccolo Spencer Morris Walter Braegger Lindsey Matthews Tel.: +44-20-7568 0705 email: sh-fme@ubsw.com United States Joe Bonin Paul Staneski Tim Weithers Radha Radhakrishna Tel.: +1-203-719 6701 APAC Onn Chan

Tel.: +65-836 5708

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Contents
Risk ................................................................................................................................................. 3 Basic Financial Instruments .......................................................................................................... 3 Futures Markets ............................................................................................................................. 5 Futures .......................................................................................................................................... 13 Pricing of Futures and Forward Contracts ................................................................................. 22 Futures/Forwards Pricing Formulas ............................................................................................ 24 Funding and Interest Rates.......................................................................................................... Equity ....................................................................................................................................... Bonds ....................................................................................................................................... Commodities and Precious Metals ............................................................................................ Options ......................................................................................................................................... Option Basics ............................................................................................................................ Equity Index Options ................................................................................................................. Foreign Exchange Options ........................................................................................................ Interest Rate Options ................................................................................................................ 27 27 29 31 32 35 39 42 47

Option Valuation ......................................................................................................................... 51 Synthetics ..................................................................................................................................... 61 Put-Call Parity ........................................................................................................................... 66 Conversions .............................................................................................................................. 67 Risk Parameters ........................................................................................................................... Delta Price Risk ...................................................................................................................... Tau - Volatility Risk .................................................................................................................... Theta Time Risk ..................................................................................................................... Gamma Changes in Delta ...................................................................................................... 69 71 74 76 78

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Risk
Whats the most risky thing youve ever done? Played with matches when you were a child? Crossed the street without looking both ways? Asked that sensationally attractive person you sit next to at work for a date? Those are all physical or emotional risks. If you want to learn how to manage risks like these, youre reading the wrong book. Were going to concern ourselves with risks that affect a different aspect of your well-being - your wealth. These are called financial risks. Well start by talking about assets. If we take a fairly narrow but common definition, an asset is something you own that has a value that is measurable in money and from which you expect to generate additional value, also measurable in money, in the future. Some common real assets are business equipment used to produce goods, real estate, fine art and racehorses. Common financial assets are bank deposits, bonds, equity shares and precious metals like gold and silver. Note that even though gold and silver are physical, many people own them primarily because they expect them to gain in value, so we classify them as financial assets. What about your good looks, your charming personality and your ability to juggle? Unfortunately they fail some of our tests, either because you didnt buy them or because it is difficult to put a direct value on them. Not that no one has ever tried to do this. Some performing artists (if you can accept rock stars as artists) have attempted to "securitise" their future earnings. We wont be thinking about such things for some time, if ever, in this piece. So if you own a financial asset, what is risk? Primarily you worry about its value. More particularly, so that we dont get bogged down in semantics, you worry about the price for which you can sell it. You may also be concerned about what cash flows it may generate in the future, both with respect to how much cash you will get and how certain you are to get it. We will also be talking about risk with respect to liabilities. Liabilities are monetary obligations that you will have to fulfil in the future. Examples are loans that you take out from a bank, or if you are a company treasurer, a bond that you have sold to investors. A promise to deliver a product at a set price potentially could be either a liability or an asset. A serviceable definition of risk is: Exposure to an adverse change in the value of an asset or a liability. For example, if you buy a share of stock, you become exposed to a drop in its market price. This could happen because of the uncovering of an accounting error, outright fraud, a bad earnings performance, or just because the stock market as a whole sells off because the economy turns bad. If you borrow money from a bank at a so-called floating interest rate, i.e. one that changes periodically, you are at risk to an increase in interest rates. If we were unable to do anything about financial risks, there wouldnt be much point in discussing them. To be fair, we could discuss them so that we could understand them better, but it wouldnt change our inability to avoid them sort of like discussing the weather. Fortunately the only inevitabilities that have been discovered so far are death and taxes and we even have ways of possibly postponing the first and reducing the second. In fact it is a rare risk that cannot be avoided or whose effect cannot be mitigated. We will spend a lot of our energy describing and analysing ways to deal with financial risk.

Basic Financial Instruments


Although most people reading this are likely to be familiar with the commonly encountered financial products, wed like to list the ones were going to talk about.

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Money Market Short term bank deposits (less than a year to maturity) Treasury bills obligations of the Federal Government that are sold at auction in maturities of 13, 26 and 52 weeks. They are priced at a discount to their face value and pay their face value at maturity Commercial paper short term obligations of corporations, usually placed directly with investors or sold through a bank. Fixed Income Market Bonds and Notes interest paying securities which are characterised by: Principal amount Coupon rate Coupon frequency Maturity Date Issuer The terms bonds and notes are used interchangeably since in the US the only distinction is that a note has an original maturity of no more than 10 years. Bonds are one of the most important types of investments and one of the most important sources of financing for governments and corporations. Equity Market Shares these represent an ownership interest in a corporation. Equity owners provide financing for the companys assets and are entitled to a residual interest in the cash flows generated by the companys activities. This means that equity holders are "paid last" after all other claimants like bondholders and the government have received what they are entitled to. Preferred shares act very much like a bond in that they generally pay a fixed amount, called a dividend that acts very much like interest. The difference is that the dividend on a preferred share is paid from after-tax income of the company. Preferred shareholders rank above common shareholders if the company gets in trouble and is liquidated (sold off). Convertible Bonds like a bond these instruments usually pay coupon interest, although sometimes they are issued as zero-coupon securities. Corporations sell CBs to raise capital, as they do with other bonds and equity. The bonds have the additional feature that the owner has the right to convert the bond into shares of the companys equity. When the bond is sold to investors, the number of shares into which the bond "converts" is set. For example a convertible bond with a face value of EUR1000 might convert into 20 shares of stock. Effectively the bondholder would be "paying" EUR50 per share for the 20 shares. Since the bondholder is not obligated to do this, conversion only takes place when the equity price is favourable to the bondholder i.e. greater than EUR50. Convertible bonds are among the most interesting and difficult to value financial instruments. Commodities Precious metals like gold, silver, platinum and palladium Oil Soft commodities like soybeans, pork bellies and wheat Exotic commodities like electricity and pollution rights We will encounter many more financial products, but since part of the reason for this discussion is to develop these ideas, we will leave our catalogue unfinished for now.

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Futures Markets
A future is our first example of a financial derivative. A derivative is an instrument that derives its value from the properties of something else. I imagine that sounds very obscure! All right lets try again. Why would you buy a share of a stock or a bond or an ounce of gold? If these are your investments, you are hoping they will increase in value or will pay you some cash, or both. So these investments are good in and of themselves. They have something you want and are willing to pay for. Futures are financial products that relate to these other, more basic, investments. Futures have been around for hundreds of years in an informal sense, but only in recent years have they become widespread, tradable products. In fact futures are the basis of a large industry. There are many futures exchanges where futures contracts are traded and many people make a good living from futures markets. So futures must fill a need in the financial world. Here is an example of how a so-called futures contract comes about. Fund managers get mandates from their clients, who might be pension funds, insurance companies or other large institutional investors. The mandate is an allocation of funds that the manager is to invest on behalf of the client. Suppose the client wants the money invested in UK equities. However the client leaves the choice of the individual equities up to the fund manager, subject to some constraints about concentrations in the various sectors of the economy and sizes of those companies. The fund manager will want to spend some time putting together a portfolio that is in accord with the clients wishes. In the meantime though, the client expects his money to be working, not sitting around idle. The manager could really use a way to get immediate exposure to the equity market without having to buy stocks. But how is that possible? The answer is a futures contract. Well describe it now and it may seem simple to you or maybe not. Just keep the background idea in mind we want exposure but we dont want to buy shares. A futures contract has a formal existence. It is a contract traded on an organised exchange. Unlike a share of stock though, a particular instance of the contract comes into existence purely through the act of being traded, i.e. no one "issues" it. The particular type of futures contract that we want to talk about here is an index future. The best known of these are futures on the major equity indexes: the S&P500 (US), the FTSE100 (UK), the Nikkei (Japan), the DAX (Germany) etc. When a future is traded one person buys the future and the other sells it. However neither party is going to buy or sell any shares because of this trade. Rather they are agreeing that they will exchange payments with one another based on the price movement in the contract. If the contract goes up in price the buyer of the future receives a payment and the seller makes a payment. The reverse happens if the contract goes down in price. The size of the payment depends on the specification of the contract. For the FTSE future, if the contract changes by 1 point the payment is GBP10. Similarly for the S&P contract, 1 point is worth USD250. The numbers, called multipliers, are set by the exchange. Each futures contract also has an expiry date. On that date there is a final settling up based on the closing price of the index and the future itself "expires" i.e. ends. For the most popular indexes there are 4 futures expiries per year, named for the months in which they expire March, June, September and December. These contracts first begin to trade a year or so before they expire. So in December 2002, you could enter into a contract whose price is based on the price of the S&P500 index in December 2003. Of course no one could know in December 2002 what the price will be in December 2003. But thats actually the point. If you buy the contract in December 2002 and its price goes up, you make a profit and if it goes down you make a loss. You have gained exposure to the price of the index. And you have done it without buying the shares in the index. Is there any money involved? Yes, you will have to deposit with the exchange an amount of money, called margin, that will be used to settle up any losses you sustain. Your margin account will also receive any profits you make. Lets look at an example to see how this works. Example: Buying an Index Future Day 1 You buy the S&P500 June future, trading at a price of 950. You deposit with the exchange a margin payment of USD16,000. This money is yours. You have not paid it to the exchange, just given it to the exchange to hold for your account. At the end of the day the contract closes at a price of

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960. Good for you! You receive 250 x 10 = USD2500 into your margin account. Your account now holds 18,500. Notice that even though you originally bought the contract for 950, you now own it for 960. That is the exchange will compare the closing price tomorrow with the closing price today when it determines the payment you will make or receive the next day. The 10 point payment you got at the end of this first day makes up the difference between the 950 you paid and the 960 at which the future closed. Day 2 The contract closes the day at 935. Bad day on Wall Street! The exchange takes 25 x 250 = 6,250 from your margin account. (25 = 960 935) Easy come, easy go! Your margin account now holds 12,250. Marking to Market This process, called marking-to-market, continues every day until you decide to close out your future by selling it. If you dont sell it before the last trading day in June, it will expire on that last day. Nothing special happens when it expires, other than your contract comes to an end and with it your exposure to the index. You also get or pay the last days mark-to-market. Closing Out the Contract Suppose you close out your contract some time prior to expiry at a price of 1000. You have experienced a mark-to-market every day you owned the contract. On some days you received money and the other days you paid it. What we can say though, is that on the day you closed out your contract, the accumulated marks-to-the-market amounted to your receiving USD12,500. We know this because in the time you held the contract the market went up 50 points. After you sell your future, you have lost your exposure to the index. Whether it goes up or down the next day there will be no further effect on your account. Synthetic Equity Investment So what might our fund manager do? Suppose the manager has been given GBP100 million to invest for the client. If the FTSE is trading around 4000, then buying a FTSE100 future is like buying the exposure to GBP40,000 of shares (since the multiplier is GBP10). If the manager wants to get exposure to GBP100 million of shares, the manager should buy 100,000,000 / 40,000 = 2500 futures contracts. Since the LIFFE, where the future is listed, trades in excess of 150,000 contracts per day, this is a significant but not excessively large trade. The manager has created a "synthetic" equity investment. That is, the managers futures position acts like an equity investment but uses a combination of futures and cash. Having seen an example, lets describe futures contracts more formally. A futures contract: Is traded on an organised exchange Is based on the price of a stock, stock index, bond, currency or commodity, referred to as the "underlying" Specifies a Price Time Amount Quality (where relevant) For The delivery of the underlying Or settlement in cash

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Here are the specifications of two popular index futures. First the one we just discussed the FTSE 100 Futures Contract that trades on the LIFFE. FTSE 100 Index Future
Unit of Trading Delivery Months Quotation Minimum Price Movement (Tick Size and Value) Last Trading Day Delivery Day Trading Hours Contract Valued at 10 per index point (e.g. 65000.0 at 6500.0) March, June September, December (nearest four available for trading) Index Points (e.g. 6500.0) 0.5 (5.00) 10:30:30 Third Friday of Delivery Month First business day after the last trading day 08:00 17:30

The analogous contract for the US market is on the S&P500 stock index and trades on the CME (Chicago Mercantile Exchange). S&P500 Index Future
Contract Size Minimum Price Fluctuations (Tick) Contract Months Regular Trading Hours Globex Trading Hours Last Trading Day Final Settlement Date Position Limits $250 times S&P500 Futures price 0.10 Index points = $25 per contract March, June, September, December 8:30 a.m. 3:15 p.m. 3:45 p.m. 8:15 a.m. The Thursday prior to the third Friday of the contract month The third Friday of the contract month 20,000 net long or short in all contract months combined

These were contracts that seem "intuitive" in that the reason for them is fairly obvious. But there are some futures contracts that stretch your imagination. Here is an "exotic" futures contract from the Chicago Mercantile Exchange Contract specifications for weather products
Product and Trading Unit Heating Degree Day Futures $100 times the Heating Degree Day Index Cash Settled Point Description 1 point = 1.00 Degree Day Index = $100 Contract Listings Oct, Nov, Dec, Jan, Feb, Mar, Apr Product Codes Name Hours Trading values Listed Limits

Clearing | GLBX2 Ticker H1-Atlanta H2-Chicago H3-Cincinnati H4-New York H5-Dallas H6-Philadelphia H7-Portland H8-Tuscon H9-Des Moines H0-LS Vegas

Mon/Thurs 3:45 p.m. 3:15 p.m. LTD (9:00a.m.)

All listed Series Implemented 4/28/02 Bands have been established that are 50 index points (plus or minus)" CME Last Price equating to a maximum exposure of $5000 per contract

Source: CME

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The Heating Degree Day Index goes up as the temperature goes down. This is of interest to businesses that supply heating oil to their major consumers such as managers of large office buildings. As you can see from the examples above, there are many financial risks covered by futures contracts. All the major participants in the financial markets may use futures markets: Investors who want to get exposure Hedgers who want to fix a price for buying or selling Market-makers who provide liquidity Arbitrageurs who try to profit from discrepancies between the futures price and the cash price of the underlying commodity. Investing, hedging and speculating Anyone who buys or sells a futures contract gets exposure to the price movement of the underlying. There are different motivations for wanting this exposure. But should we care why someone trades the contract? Are there legitimate uses and illegitimate uses for futures? So far as the exchange is concerned, if you can put up the appropriate level of margin, you can trade the contract. The exchange does insist that you understand the specifications of the contract and the risks you are assuming by trading it. This is enforced in various ways. For example if you deal through a broker, your broker is required to give you official information from the exchange regarding the nature of futures contracts and their risks. Is it possible to distinguish between investors and "speculators"? Remember our fund manager? The manager had GBP100 million to invest and bought 2500 FTSE futures to get temporary market exposure. The manager would have put up GBP10 million in margin. What happens to the other 90 million? The manager can just put it in a bank deposit and let it earn interest. Even though the cash is in the bank, the managers client is exposed to the equity market on the full 100 million. The futures contract is leveraged. Just 1 pound of margin gives exposure to 10 pounds worth of shares. Now imagine another fund manager who also has GBP100 million to invest but buys 5000 futures contracts, putting up 20 million in margin. This manager is exposed to the price change of 200 million in shares. The manager has more exposure than the amount of funds under management. If the market declines by 10%, the manager will lose 20% of the funds. This position is decidedly riskier than that of our first manager. So maybe we say this manager is speculating? There is another dimension to the investing versus speculating controversy. Suppose once again our fund has GBP100 million and we buy 2500 FTSE futures, so we are not leveraged on our total position. Today we think the market is going up so we leave our position as is. At the end of the day perhaps we are lucky enough to have a profit. Maybe now we think the next day the market will not have such a good day so we sell 500 of our futures to reduce our exposure. In fact every day we reexamine our position and change it to reflect our market forecast for the day, increasing it, up to a limit of 2500 contracts, if we are really "sure" the market is going up, down to 0 futures if we are sure it is going down a significant amount. Are we investing or speculating? These two dimensions leverage and time frame are the primary ones that distinguish investors from speculators, at least in the view of many market analysts. Many people view investing as good and speculating as bad. The exchange takes a neutral view. If you are aware of the risks and you are able to meet your margin requirements, you can have whatever position you want. Hedging What does it mean to hedge? Lets look at that really odd contract the heating degree days futures contract we saw earlier. Suppose you have agreed to supply heat to a large complex of office buildings in Chicago for a fixed price for the heating season. You know that if the winter is particularly cold the usage of heat will be much greater and your costs will rise. In order to offset this

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risk you could buy a futures contract on the number of heating degree days. What is a heating degree day? Max ( 0, 65 (high temperature + low temperature) / 2) is the number of heating degree days on any given day. For example, if todays high temperature was 10o F and the low was 4o F, then the number of degree days was 65 (10 4)/2 = 62. In the summer we might have a high of 80F and a low of 70. Then the number of heating degree days was 0 since the average temperature was more than 65. The table below shows some sample heating degree days per year and cooling degree days per year for a few US cities. Have you guessed that there is a Cooling Degree Days futures contract as well? Well, youre right! It probably should not surprise you to learn that the futures months that trade for the HDD future are October through April and the CDD futures are listed for April through October. City Barrow, Alaska Bismarck, N.D. Hilo, Hawaii Kansas City, Mo. Key West, Fla Yuma, Ariz HDD 20,370 8,932 0 5,326 68 983 CDD 0 499 3,134 1,388 4,820 4,244

Source: The USA TODAY Weather Almanac by Jack Williams

In order for you to use the contract effectively, you would have to be able to relate the number of degree days to the cost of supplying heat to your customers. But if you thought that every degree day would cost you USD1000 in heating costs, you could buy 10 futures contracts since one point is worth USD100.

The picture above shows that the December 2002 contract was trading at 1125 HDD at the close of business on the 18th of December. Question: if the number of HDD for the month of December turns out to be 1240, what would this indicate about the average daily temperature in Chicago during the month? (Chicago is NOT a warm place!) Is the futures contract a hedge? If you buy the contract at its price of 1125 then you will be compensated for a month that is colder than this but you will have to pay if the month is less cold. This is the symmetric nature of a futures contract from the point of view of a hedger you make money when the underlying moves against your "natural" position, but you lose money if the underlying move is favourable. Essentially you "lock-in" the number of HDD at the current level of the index.

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Currency Hedge Lets look at a possibly more familiar situation. A US corporation is planning on buying a business in the UK. The purchase price is expected to be GBP50 million. The transaction is expected to close 3 months from now and a consortium of banks has been lined up to provide the financing. However the US company wants to fix the purchase price in USD rather than GBP. So three months from now they will want to pay in dollars. But what if the pound strengthens relative to the dollar in the next three months? Fortunately the company can hedge with futures contracts. The contract that trades on the CME has an underlying of GBP62,500. The quote is GBP|USD, for example 1.5000 means the price of one pound sterling is USD1.5000. Since the US company needs to fix the price of pounds, it would want to buy Sterling futures. This would mean buying 800 contracts (800 = 50,000,000 / 62,500). We will temporarily ignore the difficulty in doing a trade of this size so that we can concentrate on the economics of the trade. Suppose that the 3 month futures contract is currently trading at a price of 1.5500. Then by buying the future, the company will lock-in this price for GBP. When the future expires, suppose the price of Sterling has risen to 1.6000. The company will have a profit of USD0.05 per pound i.e. 0.05 x 50,000,000 = $2,500,000. Remember the profit will be in the companys margin account. Settlement of the contract is "physical" - meaning that the company will actually take delivery of GBP50,000,000. The company would have to pay the settlement price of the contract, USD1.6000 for each pound, giving a total of $80,000,000. But the amount of profit in the margin account would make up for the additional cost to buy pounds the company ends up paying the $77,500,000 they originally planned on. Effectively the company did lock-in the price of 1.5500 per pound. By now, we hope you are convinced that futures contracts are useful, legitimate financial instruments. So now let us tell you why they are not always the solution to a hedgers needs. Futures contracts: Are for a fixed amount of the underlying GBP62,500; 250 times the S&P500 index; GBP500,000 3 month bank deposit and so on Expire on only a small number of dates during the year March, June, September and December are common Are not always very liquid daily volume is high for US Treasury bond futures but very low for the HDD futures we talked about earlier Are non-existent for many underlyings aviation fuel, industrial diamonds, beer Which leads us to discuss a related idea. Forward Contracts Forward contracts, or just forwards, as we will call them, are OTC (over-the-counter) agreements. They are frequently between two end-users of a commodity or between an end-user and a financial intermediary like a bank. The advantage of forwards is their potential for being "tailor-made" for the needs of the user. Suppose for example that a UK exporter is expecting to receive EUR7 million in payment for goods at the end of the month. Rather than waiting until the cash has come in, the exporter can arrange to sell the Euros for pounds at a price that is agreed upon now. Who would agree to do this? Probably an investment bank. The bank is used to managing foreign exchange risk so could accommodate the requirements of the exporter with respect to the amount of the trade and the day on which it will take place. The exporter does not have to be concerned with managing a futures contract or with the daily cash flows it would entail. However the exporter would need to have a relationship with the bank in order to do this trade. The trade creates an obligation for both the bank and the exporter. So the bank would want to know that the exporter is a real business not a "mail-drop" or someone wanting to "launder" money through the bank. The bank also wants to know that the client is creditworthy. When the time comes to exchange the currencies, the bank wants to know the client will perform on their side of the trade. The client of course needs the same

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assurance. A forward contract usually cant be traded away either. Once the agreement has been made, it is expected to be carried out. If the exporter changes his mind tomorrow, he can come back to the bank and negotiate an end to the contract but he cant just sell it to someone else the way he could with a future.

As you can see from the website above, the possibilities for forward contracts are endless. Economically though, there is little difference between futures and forwards. The differences have more to do with the specific features of each one, i.e., how they are traded or agreed upon, where they are traded, whether they are held to maturity and so on. So we will not make a point of distinguishing futures from forwards. You should simply keep those differences in mind for the times when they make a real difference. More Examples of Futures We have already seen three examples of major futures contracts the FTSE and S&P500 index futures and the GBP|USD currency future. Eurodollar Interest Rate Futures

Source: CME

The CME is proud of the Eurodollar interest rate futures contract and it should be. Designing a financial contract that people will really want to use is a difficult task. You have to identify a financial risk that is widespread but with people on both sides of the risk i.e. some people for whom the risk is that the level of the contract rises and others for whom the risk is that it falls. Then the contract has to be designed so that it comes close to capturing the true financial risk. In this case the risk is

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exposure to the change in the level of short-term interest rates. Both borrowers and lenders are sensitive to this risk. There are many billions of dollars of borrowing that have interest rates that "float", i.e. change periodically. So both the first requirement, widespread risk and the second, people on both sides, are satisfied. The third requirement, getting the contract to capture the risk, is trickier. A small business may take out a loan that is indexed to the prime rate, which is the rate a bank quotes to its best business borrowers. But the bank may pay interest on deposits in a way that fluctuates relative to 3 month Treasury Bills. The Eurodollar futures contract fluctuates in relation to the 3 month LIBOR rate, which is the rate large money centre banks quote to lend money to each other. Since these large banks are so dominant in the cash market it makes sense to have a contract that is tailored to their exposures. Fortunately many other users find the Eurodollar futures contract close enough to their risk that they are willing to accept the "basis" risk in trading a contract that may not be exactly equal to their real exposure. If the Eurodollar future is trading for 95.00, the level of the interest rate corresponding to this value is 5.00%. So: 3 month rate = 100 Future You might wonder why the contract was not set up to simply equal the rate itself? That is, why not just call it 5.00 rather than 95.00? Possibly the reason is to make the contract price look more like a bond price, but it can lead to some confusion. One trader we knew couldnt understand why the Eurodollar futures price, in his view, didnt move very much in a day. If the future were a bond price you might expect it to go up or down by 1 or 2% a day. If the Eurodollar future did that, it would mean a one day fluctuation of the 3 month rate of 100 or 200 basis points. If the rate is currently 5.00% a 100 basis point change in one day is 20% of the rate itself. This would imply an annual volatility in excess of 300% - very unlikely. Also the Eurodollar future would have a hard time trading above 100.00. That price corresponds to an interest rate of 0. If the future traded above 100, the rate would have to be negative. This would mean that if you deposited money at that rate, you would get back less money than you deposited. While this is not impossible, it is not at all common1 . To be sure we understand the contract, suppose that the June 2004 Eurodollar future is trading for 95.00 in March 2003. Suppose that the current 3 month LIBOR rate is 2.00% and the June future expires on 19 June 2004. What does this all mean? The Eurodollar futures are priced primarily by price discovery (discussed later). So the price of 95.00 suggests that the consensus of the market is that the 3 month LIBOR rate on 19 June 2004 will be 5.00%. Since todays 3 month rate is just 2.00%, this means that the market is expecting 3 month rates to rise 300 basis points over the 15 month period up to the expiry of the future. The market may have many reasons to suppose this improving economic conditions in the US, inflationary pressures increasing and so on. The Eurodollar future gives banks, investors and anyone else who is interested, an opportunity to express their opinion. If a bank thinks the market is wrong and that rates will be much lower than 5.00% in June 2004, the bank can take a position by buying the Eurodollar future. Each "tick" on the future is worth USD25. A tick equals 0.01 and represents 1 basis point, 1/100th of one percent. The contract size is one million dollars for a 90 day period so we get the USD25 as: 0.0001x 1,000,000 x 1/4 = 25 where the 0.0001 is one tick. If the bank buys just one future and the rate in June 2004 turns out to be 2.00%, i.e. the rate hasnt changed from today, then the future would be trading for 98.00. The banks profit would be 98.00 95.00 = 3 which is 300 ticks = 300 x 25 = USD7500. But if the rate turns out to be even higher than 5.00%, the bank would have a loss. For example, if the rate turns out to be 6.00% then the future would be trading for 94.00. The bank would have a 100 tick loss: 94.00 95.00 = -1.00. This would cost the bank USD2500.
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On 27 January 2003 a bank in Tokyo deposited JPY overnight at a negative interest rate they were paid less Yen the next day than they deposited.

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The bank is "Long the Future"

The bank is "Short the Rate"

Because the bank has bought the future, they make a profit when the future goes up and a loss when the future goes down. But what makes the future change is the interest rate. When the rate goes up, the future goes down and the bank has a loss. When the rate goes down, the future goes up and the bank has a profit. So, as the two pictures above show, the bank has a long position in the future but a short position on the rate. If that confuses you, wait until we get to foreign exchange! There are 3-month Eurodollar futures contracts for each of the months March, June, September and December. Contracts are listed for a 10 year period into the future! This means that it is possible to trade a future on the 3 month interest rate that will not be observed until 10 years from now. Why would anyone want to trade a contract that doesnt expire for 10 years? Many banks and financial institutions have long-dated obligations and assets like loans and bonds. The Eurodollar futures allow them to reduce their exposure to the movement in interest rates over the entire life of many of these instruments. The table below shows the official contract specification of the Eurodollar futures contract. Futures
Contract Size Quotations Minimum Price Fluctuation (Tick) Contract Months Regular Trading Hours (Central Time) Globex Trading Hours (Central Time) Last Trading Day $1,000,000 Index Points 0.0025 = 6.25/contract for spot-month contract 0.005 = $12.50/contract for all other contracts Mar, Jun, Sep, Dec and 4 serial months 7:20 a.m. 2:00 p.m. 4:30 p.m. 4:00 p.m. the following day, on Sunday, trading begins at 5:30 p.m. 11:00 a.m. London time on the second London bank business day immediately preceding the third Wednesday of the contract month Based on the British Bankers Association Interest Settlement Rate

Final Settlement

Source: CME

What if your exposure is to an interest rate in a different currency, like GBP or EUR or JPY? The Eurodollar contract has been so successful that it has been extended to interest rates in these and some other currencies as well. For example there is a "Short Sterling" contract that trades on the LIFFE whose underlying is the 3 month Eurosterling LIBOR rate.

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Treasury Bill Futures

Source: CME

The three month Treasury bill future existed before the Eurodollar future was conceived. The underlying is a three month Treasury bill, which is a discount security issued by the US Treasury. US Treasury bills are auctioned (sold) every week and mature 13, 26 or 52 weeks later. The expiry of the Treasury bill future is chosen so that there will be Treasury bills which have 13 weeks to maturity as of the "delivery date" of the T Bill future. You will gather from this that the settlement of this contract is by means of an actual Treasury Bill. This means if you are long the contract when it expires you will have to take delivery of (buy) a Treasury bill with a face value of USD1 million. You will pay the price based on the expiry discount of the contract. Like the Eurodollar contract, the T Bill contract is quoted as 100 rate. There is a difference in that the rate is a discount rate. For example if the closing price on expiry for the future is 94.00, then the delivery price of the bill is: 1,000,000 1,000,000 x 0.0600 x 91/360 = 984,833.33 Notice that the actual day count of 91, which equals 13 weeks, is used and that the discount: 100 94.00 = 6.00 is subtracted from the price. This is the meaning of a discount rate. The Treasury bill futures contract trades a much smaller volume than the Eurodollar futures. This reflects the greater exposure to and interest in the LIBOR rate on the part of the big players in the interest rate markets.

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Benzene Futures!

Source: CME

Notice that settlement for the Benzene Futures contract is in cash there is no physical settlement i.e. no one makes or takes delivery of actual benzene. The contract is designed for end users to hedge their exposure to the price of benzene. The 30 year US Treasury Bond Future on the Chicago Board of Trade:

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30 Year U.S. Treasury Bonds Futures


Trading Unit Deliverable Grades One U.S. Treasury bond having a face value at maturity of $100,000or multiple thereof. U.S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the delivery month or, if not callable, have a maturity of at least 15 years from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor plus accrued interest. The conversion factor is the price of the delivered bond ($1 par value) to yield 6 percent. 1/32 of a point ($31.25/contract); par is on the basis of 100 points. Points ($1,000) and thirty-seconds of a point; for example, 80-16 equals 80 16/32. Mar, Jun, Sep, Dec Seventh business day preceding the last business day of the delivery month Last business day of the delivery month. Federal Reserve book-entry wire-transfer system. Open Outcry: 7:20 a.m. - 2:00 p.m. Chicago time, Mon-Fri. Electronic (beginning 10-15-00): 8:00 p.m. - 4:00 p.m. Chicago time, Sun.-Fri. Trading in expiring contracts closes at noon (Chicago time) on the last trading day. Open Outcry: US Electronic: ZB None

Tick Size Price Quote Contract Months Last Trading Day Last Delivery Day Delivery Method Trading Hours

Ticker Symbols Daily Price Limit

This is a much more complicated contract than the Eurodollar contract. This contract is used by bond portfolio managers, pension funds and insurance companies to manage the interest rate risk of their assets and liabilities. The "long bond" contract is arguably the most successful and most widely copied financial futures contract ever devised. The bond future acts like a 30 year bond with a 6.00% coupon. When long term interest rates go up, the bond futures price goes down and when rates go down, its price goes up. What is different though is that the future is always like a bond with 30 years to maturity. A "real" 30 year bond would change over time to a bond with less and less time to maturity. But, for example, the June 2004 Treasury Bond Future is like a Treasury bond that has 30 years to maturity in June 2004. The September 2004 Bond Future is like a Treasury bond with 30 years to maturity in September 2004. So these must not be the same bond. The bond futures act as if the government auctions off a new 30 year bond with a 6.00% coupon every 3 months. But the government does not do that. This is because the US Treasury only auctions bonds every 6 months and in the year 2001 stopped auctioning off 30 year bonds entirely. Also the coupon on a newly auctioned Treasury Bond reflects the level of interest rates when the bond is issued. This means that there is no actual bond that is identical to the one that nominally underlies the future. But at expiry the contract calls for physical delivery. So if you are short the contract and have to deliver, what are you expected to do? And if you are long, what are you going to be buying and how much will you pay? Delivery for the contract is a bond from a list of "deliverable" bonds that must have specific characteristics with respect to time to maturity and must be a "genuine" US Treasury bond. This means it must be backed by the "full faith and credit" of the US Government. There will be a number of bonds that are eligible for delivery. But at expiry there is only one price for the future. Suppose that at expiry, the future settles at 105. This means that a 30 year bond with a 6.00% coupon would sell for 105. That must mean that long term interest rates are less than 6.00%.

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Now suppose that you are short the contract and decide to deliver a bond with a 5.00% coupon that has exactly 25 years to maturity. How much would you actually be paid? The CBOT applies a conversion factor to the future to determine the price. This conversion factor is meant to provide a price that gives a fair value for all the different deliverable bonds. It is computed by calculating the price of the delivered bond using a yield-to-maturity of 6.00%. So this bond would have a conversion factor of 0.87135 because that is its price1 at that yield divided by 100. This is then multiplied by the futures price to get the amount the seller receives: 105 x 0.87135 = 91.492 What if instead the bond that is delivered has an 8% coupon and just 20 years to maturity? The conversion factor for that bond is 1.23115 (calculated using a yield to maturity of 6.00%). So the price received for this bond would be: 105 x 1.23115 = 129.271 We would expect that the price of these bonds in the cash market would be close to the price the seller would receive if the bonds were delivered to fulfil the futures contract. In fact there are some bonds that trade closer to their delivery prices than others. We would discuss this idea in a bonds class but wont take it up now. Well, we did say it was complicated didnt we? Want to know the worst of it though? The contract almost never results in delivery! Before the future expires, people with open positions simply close them out buy back any futures they have sold or sell back any futures they have bought, rather than wait until expiry and go to delivery. Nonetheless, the possibility of physical delivery affects how the future trades. We wont say anymore about that right now. It is something that would be discussed at length in a class or book about bonds. Physical Delivery Futures contracts can be complicated when the underlying is a physical commodity and the contract calls for physical delivery. Lets look at the crude oil contract on the NYMEX:

So the trading unit is 1,000 barrels of oil. Pretty substantial, isnt it?

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Since some users are exposed to the price of oil over a long period of time, the futures are sometimes traded in "strips". This means you could buy or sell a number of consecutive contracts all at once. For example if you buy the year 2004 futures strip you are locking in a price for oil for the entire year. The price quotation is an amount over or under where the strip closed yesterday. Suppose that the prices yesterday were: Contract Month March June September December 25.00 23.50 22.00 26.00 And you buy the strip 0.20 over yesterday. Then your prices are: Contract Month March June September 25.20 23.70 22.20

December 26.20

Maximum price fluctuations are set to "calm" the market in case of a crisis like a political event. This gives the market a chance to think over the implications of the event rather than panic. This contract potentially results in the delivery of crude oil. Most of the people trading the contract will try to "offset" their positions before the first day of the delivery month. Most of the traders have no ability to either make delivery or take delivery (would you have a place to store 42,000 gallons of oil?). If delivery is going to occur, you can imagine that the specifications for delivery are very precise.

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You would also want to be sure that what you are taking delivery of is of the quality you are expecting:

Notice that if the seller delivers Norwegian oil they get paid a discount but if they deliver Nigerian "Bonny Light" they receive a premium. Well, we guess there must be quality differences, sort of like Bordeaux versus Burgundy wines, perhaps? Interest Rate Swaps We wont take the time needed to explain these important instruments in all their detail. But we will want to refer to them and to options based on them later on, so well give you just a brief introduction. When a bank lends money to a corporate customer it often does it using a "floating" interest rate. What these means is that if the company borrows money for a 3-year period, the rate of interest the company pays has the potential to change periodically. Often that period is 3 or 6 months. The way this works is that every period - lets use 6 months to be specific - the bank will notify the company of the rate of interest the company will have to pay for the next 6 months. Suppose the company takes out the loan in November of 2003 and the interest rate for the first 6 months is 5.00%. It might happen that over the three-year period the company pays: Period Starting Ending Rate November 2003 May 2004 5.00% May 2004 November 2004 5.20% November 2004 May 2005 5.60% May 2005 November 2005 5.80% November 2005 May 2006 6.00% May 2006 November 2006 6.25% You can see that the interest rate went up over the three-year period. Well that happens sometimes. Of course sometimes rates go down as well. You never really know exactly what is going to happen. But the company may not have been happy to just wait and see what rate it was going to pay. It might have wanted to pay the same rate of interest for the whole three-year period. So why didnt it just ask the bank for a fixed-rate loan? It may be that the bank was not willing to make a fixed-rate loan. Or it may be that the rate the bank offered as a fixed rate seemed too high to the company. So what can the company do about it? The company can use an agreement known as an interest rate swap:

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3 year Interest Rate Swap


Fixed Rate Payer Fixed Rate Receiver Notional Amount Tenor Start Date Maturity Date Fixed Rate Floating Rate Company XYZ SwapItBank USD10 million 6 months 15 November 2003 15 November 2006 5.50% LIBOR

What is this and how does it work? The size of company XYZs loan is assumed to be USD 10 million. Company XYZ is going to pay 5.50% (the fixed rate) to SIB (SwapItBank). The amount of interest will be based on the USD10 million. Since each payment is just for a 6-month period of time the actual amount would be 2.75% of 10 million, or USD275,000. SIB will in turn pay to XYZ the amount of interest calculated using the rate of interest that prevailed at the beginning of the interest rate period. This is referred to in the description as the 6-month LIBOR rate. LIBOR: London Interbank Offered Rate The interest rate that one major bank would charge another bank on a loan of dollars in the interest rate market outside of the US. This rate is "officially" set every day by polling a group of London banks. In our interest rate swap the interest rate is reset every 6 months. Two business days before 15 November and 15 May, the LIBOR rate would be observed and that rate would be used for the 6 month period starting on either 15 November or 15 May. The amount of interest SIB would pay would be this rate multiplied by the 10 million notional multiplied by the number of days in the period and divided by 360. This is known as an actual/360 day count. For example for the period from 15 November 2003 to 15 May 2004, if the rate for the period is 5.00%, then SIB would owe XYZ: 10,000,000 x 0.0500 x 182/360 = 252,778 In practice, because XYZ owes the greater amount (275,000), they would pay the difference, 22,222 to SIB. This is called "netting of payments". XYZ still has to pay whatever the floating rate is that its lending bank is charging it. To make it simple, well assume that XYZ is supposed to pay LIBOR to bank ABC, although it might have to pay LIBOR plus a margin or its floating interest rate might be based on another interest rate entirely. Thats greater detail than we need to go into here. The swap is a "side" agreement between XYZ and SIB. This is usually called an Off Balance Sheet agreement since it does not appear on XYZs balance sheet (although the existence and value of the swap would be disclosed in the Notes to the Accounts). Whenever the floating rate is less than 5.50%, XYZ will make a payment to SIB that will bring XYZs total interest payment for the period up to 5.50%. Conversely, when the floating rate is more than 5.50%, SIB will make a payment to XYZ that will bring its total interest payment down to 5.50%. The interest rate swap has "locked-in" a rate of 5.50% for XYZ for the entire 3 year period. The picture shows the cash flows between XYZ, its bank, ABC and the swap counterparty SIB:

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Notice that the picture clearly shows that SIB has not lent any money to XYZ. XYZ borrowed the 10 million from ABC. If at the end of the three years XYZ is unable to repay the 10 million, it is ABC that loses out. On the final date of the swap, the most that SIB could lose would be the difference between the 5.50% and the LIBOR rate from the beginning of that last period. If the LIBOR rate is higher than 5.50% then SIB would lose nothing even if XYZ failed to repay its loan. Prior to the expiry of the swap agreement there is bilateral risk between XYZ and SIB. When fixed rates are higher in the market than 5.50%, the swap agreement has a positive value to XYZ. When rates are lower than 5.50% the swap agreement has a positive value to SIB. For example suppose that on 15 November 2005, with one-year left to the swap, the one year fixed rate is 6.50%. Then XYZ is paying 1% less than the current fixed rate. What is this worth? If XYZ had to pay 6.50 %, its remaining two payments would each be 50,000 more than they actually will be (0.50% of 10,000,000). The present value of this amount using the current 6.50% rate to discount with is: 50,000/(1.0325) + 50,000/(1.0325)2 = 95,328 If SIB "defaulted" on its obligation to make its payments on the swap, then it would cost XYZ this additional amount in interest. Conversely if the 1-year rate was 4.50%, then SIB has risk to XYZ. The additional amount of interest that SIB would be getting compared to the current 1-year rate would be worth: 50,000/(1.0225) + 50,000/(1.0225)2 = 96,273 to SIB. So risk in the swap goes both ways. That is, a swap is like a futures contract. At the beginning it has no economic value, but as the underlying changes, the value of the agreement changes. Interest rate swaps are among the most versatile of all financial instruments. You will certainly encounter them in many situations as you continue to work in or study the financial markets.

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Pricing of Futures and Forward Contracts


Remember that we are not going to distinguish between futures and forwards, so from now on we are just going to use whichever word seems more convenient or sounds better. Futures are priced either of two ways: Arbitrage pricing Price discovery Arbitrage Pricing This refers to arriving at a price that would not allow someone, starting with no position in the market, to make a series of trades that would result in a risk-free profit. This seems reasonable doesnt it? How would it be possible for instruments to trade in the market at prices that would let someone just do a few trades and walk away with a certain profit? Such a market would not exist for long. Another way to understand the idea of arbitrage pricing is to take the point of view of a person who provides liquidity to the market. We call these people market-makers. Such a person provides a twoway price to the end-users, i.e. a price where the end-user can sell and another price where the enduser can buy. A typical example is if a market-maker in shares of IBM quotes prices of 85.25 | 85.35 for trades of up to 1000 shares. If an investor wants to buy shares, the investor would pay 85.35, since that is the price the market-maker is offering them, while if they want to sell, they would sell at 85.25 since that is what the market-maker is willing to pay. Because the market-maker is willing to either buy or sell, he or she cannot be primarily concerned with the direction of the share price. The market-makers profit comes from the difference between the bid price and the offered price. Suppose you are a market-maker in the gold future. You have to put up a bid price and an offer price. Suppose someone takes your offer. What will you do next? Like the stock specialist in IBM you might hope to make your money on the bid-offer spread. If youre lucky and the market is liquid, then you may always be able to trade the spread and end up with no net position. But suppose you end up with a position? Lets be specific. Suppose you have agreed to sell 1000 ounces of gold in 3 months time for a fixed price. You are clearly exposed to the price of gold. If gold is priced higher when the future expires than it was when you sold the future, you will have a loss unless you take some action to prevent it. Your position is shown graphically below, where F is the price you agreed to.

What could you do today, to "hedge" your position? Since you are exposed to an increase in the gold price, you could buy gold today and hold it until it is time to make delivery. What would you have to consider? Considerations: Gold price in spot market Funding cost, i.e. the cost to borrow money to buy gold

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Suppose you borrow money and buy gold in the spot market. The total cost to hold the gold to expiry would be the cash price plus the interest on your loan. Your position is now hedged since you have the gold to deliver in three months time and have locked in your financing costs. Your total position is shown below where C is the total cost to hold the gold for three months. Notice that there are two points labelled C.

In the new picture, the red line shows your P/L on the futures trade. Your profit and loss on your physical gold position is represented either by the solid blue line or the dashed blue line. How do you know which one it is? It depends on which of the two points labelled C represents your true cost to hold gold. If the total cost to hold gold is less than F, the price you agreed to sell for, then you have a profit and the solid line represents this. But if you, unfortunately, agreed to sell at a price lower than your total cost, then you have a loss and that is represented by the dashed line. The net position is shown in the next picture, which represents the difference between the red line (the money you receive) and the blue lines (the money you pay out).

Well you dont want to lose money do you? Then you need to determine what your costs are. Suppose that gold is trading right now for USD350 per ounce and that you are able to borrow money for 3 months at 6.00%. Then the total cost to you to buy the gold today and hold it to the expiry of the contract is: C = 350 + 350 x 0.0600 x 1/4 = 355.25 So if you agreed to sell gold at a price of 355.25, you would be assured that you make neither a profit nor a loss. This is a "breakeven" price. You would make a market around it e.g. 355.00 | 355.50. This was an example of arbitrage pricing. Using our own costs for both gold and funding, we were able to determine a price at which we were sure not to lose money. Many futures contracts are priced in this way gold, as we just saw, as well as equity, index, currency and bond futures. The formulas for calculating the futures/forward price are shown on the next page. In each case we start with the spot price. Then we add to it the cost to hold the spot until expiry of the future. This is usually the funding

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cost, but could also include the cost of storage, insurance, shipping, etc. Then we subtract any monetary benefits we enjoy from holding the spot. This would include any dividend an equity paid while we owned it, accrued interest on a bond or interest received from depositing currency. It would not include the voting rights of the shares or the patriotic feeling we might get from owning Government bonds or the gratification of looking at gold bars because they dont have a monetary value. So in general the "formula" for pricing the future is, as shown on the next page: Future = Spot + Costs - Benefits

Futures/Forwards Pricing Formulas


Formula
Equity Spot + Spot x r x t Dividends Index Index + Index(r div yield) x t

Example
IBM = 85 r = 4.00%
x
1

time = 1/4 year

div = 0.25

F = 85 + 85 x 0.0400 UKX = 3941 r = 4.00% (a/365)

/4 0.25 = 85.60

time = 72 days

div yield = 6.96%

F = 3941 + 3941(0.0400 0.0696) x 72 / 365 = 3918 Currency Spot x ( 1 + rnum x t) / (1 + rdenom x t) Bond "Clean" (Quoted) Spot Price + (Dirty Spot Price) x rrepo x t Accrued Interest During Period F= Dirty Price = Clean Price + Accrued Interest from last coupon 113.30 + (113.30+0.6572) x 0.0395 x 67 / 365 1.3345 = 112.79 AUD | USD = 0.5721 rUSD = 1.40% rAUD = 4.75% time = 1/4

F = 0.5721 x (1 + 0.0140 x 1/4) / (1 + 0.0475 x 1/4) = 0.5674 UKT 7 1/4 December 7 2007 Cash price = 113.30 Repo rate = 3.95% (a/365) Time = 67 days Accrued Interest from last coupon = 0.6572 Accrued Interest in period = 1.3345

Arbitrage Pricing: Future = Spot Price + Costs - Benefits

Why arent all Futures priced this way? Read on! Price Discovery One of the examples we saw earlier was the NYMEX oil futures contract. This called for the delivery of 1,000 barrels of crude oil. When we priced the gold future, we ignored the storage and insurance costs you might have incurred in holding gold. These costs should have been included and would have resulted in a somewhat higher futures price. But the difference would not have been large. But if you consider trying to hedge your risk when you are short 100 oil futures, you might realise how daunting those costs would be. Most people dont have the ability to store 4.2 million gallons of crude oil! What would the neighbours think? So arbitrage pricing doesnt really apply here. In general futures on commodities like oil, gasoline, benzene, soybeans, wheat and other agricultural products are arrived at by the process of people trading the contract with one another. That is, the futures price represents a consensus of the market as to what the spot price of the commodity will be when the futures contract expires. Clearly no one knows what the spot price will be in the future, but major players in the market, such as the big oil companies and the big electrical utilities and other consumers who use the oil, have an idea and an opinion. They express their opinions by trading the contract.

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For example if you are going to need heating oil in December and the December contract is trading at 75 cents per gallon, you have the opportunity to hedge your exposure by buying the contract. If you think the price will be higher than 75 cents in December you would certainly consider doing this. If a lot of people think so, then they would buy the contract as well and its price would go up. Alternatively if an oil company thought the price would be lower than 75 cents in December they would be tempted to sell the contract. If a lot of other companies thought so, they might also sell the contract and its price would go down. By this process of buying and selling, the market arrives at a consensus price, which represents the "average" opinion of the people trading the contract. It sometimes happens that the futures price is actually less than the spot price for commodities like oil, or industrial materials like copper. The economists call this "backwardation". Because there is a cost to hold the commodity you might expect the futures price always to be higher. But if you thought it should be, is there any way to "arbitrage" the price? This would involve buying the, presumably, low-priced future. Then what? How do you hedge? You would need to have an offsetting position in the spot oil market. You could try to get this by selling oil you do not own. This is called selling short and we will discuss this in some detail later. But in order to do this, you would have to borrow oil. Do you like the idea of going to a big oil company and asking if you could please borrow a tanker of oil for a few months? I didnt think so. Because it is impractical to do this, the oil future is priced by discovery not arbitrage. Arbitrage Pricing and Price Discovery If you reflect on the two different ways of pricing futures, you come to an interesting conclusion. When Futures are priced by arbitrage, the price of the future has no information in it as to what the market believes the price in the future will be! The futures price is simply todays price adjusted for todays funding costs and the known or expected benefits of the underlying. On the other hand, with price discovery, the futures price reflects the expectations in the market for what the price in the future will be. Neither way of pricing futures is inherently better than the other. Price discovery markets serve the useful purpose of communicating information. Arbitrage pricing permits cost efficient hedging. With either price mechanism there is also the possibility of what economists call a "risk premium". This occurs when the future deviates from its arbitrage price in a market where you would expect the price to be determined by arbitrage, or when the price in a price discovery market reflects higher perceived risk from being on one side of the contract rather than the other. As an example, the Hong Kong dollar is "pegged" to the US dollar i.e. the Hong Kong Monetary Authority is committed to a fixed exchange rate between the HKD and the USD (HKD7.7991 = USD1). This should imply that the futures price of a HKD in terms of the USD is the same as the spot price, i.e. the fixed exchange rate. However the HKD usually trades at a discount to the USD in the future. That is if you agree to buy HKD (sell USD) in the future, you can receive more HKD than the current spot price. This reflects the possibility that the peg might "break", that is, the Hong Kong authorities might allow the HKD to float against the USD. Should that happen the HKD might weaken relative to the USD. So being long HKD in the future might be regarded as a risky position. In that case the futures price of a US dollar would be higher. This difference is the risk premium. Arbitrage pricing here is technically still effective in that interest rate parity still holds. That is, you can calculate the futures price for HKD as: Spot x For example: 7.7991x 1.01550 = 7.8183 1.01300 1+rHKDt 1+rUSDt

Where is the risk premium? You can view the 192 "pip" difference between the forward price and the spot price as the premium, because the peg is 7.7991, even though the arbitrage price is 7.8183.

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Or you can view the additional interest rate of 25 basis points as being the risk premium. To see this, suppose you start with no position in USD or HKD. You could borrow USD for 1.30% for one year, sell the USD for HKD and deposit the HKD at 1.550%. In one year, if the peg is still in effect, you could sell your HKD for USD and have some USD left over after you repay your loan. Where is the risk? The risk is that the peg does not hold and your HKD are worth less than the amount of USD you have to repay. A similar effect could occur in some price discovery markets. For example, is it riskier to be long electricity or short? What does this mean? Electrical generating companies may have excess capacity which they are willing to sell. But it is only capacity. If they dont sell it they dont have to generate it. On the other hand a business that uses electricity may be very dependent on an uninterrupted supply. The business might be willing to pay a premium to assure itself of that supply. So it might be willing to pay something in excess of its expectation of future prices. This again reflects the additional risk of their position, which in this case is being short. We said earlier that we would not make any distinction between futures and forwards, but there can be some differences. Here is an excerpt from the Starbucks website: Long-term contracts By offering long-term contracts to our producers, they are guaranteed attractive prices over multiple crop years and Starbucks is able to secure future coffee supplies at predictable costs. This year, Starbucks has increased the amount of coffee purchased through long-term contracts, at outright prices, to 31%, from 3% last year So if you compared the forward price Starbucks has agreed to pay with the coffee futures contract for the same period, there would presumably be a difference, even if the future covered the same quality coffee as the company buys from its suppliers. This is just to show you that its not always a matter of maths or efficient markets.

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Funding and Interest Rates


Whenever we buy or sell something we have to think about how the transaction is to be funded: if we are paying money, where will we get it and what will it cost; if we are receiving money, what will we do with it and what will we earn? Take the case of a simple investment like buying a share of stock. If we take the point of view of an individual investor, then in order to buy the stock, we will have to have cash. Where do we get it? We might have it in a savings account. Or even if we happen to have it in paper currency, we could have put it into a savings account. Either way we look at it, buying the share means forgoing the interest we could have earned on the share price. We think of the cash as "funding" the stock purchase and the interest rate on the cash as the "funding rate". When we instead take the view of a trader or other agent of a bank, we have to be a bit more sophisticated about interest rates. A bank will generally have a department whose main function is to manage the funding of the banks positions. This is motivated by potential offsets and by economies of scale. If the equity-trading desk buys GBP2 million of shares and, at the same time, the structured products desk sells GBP2 million of a medium term note, the two funding positions offset one another. There is no point borrowing GBP from an outside source to fund the first position or to placing the funds from the second position with some other bank. Still, at the end of the day, when all the positions the bank has taken on that day are netted out, there may be a residual that needs to be funded i.e., borrowed or lent. Because the bank can fund itself in the professional money market, the interest rate it obtains will be more favourable than what would be available to most individual investors. The market standard interest rate for borrowing money to fund long positions is LIBOR (the London Interbank Offered Rate), which we discussed earlier. A professional firm like a bank will fund itself in some relation to LIBOR. A highly rated bank might be able to borrow money at some number of basis points1 below LIBOR while a less well-rated bank would have to pay something more than LIBOR. Short positions Shorting a security means to sell it without actually owning it. Shorting a security is an ordinary runof-the-mill transaction in the financial markets. We will see many examples of how this comes about, particularly in the risk management of derivative positions. When a trader, or an individual investor, shorts a security they have to arrange to borrow it from someone who does have it, in order to "make delivery". Technically speaking, borrowing money is itself a shorting transaction, namely shorting the underlying currency. You borrow it today and return it later on. So suppose we short something today, that is, sell something we do not own. How do we get it in order to make delivery? And what costs are involved? The answer depends on what we have shorted. Well look at some different examples.

Equity
When we short an equity, we will sell it in the market and have to make delivery some number of days in the future. In some markets, trades settle 3 business days after the trade date, while in other markets it might be 5 days. Over time these intervals are likely to decrease, as settlement systems improve. In order to get the stock we have gone short of, we might approach another bank, a pension fund, a mutual fund or investment trust, a University endowment fund or even an individual investor. For professional brokerage firms, many customers keep their shares in what is referred to as "street name". This means that the firm takes responsibility for collecting dividends and for other simple transactions related to the shares for the client. The firm then reserves the right to "lend" the shares. This means that a large brokerage firm has access to a great deal of shares owned by its clients. For banks with many wealthy individual clients whose accounts are managed by their Private Banking division (sometimes called Wealth Management), the supply of shares may be plentiful indeed. So lets suppose we have found someone who has the stock. Why would they lend it to us? They must get something out of it themselves. Borrowing the stock will incur a cost to us. For example if
1

A basis point is 1/100th of 1% e.g. 9.01% is 1 basis point more than 9.00%they deposited.

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we borrow GBP1 million of shares from a pension fund, we might have to pay a fee of 10 or 20 basis points to the fund for the time we have the shares. For example, if we borrow the shares for 30 days and pay a fee of 20 basis points this would amount to: 0.0020 x 1,000,000 x 30 / 365 = 164.39 We would pay this to the fund when we return the shares. There is a different way to accomplish essentially the same thing. Since we will receive the GBP1 million from the person we sold the shares to, we could give the proceeds - the GBP 1 million - to the pension fund for the 30 days. When we return the shares, they would give us back our cash. In this way, the pension fund has less credit risk on the transaction since the cash acts as "collateral" for the shares we borrowed. Now when we return the shares they will pay us not only our cash, but also will pay us interest on the cash. After all they had the use of our cash for 30 days. Remember though that the fund expects to make 20 basis points on the transaction. Suppose that the fund is able to earn 4.00% interest on the money we give it. They might do this by depositing the funds in a bank account or by buying a short-term money market security. Then they would agree to pay us just 3.80% on our cash. The economic effect is the same as if they had charged us the 20 basis points. We refer to the 20 basis points as the borrow cost, or the cost of funding the short position. The actual number of basis points will depend on, among other things, the supply of the shares available for borrowing. If the shares become hard to borrow, perhaps because a lot of firms are taking a short position, or because of a corporate action, like a special dividend or a merger, then the borrow cost will rise. If the shares become extremely difficult to borrow we talk about there being a "short squeeze" on the shares. Equity Finance may be a business unit of a bank that does a lot of borrowing and lending of shares. This can be a value-added activity since it can minimise the costs to the trading department of funding long positions as well as short ones. For example, if the trading desk buys GBP2 million of shares, the Equity Finance department might be able to lend those shares out to another bank. If we charge the counterparty 20 basis points by taking their cash and paying them 20 basis points below the rates in the cash market, then we effectively have funded our long position at 20 basis points lower than the cash market rates. In general the Equity Finance department will try to earn a margin on the total size of its book. If the GBP book is long 500 million GBP and short the same amount, then every one basis point is worth GBP50,000 per year. They would earn this by lending cash at 1 basis point higher than where they borrow it. So if they generally earn a margin of 20 basis points they can generate GBP1 million in profit. Repo/Reverse Repo There is a particular terminology associated with the borrowing and lending of securities. Repo: If a firm lends securities and borrows cash it is doing a repo transaction. We say they "repoed" the security. Reverse-Repo: If a firm borrows securities and lends cash, it is doing a reverse- repo transaction. We say they "reversed in" the security. Repo stands for "repurchase". The actual documentation and legal definition of the transaction depends on how the transaction is structured. We wont take this up right now. However we should note that regulations in some markets put restrictions on the shorting of securities, Sometimes it is prohibited outright and in other cases it must be structured as a so-called "buy and sell back" transaction. Dividends and Voting Rights Generally the beneficial owner of a share is entitled to receive dividends and to vote in corporate actions. So if a firm shorts a security how are these things affected? If the firm is short a share on a dividend date, it will have to pay the dividend amount to the firm lending the shares. If the lending firm wants to vote in a corporate action, it will have to "recall" the shares i.e. the voting rights follow the shares. These can be important considerations and, like virtually everything else in the financial markets, are often affected by tax issues. Once again, we will not go any further into this right now.
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Bonds
Having discussed equities, bonds present little additional difficulty from the technical point of view. Long positions can be funded by lending the bonds bought and paying interest on the money received and short positions can be managed by reversing the bonds in and receiving interest on the money lent. The difference in the bond market has to do with the participants and with the types of bonds used. General Collateral There is a large market in borrowing and lending high-quality bonds. High- quality usually means the sovereign debt of G7 countries1. The participants in the market include the large money centre banks, investment banks, pension funds, insurance companies, government bodies such as cities and states in the US and local authorities in the UK. Basically any political or financial institution with either a large source of funds or a large source of bonds can participate in the repo market. The main motivation for many of the participants is simply to lend or borrow money, not to take long or short positions. Think of the repo market as being a market in collateralised loans. When a city, for example, lends out bonds that it owns, and takes in cash, it is taking out a loan that is collateralised by the bonds it has lent out. When a money market fund lends out cash and takes in a bond, the bond acts as collateral for the loan the fund is making. In fact the money market fund will tell its investors that it is "investing in repo". Now imagine that you are the treasurer for a US city and have USD10,000,000 that you will not need to use for another week (apparently the city is not New York!). Rather than let it sit idle and rather than put it into a low-paying account in a bank, you decide to use the repo market. You approach a broker in 1-week repo and ask for the "market". The broker comes back with 4.00 | 4.10 for general collateral. What does this mean exactly? The broker is telling you that you can earn an annualised rate of 4.00% on a 7-day repo transaction if you are willing to take as collateral any US Treasury bond the brokers client can supply. Additionally it is expected that, if in the course of the week the lender of the bond wants to substitute a different bond for the collateral you received, you would not object. It is understood that the bond to be used as collateral will be a US Treasury bond, not an agency bond or any other bond that is not backed by the "full faith and credit of the US Treasury". Also that it will be a coupon bond, not a discount security. An example would be the 5 3/8s of February 2031. This is a US Treasury bond, issued in February 2001 with a coupon rate of 5 3/8%. This bond could be used as general collateral. You, as the treasurer, could agree to lend your USD10,000,000 for 1 week and would receive (via the "fed wire") a face amount of this bond with a market value of USD10,000,000. One week later you would return the bonds and be paid: 10,000,000 + 10,000,000 x 0.0400 x 7 / 360 = 10,007,777.78 and in this way would have earned USD7,777.78 for lending your cash for 1 week. If, when you are ready to return the bonds, the counterparty on your trade should happen to default, i.e. does not have the money to repay you, the bonds serve as your guarantee that you will not lose your loan. Whether you would now have the right to sell the bonds in the market to get your money back depends on the documentation in your repo agreement. The point is that you have securities that are worth what your loan was worth. Specials Just as equity shares may become hard to borrow, so too can specific bonds. When this happens the bond is said to be "on special". What will happen to the repo market for a bond that is special? Since it is in great demand for borrowing and since people who lend the bond are meant to pay interest on the cash they receive, it must be that the interest rate for such a bond will be less than the rate for general collateral. This represents an increase of the "cost to borrow" the bond. Why bonds go on special is a topic for an interest rate class but we will just mention that if a particular point on the yield curve seems out of line with the rest of the curve, e.g. suppose 5 year rates seem low relative to 3 year and 7 year rates, then the market may decide to put on a trade to take
1

The G7 countries are US, UK, Germany, France, Italy, Canada and Japan

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advantage of the apparent mispricing. This might involve shorting 5-year bonds and would thereby create a demand to borrow them. Term repo and marking-to-market We mentioned in the discussion above that a treasurer might want to lend cash for a fixed period, like one week. The period could be shorter, as short as one day, or longer such as one, two or three months. Dealers will make a market in term repo, i.e. repo agreements that last for a fixed period of time. You might worry, as the treasurer, that if you enter into a longer-term repo agreement such as 1 month, that the value of the bonds you were given might fluctuate during that time. In particular, what if interest rates were to go up suddenly and the value of your collateral were to drop to 9,900,000? The convention in the repo market is that repo positions are marked-to-market on a regular basis. This means that if the bond value does decrease, the lender of the bonds will have to give you more bonds so that the market value fully covers the loan. Conversely, if the bond value goes up, you may have to return some of the bonds to the lender. This is done to protect both sides of the repo trade. Once again, this also depends on how the repo agreement is structured. So if you are actually going to do a repo transaction be sure you understand the documentation. Non-G7 Debt and Haircuts There is a repo market in the sovereign debt of G7 countries. There is a less well-developed market for other forms of debt such as corporate bonds, emerging market bonds and so-called "distressed" debt. In each case if you were going to be the lender of cash and the receiver of collateral, you might worry not just about your counterparty but about the value of the collateral itself. A way to protect yourself, if you wanted to get involved in the repo market for lesser credits, would be to ask for collateral that is significantly more than the amount of cash you are lending. For example if you lend USD10,000,000 against a bond issued by Ford Motor Corporation (their credit rating is just barely investment grade) you might ask for USD10,500,000 market value of bonds. This protects you against a 5% drop in the value of the bonds. The additional 5% is called a "haircut". Haircuts can be very large for bonds whose market prices are highly volatile. The reason for a "real money" investor to get involved in this market would be to earn the higher interest rates available on non-G7 repo. But there is increased risk as well. For traders who want to short the lesser credits, this haircut might look attractive (lend 10 million dollars and receive 10.5 million in bonds) but because these bonds may well become special, the benefit might turn out to be very small or non-existent.

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The rates shown above give an indication of repo rates in the bond market at the beginning of 20031. Note that the overnight rate on general collateral (Repo GC) in the US market was 1.25%. The overnight rate on the 6.00% Ford bonds of February 2005 was just 0.80%, reflecting that this bond was special. At the time, traders were interested in shorting that bond, possibly to speculate on a downgrade of the credit. The market was charging them to borrow these bonds, as the interest rate should otherwise have been higher than the general collateral rate.

Commodities and Precious Metals


Someone once said, "You cant short cattle! What would you do, cut off their legs?" Generally there is no repo market for commodities. However there is a repo market for precious metals such as gold. The terminology is a little different in the gold borrowing/lending market. Here they talk about the "lease rate". The lease rate represents the cost to borrow, or the benefit of lending, gold. If the lease rate is 1%, it would mean that if you want to borrow gold, you would have to pay 1% in interest on your loan. For example suppose you borrow 100 ounces of gold for 1 year when gold is priced at USD350 per ounce and agree to a lease rate of 1%. Then in one year you will have to return the 100 ounces of gold and pay either 1 additional ounce or USD350 in interest. The method of payment would be agreed on by you and the lender of the gold at the time you borrow it. The lease rate goes up and down depending, as usual, on the demand for borrowing gold. In the late 1990s when some central banks were selling large quantities of their gold reserves, the gold price was dropping constantly. This led a number of traders to take short positions in the gold market. This in turn led to an increased demand to borrow gold. Lease rates went well above 1%. To bring this discussion to an end then, simply realise that the appropriate interest rate to apply in any situation depends on the underlying security, the length of the time period and whether the position in the security is long or short.

Source: UBS Warburg

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Options
Futures were our first example of a financial derivative. Futures themselves are the foundation of a major business. There are many futures exchanges around the world, both the physical "bricks and mortar " type like the Chicago Mercantile Exchange and the Chicago Board of Trade and the electronic exchanges like Eurex (owned by the Deutsche Termin Bourse and the Swiss Exchange) and Globex, the after trading hours facility of the CME. A great many people make a very good living trading, brokering and executing futures trades. Having seen some of the uses for futures we realise that when we buy or sell a futures contract we are just as exposed to the price of the underlying as if we had bought the underlying itself. That is, the price risk of the futures contract is essentially the same as the price risk of the underlying. Options are different. Options give the owner of the option a choice. For our purposes there are just two types of options Calls and Puts. Later we may discuss some options that have different terms than what are known as standard or "plain vanilla" options. For now well just stick with the simple types. Call Option A call option should be thought of as a buyers option. It gives the owner of the option the right but, as the standard definition says, not the obligation to buy. Sounds like something a sales person might say try it, youre under no obligation. Well in this case its true. Lets look at an example: Car Lease You lease a new BelchFire 88 (not a real car!) for GBP300 per month on a 30 month contract. The contract says that at the end of the lease period: The leaseholder can return the car to the dealer or can buy the car for GBP5000. If you have leased the car you have the right to buy it, in 30 months for GBP5000. Will you exercise" your right i.e., will you buy the car for GBP5000 in 30 months? It depends on whether you want to or not, because its your choice. You can wait until 30 months from now and see if it is advantageous for you to buy the car for that price. If it is you will do it and if it is not you will not. Thats an option. Since you have the right to buy something, it is a call option. Mortgage You buy a house for USD250,000. You pay USD50,000 in cash and finance the remaining USD200,000 with a 20-year mortgage with a fixed interest rate of 7.00%. A clause in the mortgage says: The borrower can repay the mortgage at any time prior to the original maturity date. You have an option. This time you can exercise your option at any time. This is unlike the car lease, which could only be exercised at expiry. What kind of an option is this mortgage option? Essentially you are buying back your mortgage, or if you like, buying back your loan. Why would you do this? Suppose interest rates have gone down to 6.00% from 7.00%. You could borrow the amount remaining on your mortgage, possibly even from the same bank that gave you the original one, and re-finance at the lower interest rate. Once again you have an option a choice. It is a call option because you can buy something your outstanding loan, for a fixed price the face amount left owing on it1 .

For those of you who are fussy the face amount does change if you have an amortising mortgage. Happy now?

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Another mortgage This time you borrow the USD200,000 for 20 years but the interest rate is reset every 3 months to Current 3 month Treasury Bills plus 50 basis points Naturally you worry about interest rates going up so the lender says: The interest rate you pay will never exceed 7.50% You have an option the option to pay the current 3-month rate plus 50 basis points, or to pay 7.50%. You will exercise your option anytime the rate goes above 7.50%. Actually you have 4 x 20 = 80 options because the rate is reset every 3 months for the entire 20 years of the mortgage. This type of option is called a cap and is very popular in the US, the UK and, as the following web page shows, in Canada.

Put Option You buy an expensive rug from a reputable dealer. The dealer says: Bring the rug back anytime in the next one year and I will give you your money back. This is to guarantee you are satisfied with the rug. What kind of an option is this? This time you have the right to make the dealer buy the rug back from you at a predetermined price. This type of option is called a Put and should be thought of as a sellers option. We will be concerned with financial options where the underlying, i.e. the thing you have the right to buy or sell, is a financial instrument like a share or a bond or a product based on a financial value like an interest rate. Financial Options Were going to make a little catalogue of the options that are used most widely. Well start with equities. Share options Think you might like to buy shares of Amazon.com? Or maybe you think Amazon is grossly overvalued and the shares are bound to fall in price? Taking a long position, i.e. buying the shares, could

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prove profitable but there is also the probability of losing a significant amount of your investment. When you think back to some of the disaster stories of the years 2001-2 ENRON, WorldCom, Marconi, Railtrack and so on, you soon realise that investing in equities entails a lot of risk. A call option on the shares gives you the opportunity to participate in price increases while limiting your potential loss to a fraction of the price of the shares. For example if a share is priced at 100 pence, a 3-month option to buy the share for 100 pence might cost 20% of that amount. Later we will see what goes into determining the price or value of an option, but the option generally will cost much less than the share. A put option allows you to take a short position in the shares, i.e. profit from a decrease in the share price, and limit your potential loss to the price of the option just as in the case of a call. There is an additional benefit in that buying a put is a more reasonable choice for most investors than selling the shares short in the market. Hedge funds may choose to sell short rather than buy puts, but many investors are not comfortable with the whole idea. We should probably establish the vocabulary for options before going any further. Option Definitions
You have the right but not the obligation To buy To Sell 1000 shares of MKS (Marks and Spencer) For 300 pence per share On Or before 31 March 2004 Its an option Its a call Its a put Contract size The underlying The exercise or strike price Its European-style Its American-style The Expiry date

Exercising an Option When you use your call option to buy shares of the underlying equity, you are exercising the option. Similarly if you use a put option to sell the shares. When you do this you will pay (call) or receive (put) the exercise price. The exchange of shares for cash will take place just as if the option exercise was an ordinary share trade. This means that if you exercise a put, you will need to have the shares to deliver. An investor who did not actually want to trade the shares could sell the option prior to expiry and realise any gains or losses on the option. If the option is exchange-traded it is usually possible to do this. If the option was traded OTC (over-the-counter), the investor would probably have to go back to the bank or other counterparty who sold the option to try to sell it back. Most OTC options are not "assignable" to a third party. Settlement of an Option At expiry of an exchange-traded equity option the settlement is into the underlying shares. That is, an in-the-money call will result in the investor buying shares and an in-the-money put will result in the investor selling shares. In-the-money simply means that the exercise price is favourable to the investor compared to the market price. However, on most exchanges, exercise is not automatic. The investor has to positively decide to exercise the option. There are sometimes provisions that if the option is sufficiently in-the-money then the exchange will automatically exercise it even if the investor has not filed an exercise notice, but investors should be particularly aware at expiry of whether any of their options are in-the-money and take action when they are. We mentioned above that an investor might want to buy a call option in preference to buying the actual shares. Lets look at the advantages and disadvantages of doing this. Before continuing with our catalogue, we will use a single example to illustrate the most important ideas about options.

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Option Basics
Options Compared to Forwards Compared to buying the underlying shares, options cost considerably less. What value does this give to the option? We already know about forwards and futures and how they relate to the underlying. For example if Microsoft (MSFT) = 60, US 3 month interest rates are 4.00%, and if MSFT does not pay a dividend during the period, a 3 month forward on MSFT would be priced at 60.60. Suppose the 3 month 55 Call on MSFT is priced at 8.00. The 55 Call lets us buy the shares in 3 months time for 55 per share. But the forward is priced at 60.60. So part of the value of the 55 Call is the difference between 60.60 and 55 = 5.60. This difference is called parity to the forward. Lets explore this a little more. The correctly priced forward would trade for 60.60. So if an investor wanted to own MSFT in 3 months, the investor would be indifferent, at least from an economic point of view, between buying MSFT today for 60 or agreeing today to buy MSFT in 3 months for 60.60. We dont have to belabour the point since we discussed it at length earlier, but the price exposure to the forward is the same as the price exposure to the share. Two investors could agree today to trade MSFT in 3 months for 60.60, with one of them buying and the other one selling, and this would be a "fair" trade. This means that neither investor would feel they had to be paid to do the trade. So no cash would change hands until the forward agreement expires in three months. Off-Market Forward But suppose that one investor says "I want to buy MSFT in 3 months but I only want to pay 55". Then what? No one is going to agree today to trade at that price in 3 months time. The price the investor is asking for is "off-market". But suppose the investor said in addition "I have my reasons for wanting to trade at that price in 3 months, but I am willing to make a payment up-front today in order to get you to agree to the trade". What would you say in return? You would want the charge today to "make you whole" in turn for agreeing to the off-market price in 3 months. That charge would be the present value of 5.60. This is 5.60 / 1.01 = 5.54. If you receive 5.54 today, you could put it in a bank at 4.00% interest for 3 months. Then in 3 months time it would be equal to 5.60. So when you sell MSFT in 3 months time for 55, the additional amount would bring your total to 60.60, just as if you had traded the forward at the correct on-market price of 60.60. That was a long-winded explanation but what we can conclude from it is that the minimum value of a call whose exercise price is less than the current forward price is the present value of its parity to the forward, the difference between the forward price and the strike price. The same must be true for a put whose strike price is higher than the forward price. For example, consider the 3 month 70 Put on MSFT. This gives you the right to sell MSFT for 70 per share in 3 months time. This is also like an off-market forward. If an investor wanted to get a trader to agree today to let them sell shares of MSFT in 3 months for 70 per share, the trader would have to be paid the present value of 70 60.60. This would be 9.40 / 1.01 = 9.31. If the trader is paid this amount today he or she could put it in an account at 4.00% interest. In three months if they buy MSFT from the investor for 70, the net amount they will actually pay out would be 70 9.40 = 60.60. In summary, one type of value an option has is forward value: Forward Value If Forward Price > Strike price, then a call option with exercise price X is worth at least the present value of F X. If Forward Price < Strike price, then a put option with an exercise price of X is worth at least the present value of X F. For a given strike price X, just one of the options will have forward value. The difference F X or X F, whichever one is positive is the parity to the forward and its present value is called the "forward

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value" of the option. If it happens that F = X, then the forward value of both options is 0. Forward Value of an Option
F>X Forward Value of Call = PV (F X) F<X Forward Value of Put = PV (X F)

They say "a picture is worth a thousand words". So it might help if we looked at some graphs, which are the mathematical equivalent of pictures. Graphical Representation of Options The first type of graph we are going to look at is called a value graph, or parity graph. It shows the value of the option at expiry on the vertical axis, for each price of the underlying at expiry on the horizontal axis. Lets look at the value graph for the (long) 55 call on MSFT.

This graph shows why the buyer is required to pay for an option. The option cannot be worth less than 0 at expiry and may be worth a lot more. So it must have a positive value today. The amount paid by the buyer is called the premium. How would this graph compare to buying the forward on MSFT for 60.60?

Suppose we put the two graphs together?

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Interesting isnt it? The value of the 55 Call at expiry is always more than the value of being long the forward. However, the price of the 55 Call will make up for this difference. Suppose, as we suggested earlier, the price of the call today is 8.00. Then what happens to this graph?

Notice how the graph has been re-labelled as Profit/Loss rather than Position Value. If you buy the 55 Call for 8.00 and the price of MSFT is not above 55 at expiry, you will lose the entire 8.00 you paid1. If the price of MSFT is 65, then you have a profit of 2 on your option. The 55 Call is worth 10 at expiry if MSFT is priced at 65, but you paid 8 for the call so your profit is only 2. Breakeven Price Suppose that MSFT happens to be priced at 63 at expiry. Then the 55 Call would be worth 8 and since you paid 8 for it your profit/loss is 0. We call this price of the underlying the "breakeven" price. At that price you have just broken even on your long option position. If you buy the 55 Call as an investment on its own, then you should have an optimistic view of the stock. A long call option is a long position in the underlying it gains when the price of the underlying goes up. Volatility Value Why did we have to pay 8 for the 55 Call? We knew that we had to pay at least 5.54, because it had this value simply as an off-market forward. But there is a difference between the long call and a long forward position. Namely, you do not have to buy the shares of MSFT at expiry if you dont want to. If you had bought the forward for 60.60, or if you had bought the off-market 55 forward, you would have had to buy MSFT at expiry, no matter what the actual price at expiry was. In either case you would have paid out a total of 60.60, as we explained earlier. But if you own the 55 Call you have a choice. If MFST is priced above 55 at expiry, you will exercise your option and buy MSFT for 55. You still may not have a profit of course. If MSFT is trading at 60 at expiry, the 55 Call is worth 5 and you would exercise it, but since you paid 8 for the option, you have a loss of 3. However, what if the price of MSFT is 45 at expiry? If you had bought the forward for 60.60, you would have a loss of 15.60 at this price. But if you own the 55 Call you dont have to exercise it. So you have no losses below 55 other than the 8 you paid for the option. The lower the price of MFST at expiry, the more advantageous the option position is compared to the long forward. If MFST is trading at 30 (its not impossible) the forward would have lost 30.60. Once again if you owned the 55 Call you wouldnt be all that happy since you lost what you paid for it, but it was only 8 not 30! So the "additional" amount you paid for the call above its forward value: 8.00 5.54 = 2.46 is to protect you from the downside of the forward. We call this volatility value since it relates to the uncertainty of what the price of the underlying will be at expiry. Later on we will explain how we can calculate volatility value without already having the value of the option. For now it is enough to realise that the 55 Call has two kinds of value forward value and volatility value. To be even-handed we should look at a put as well. So lets now discuss the same ideas for the 70 put. Lets suppose the 70 strike 3-month put on MSFT is priced at 11.00. A long put, i.e. a put that you own, is a short position in the underlying its value is greater when the spot price of the
1

If the fussy people are still reading, I know weve left off the additional 0.02 in interest it cost to finance the call for 3 months. Well take care of that later.

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underlying is lower. So when we consider its value we should compare it to a short forward position. Since the forward on MSFT is valued at 60.60 you could agree to sell the forward to a trader for 60.60 and this would be the fair price. Suppose that you wanted to agree today to sell shares of MFST in 3 months for 70. This is an off-market agreement so you would have to pay to do this trade. The parity to the forward is 70 60.60 = 9.40 and its present value is 9.31 so it would be a fair agreement if you paid 9.31 today and agreed to sell shares of MFST in 3 months for 70. Notice that this is not an option you are agreeing to sell the shares for 70 even if that turns out to be a bad trade in 3 months. If MSFT is trading for 100 in 3 months time you wont be very happy about selling the shares for 70. But if you trade the short forward, you wont have a choice. Your position looks like:

This is the value of your position at expiry if you either sell the forward today for 60.60 or pay 9.31 today and sell MFST in 3 months for 70. Why? If you sell the forward for 60.60 and MFST is 65 at expiry you lose 65 60.60 = 4.40. If you pay 9.31 today and sell MFST for 70 at expiry when it is trading for 65, then you take in 70 at expiry but have to buy the shares for 65. In addition the 9.31 costs you 9.40 in total (with interest costs) so your cash flow at expiry is: 70 65 9.40 = -4.40. Also, as the picture shows, if MSFT is 55 at expiry, then you have a profit of 70 55 9.40 = 5.60. What is the value of the 70 Put at expiry?

You can see the value of the 70 Put is greater than the value of the short forward no matter what the price of MFST is at expiry. But what happens when we take into account the USD11 cost of the option?

We see that the most we lose with the option is 11, the amount we paid for it. But we have the

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potential to lose more if we sell the forward. If MSFT is trading at 90 at expiry, we would have lost 29.40 if we had sold the forward. If MSFT is trading at 100, the loss would be 39.40 and so on. The difference between the 11 we paid for the option and the forward value of 9.31 is volatility value: 11.00 9.31 = 1.69. The 70 put protects the owner from the losses they would sustain at prices higher than 70 at expiry. Any one who is short a stock worries constantly about the stock price rallying. With a put, you can sleep at night since your loss is limited to the option premium, in this case 11, which is small compared to the potential loss on the short forward. There is a breakeven for a put just as there is for a call. We paid 11 for the put. At what stock price at expiry will the 70 Put be worth the 11 we paid for it? The breakeven price of MSFT at expiry must be 70 11 which is 59. At that price we will have just gained back the option premium we paid. You may have noticed that the volatility value of the 55 Call (2.46) was greater than the volatility value of the 70 Put (1.69). We will see later on why this is so. For now just realise that not only the potential size of the loss is important but also how likely that loss is to occur. The exercise price of the 70 put is relatively farther away from the forward price than the exercise price of the 55 Call. So the protection of the 55 Call is worth more. We will make this more precise later. Before we go on to discuss option pricing in a more detailed way, we want to return to our description of options that are used in different product areas.

Equity Index Options


Equity Index options are very much like equity options since the underlying is a basket of stocks. There are different types available in various exchange-traded markets: European-style options on the cash price of the index American-style options on the cash price of the index European-style options on an index future American-style options on an index future Options on the Cash Price of an Index These options on an index are invariably cash-settled on exercise or expiry. For example, there is an option with symbol OEX that trades on the CBOE (Chicago Board Options Exchange) whose underlying is the cash price of the S&P100 stock index. The options are American exercise. If you exercise the 300 Call when the index is priced at 350, you receive USD5000 in cash (multiplier is 100) but you do not buy any shares of stock. Similarly if you exercise the 375 Put, you would receive USD2500 in cash but would not sell any shares. Also traded on the CBOE is a European-style option on the cash price of the S&P500 index. When the option expires, the owner receives parity to the settlement price of the index. The description from the CBOE website is shown below.

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S&P 500 Index Options SPX


Multiplier: $100. Strike Price Intervals: Five points. 25-point intervals for far months. Strike (Exercise) Prices: In-,at- and out-of-the-money strike prices are initially listed. New series are generally added when the underlying trades through the highest or lowest strike price available. Premium Quotation: Stated in decimals. One point equals $100. Minimum tick for options trading below 3.00 is 0.05 ($5.00) and for all other series, 0.10 ($10.00). Expiration Date: Saturday immediately following the third Friday of the expiration month. Expiration Months: Three near-term months followed by three additional months from the March quarterly cycle (March, June, September and December). Exercise Style: European - SPX options generally may be exercised only on the last business day before expiration. Settlement of Option Exercise: The exercise-settlement value, SET, is calculated using the opening (first) reported sales price in the primary market of each component stock on the last business day (usually a Friday) before the expiration date. If a stock in the index does not open on the day on which the exercise & settlement value is determined, the last reported sales price in the primary market will be used in calculating the exercise-settlement value. The exercise-settlement amount is equal to the difference between the exercise- settlement value, SET, and the exercise price of the option, multiplied by $100. Exercise will result in delivery of cash on the business day following expiration.
Source: CBOE

The LIFFE lists options on the cash FTSE100 index, Both European-style and American-style options are available. The specifications are shown below.

Source: LIFFE

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Options on Futures: We have discussed futures already so the idea of an index future is nothing new. There are futures, as we know, on the FTSE100, the S&P500, the DAX, Nikkei and many other stock indexes. An option on the future is either a call or a put on the future, i.e. the right to buy the index future or the right to sell the index future. So if the option is American-style and you exercise, you get either a long futures position - if you exercise a call, or a short futures position - if you exercise a put. You also receive the mark-to-market based on the closing price of the future on the day you exercise and the strike price of the option. So if you exercise the 900 Call on the S&P500 future when the future is trading for 1000, you get a long futures position and since the future is 100 points higher and the multiplier is USD250, you also receive USD25,000 in cash. If you exercise the 1100 Put on the future you get a short futures position and USD25,000 in cash. If you are long an option on the future when the future expires you simply receive the parity value of the option if it is in-the-money. Since the future has expired you do not also get a futures position. Here is the specification for the options on the S&P500 future that trade on the CME:

As you recall there are 4 futures expiries each year March, June, September and December. But there are monthly expiries for the options. So how does that work? The January, February and March options all have the March future as the underlying. So when January expiry comes around and you are long an In-the-Money Call on the future, you will get a long position in the March future when you exercise your option. Meanwhile, over at the CBOE there is a January option that has the S&P500 Index as its underlying. But when this option expires, it settles into cash relative to the cash value of the S&P500 Index. Example Today is the expiry of the January options. The S&P500 cash index is trading at 920 and the March future is trading at 925. If you are long the 900 Call on the S&P500 future: You exercise it You receive a long position in the March futures contract You receive 25 x 250 = 6,250 in cash (because the multiplier is 250) You are still exposed to the price movement in the S&P500.

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If you are long the 900 Call on the cash S&P500 index: You exercise it You receive 20 x 100 = 2000 in cash (because the multiplier is 100) You are no longer exposed to price movement in the S&P500
Exercise 900 Call on Future Long F uture Plus $25

$25 900 925 925

Ex ercise 900 Call on Index Receive $20

$20

900

920

Foreign Exchange Options


There are exchange-traded options on foreign exchange that are similar to equity and futures options. The CME trades options on currency futures, while the Philadelphia Exchange lists options on the actual currencies. A peculiarity of these options is that the exercise prices and spot prices are always in American terms. That is, the quotation is always how many USD you need to pay for 1 unit of the "foreign" currency. It doesnt matter if the quotation is different in the Interbank market. For example banks quote the Swiss franc against the USD so an Interbank quote might be: USD|CHF = 1. 5000 Which means it costs CHF1.5000 to buy USD1. But so far as the US exchanges are concerned the price is: CHF|USD = 0.6667 On the CME this would be quoted as 66.67, since they apparently dont like numbers smaller than 1. Why do they do this, when the rest of the world does it the other way? A possible explanation, being as kind as we can to US sensibilities, is that when option premium is paid and when futures are marked-to-market, the only currency involved is US dollars. If standard bankers quotes were used the mark-to-market for USD|CHF would be in Swiss francs and would require access to a settlement facility in Swiss francs. If you want to be unkind you might think that it is just ethnocentrism in the US, but you didnt hear us say that. In the Interbank market, bankers quotes are used, but option premium can be paid in either currency. Consider an option to pay USD100 for CHF150. The person who owns the option can sell USD so we

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can say this is a put on USD. Alternatively, the option owner receives CHF so we could say it is a Call on CHF. In the FX market they settle the argument by saying this is the 1.5000 strike USD Put / CHF Call. Very egalitarian! At the risk of confusing you further (if that is possible), lets try some graphs. Lets first look at an option described in bankers quotes. For example the 1.5000 Call on USD | Put on CHF. Since the "underlying" here is the USD we will use the USD price in CHF terms as the x-axis. Then the y-axis will be the value of the option expressed in CHF.

Owner of the 1.5000 Call has the right to BUY USD for 1.5000 CHF Now lets look at this option in American terms. The x-axis is now the dollar value of one Swiss franc and the y-axis is the dollar value of the option.

Owner of the 0.6667 Put has the right to sell CHF for 0.6667 USD Are these really the same option? Well, sort of. Suppose you have an underlying position of CHF15,000,000. You are worried about the value of your Swiss francs in terms of USD. So you buy a Call option on USD10,000,000 with an exercise price of CHF1.5000. Alternatively you buy a Put option on CHF15,000,000 with an exercise price of USD0.6667. Notice that: The strike price of CHF1.5000 is equivalent, at the current spot price, to the strike price of USD0.6667 The underlying amount of the first option USD10,000,000 is equivalent, at todays spot price, to the underlying amount of the second option CHF15,000,000 Suppose a bank quoted a price for the first option of CHF300,000. Then the price of the second option would have to be USD200,000. BECAUSE THEY ARE THE SAME OPTION! The option could be described in a more neutral way:

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The owner of this option has the right to pay CHF15,000,000 for USD10,000,000. This option costs CHF300,000 or USD200,000 Exercise Do you think you understood the example? Try this one using USD and JPY: Interbank CME and PHLX USD|JPY = 112.50 JPY|USD = 88.88 Where you could think of the 88.88 as meaning that it costs 88.88 cents to buy JPY100 or that it costs USD88.88 to buy JPY10,000. Analyse the USD Put | JPY Call with an exercise price of JPY 100. Suppose that your underlying position is that you are a Japanese investor who has USD10,000,000. Suppose that a bank quotes you a price of USD75,000 For the option to sell USD10,000,000 to buy JPY1,000,000,000. Draw the graphs of the option in both Bankers quotes and American terms. OTC Expiry An additional fact about FX options is that since they are traded on a global basis, time zones are important. If you own the option we just described and it expires next Tuesday, just exactly at what time does it expire? The FX market recognises two possible times for expiry called New York "cut" and Tokyo cut. Tokyo cut is 3 p.m. Tokyo time (6 a.m. GMT) and New York cut is 10 a.m. New York time (3 p.m. or 4 p.m. GMT depending on the time of year). There is a, possibly apocryphal, story that an investment bank once bought an option that expired at Tokyo time and sold an otherwise identical option that expired at New York time. When the option in Tokyo expired it was out-of-themoney but several hours later when the option they were short expired it was in-the-money. Bad timing! Not realising the difference they had done nothing to hedge their risk in the meantime. Bad risk management! As a wise person once said, "Foreign Exchange is not difficult, its just confusing and FX options are really confusing." Part of the confusion for some people is that they are just not used to thinking about foreign exchange. But the truly potentially confusing part is the idea that when you "buy" one thing you are "selling" something else. The reason the idea of a 150 Call on IBM doesnt cause this kind of confusion is because we think "of course" were buying IBM and "of course" were paying dollars. We would never think of this option as a put on dollars, i.e. that we are "selling" dollars. But when it comes to the 1.5000 CHF call on USD, we are paying, i.e. selling CHF so it makes just as much sense to talk about the option as a put on CHF. Well leave this for now since you may well have a headache. The end-users of foreign exchange options include corporations with financial exposures in currencies outside of the country in which they are legally domiciled. In particular a company that reports its financial statements in USD has to worry about foreign exchange gains and losses. The use of options by corporate treasurers has a long history and many of these users are well-versed in options. Many of them are familiar with the basic strategies and will: Sell calls on currencies they are due to receive to increase their potential profit from selling the foreign currency Buy puts on currencies they are due to receive to protect themselves from a decrease in the value of the foreign currency Buy puts and sell calls simultaneously to minimise or even eliminate the premium they have to pay out.

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Example1 A European food company exports cheese to the UK. They expect to receive GBP10,000,000 in 3 months. Currently EUR|GBP = 0.6593 but the Euro has been strengthening recently and the company is worried about the value they will receive in their own currency. The 3 month forward price is EUR|GBP = 0.6615. This means of course that if the company sells its GBP forward, the price for a Euro is higher than it is today. Confused yet? Say it slowly today you have to pay 0.6593 Sterling to get one Euro, but if you want to buy that same Euro in 3 months the price is 0.6615, thats more than the spot price. If you want to do it the "other" way, today GBP10,000,000 could be sold for 10,000,000/0.6593 = 15,167,602 Euros. But the three month forward amount would be 10,000,000/0.6615 = 15,117,158, which is less. So if you were the treasurer what would you do? Suppose that you have these options available: A. 0.6550 EUR Put GBP Call trading for GBP0.0050 B. 0.6615 EUR Put GBP Call trading for GBP 0.0080 C. 0.6615 EUR Call GBP Put trading for GBP 0.0080 D. 0.6660 EUR Call GBP Put trading for GBP 0.0050 Here are the Parity graphs of these options (the x axis is the price in GBP of one EUR):

Here are the Profit and Loss graphs:

Lets view these from the position of someone who is long these options. The first option (A) allows the holder to sell EUR. Do you want to sell EUR? No, you have GBP to sell; you want to buy EUR. So this is not an option you would consider buying but you might consider selling it. Why might you sell it? If you sell A: You receive GBP0.0050 for every EUR covered by the option If the option is exercised by your counterparty you will pay (sell) GBP0.6550 for every EUR covered by the option Your effective price for a Euro will be 0.6550 0.0050 = 0.6500 For GBP10,000,000 you could receive EUR15,384,615 compare that to both todays spot price and the 3 month forward price

We should warn you this is a really difficult example. You may have to spend an hour on it!

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Sounds good but the option might not be exercised. It will only be exercised if GBP strengthens against the EUR so that the EUR is worth less than GBP0.6500. If that does happen, you might experience a bit of regret. Suppose that when the option expires, EUR | GBP = 0.6400. Then if you had not sold the option you could have bought Euros for just GBP0.6400. This means you could buy 10,000,000/0.6400 = EUR15,625,000. Should we remind you that nothing is for free? We included B and C just for reference. These options are at-the-money, i.e. the strike price 0.6615 is equal to the forward price. In this circumstance the Call and the Put are worth the same. Well understand that better when we discuss option valuation. Could you use B or C? Yes, you could sell B for the same reasons as selling A. If B is exercised you would pay an effective price of 0.6615 0.0080 = 0.6535 for each Euro. And what about C? Well this option gives the owner the right to buy EUR. Do you want to buy EUR? Yes you do. So this is not an option you would want to sell. Instead you might consider buying it. If you buy C, then You pay GBP0.0080 for every Euro covered by the option If you exercise the option then you will pay an effective price of GBP0.6615 + 0.0080 = GBP0.6695 for every Euro. For your GBP10,000,000 you could receive EUR14,936,520. Compare that to the spot and forward prices. That actually doesnt sound so good does it? You could buy Euros for GBP0.6615 by simply buying them forward. Why pay more? This is an example of buying an option to protect yourself from bad things happening. The bad thing here being that Sterling weakens relative to the Euro. You would consider buying this option if: You believe that EUR will be weaker than 0.6615 in 3 months You do not want to commit yourself to paying the forward price You want protection in case youre wrong And now for our last option! What about D? D is like C but the price is worse for you. If you buy D, then You pay GBP0.0050 for every Euro covered by the option If you exercise the option then you will pay an effective price of GBP0.6660 + 0.0050 = GBP0.6710 for every Euro. For your GBP10,000,000 you could receive EUR14,903,130. Compare that to the spot and forward prices and to the prices from the other option strategies. That price is getting worse isnt it? This option is for "disaster protection". If you do not want to lock-in the forward price, because you think EUR will be weaker in three months but you cant afford to be really wrong, then this option might be for you. If you buy it, you can stay long GBP (short EUR) and hope that your view comes to be. But if it doesnt and Sterling sells off, you have this EUR Call | GBP Put for protection. You hope you wont have to use it. Why buy this option when the 0.6615 strike option gives you more protection? Simple answer it costs less. You will not have failed to notice that option A and option D are the same price. Also you want to buy D and you are willing to sell A. So why not do both? If you do then here is your position in 3 months: You have GBP10,000,000 from your business Someone else has the right to buy them off you and give you Euros at a rate of 0.6550, for a total of EUR15,267,176 You have the right to make someone else buy them from you at a rate of 0.6660, for a total of EUR15,015,015

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If neither option is in-the-money you will just sell the GBP10,000,000 in the market for some amount of Euros between EUR15,267,176 and EUR15,015,015. Naturally you would prefer to sell them for the largest number of Euros but only time will tell. Is a picture worth 1000 words? See the one below and remember that a weak Euro is good for you because you have pounds to sell and Euros to buy:

This is a picture of a "risk-reversal"1. A risk-reversal can be either: +Put Or -Put Short Forward Long Call Long Forward Short Call

In market terms, the first position is considered "buying" the risk-reversal and the second is "selling" the risk-reversal. But as you can see from our example a company with a short exposure is a natural "seller" of the risk-reversal. So the terms buy and sell here are not particularly useful in understanding the underlying motivation for the trade.

Interest Rate Options


Interest rate options can relate to either short-term interest rates or long-term interest rates. Understanding them requires an understanding of other derivatives like interest rate futures and forwards and interest rate swaps. The brief introduction to these instruments that we gave earlier is enough to understand the basics of the options we will discuss. Options on Short-Term Interest Rates We discussed Eurodollar interest rate futures earlier. Suppose that the September Eurodollar future is trading at a price of 95.00. This corresponds to an interest rate of 5.00%. Since the futures price goes up when the rate goes down, and goes down when the rate goes up, someone who wants to lock-in a rate for borrowing dollars for 3 months starting in September would sell the future and someone who wanted to lend money for three months could buy the future. The future itself is cashsettled at expiry.

If youve seen this sort of thing before it may look like we have it "reversed" but thats only because the underlying is the EUR and your position is short.

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Example Suppose you will need to borrow USD1,000,000 for 3 months starting in September. If you were to sell the September future at 95.00 and it expired at 94.00, this would mean: 3 month interest rates are 6.00% If you still want to borrow money now, it will cost you more You have a mark-to-market gain of USD2500 on your short futures position since the future has moved 100 basis points lower and each basis point is worth USD25 (0.0001 x 1,000,000 x 1/4) The mark-to-market gain makes up for the additional amount of interest you will have to pay. What if it expires at 96.00? This would mean: 3 month interest rates are 4.00% If you still want to borrow money now, it will cost you less You have a mark-to-market loss of USD2500 on your short futures position since the future has moved 100 basis points higher and each basis point is worth USD25 (0.0001 x 1,000,000 x 1/4 The mark-to-market loss makes up for the smaller amount of interest you will have to pay. So if you sell the September future you have locked-in the 5.00% interest rate. What options are available? There are Calls and Puts on the September future. So instead of selling the future you could buy a Put. By now you should be pretty used to what this means. Suppose the 95.00 Put is trading for 0.40. If you buy it then: You pay 40 basis points x USD25 per basis point = USD1000 If rates in September are more than 5.00%, you will exercise your Put Your effective cost for borrowing money will be 5.40% since you sold the future for 95.00 and paid 0.40% for the option If rates in September are less than 5.00%, your Put will expire worthless You can borrow money at whatever the current market rate is. Your effective cost to borrow money will be the market rate plus 0.40%, the cost of your option. For example if the market rate is 4.00%, then your effective rate is 4.40%. Buying the put allows you to wait and see what rates are like in September. If they are favourable to you, you can just borrow at the market rate. But if rates have gone up you have protection you will not have to pay more than 5.40%. In the Interbank market there is a product called an interest rate cap. This is a portfolio of options rather than one option. Here is a typical example: 5 year 6.50% Interest Rate Cap on a Notional Amount of GBP25,000,000
Tenor Expiry Dates Last Expiry Date Notional Payment 6 months Every 6 months starting with 15 September 2003 15 March 2008 (10 options) GBP25,000,000 If 6 month LIBOR > 6.50% on an observation date (two business days prior to an expiry date) the owner of the cap will receive GBP25,000,000 x [LIBOR 0.065] x 1/2 , otherwise the payment is 0 Payment will be 6 months in arrears from the expiry date

This instrument protects the owner from interest rates rising above 6.50% for five years starting in September 2003. Notice that the rate is observed at the beginning of a 6 month

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period but the payment is at the end of the period. This is done to match a loan the buyer of the cap may have taken out. When you take out a loan you usually pay interest at the end of a period not the beginning. Since there is an observation date every 6 months for 5 years there is a total of 10 options. At some of the observation dates LIBOR might be below 6.50% and there would be no payment and on others the rate might be above 6.50% and the cap buyer would receive a payment. Anytime there is no payment on the cap, it means that the market rate is lower than the cap rate so the cap owner is paying less interest on the loan. If you refer back to the Rate-Capper Mortgage at the beginning of the discussion of options, youll now realise that the homeowner who takes out such a mortgage is being given a cap by the bank with a strike rate of 7.50%. So youve learned something! Options on Long-Term Rates Sometimes a potential borrower or lender wants to lock-in a single rate for a longer period of time. This time lets take the point of view of an insurance company with USD100,000,000 to lend for 10 years. Suppose the insurance company plans to lend this money out starting 6 months from now. They have a view that rates are going up in the next few months but they want protection in case theyre wrong (sound familiar?) Receivers Swaption
Trade Date Maturity Date Payment 15 March 2003 15 September 2003 If 10 year USD Swap Rates > 5.50% there is no payment If 10 year USD Swap Rates < 5.50% then the owner of the swaption will receive: Present Value of a 10 year annuity of 100,000,000 x [0.0550 10 year swap rate] x 1/4 paid every 3 months calculated using the prevailing 10 year swap rate

This looks a little complicated but all it means is this: if the 10 year interest rate based on quarterly (3 month) payments is less than 5.50% the insurance company is going to be compensated for rates being lower than what they thought they would be. We calculate how much they are to be paid by calculating the difference between 5.50% and the prevailing swap rate and multiplying by the amount they wanted to invest, based on interest payments occurring every three months.

There are 40 of these payments, one every 3 months for 10 years This represents the amount of interest they lose by having to lend for 10 years at the current 10-year rate. Naturally these payments have to be present-valued. We are agreeing to do this by discounting each payment using the current 10-year rate. Lets do a specific example to illustrate. Suppose the 10-year rate in 6 months turns out to be 4.00%. Then the insurance company will probably have to buy a 10-year investment that pays 4.00%. To make up for the lost interest they get paid: Payment 100,000,000 x [0.0550 0.0400] x 1/4 = 375,000 (each "arrow" in the diagram is 375,000) Number of payments = 40 Discount Rate = 4.00% Present Value = USD12,313,0071

We used a bond calculator to get this.

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They receive this payment "up-front" rather than receiving the 40 separate payments. In this case the option was "cash-settled". There are different forms for these options and they can settle into cash as we have described or they can result in the owner actually entering into an interest rate swap as the receiver of the fixed interest rate. The insurance company might prefer to do this rather than have the up-front payment. In this way their profit on the swaption would be spread out over the entire period of their investment. A potential problem with this type of settlement i.e. settlement into an actual swap, is that it creates a potential obligation that extends over the full 10 year period. This means that the counterparty on the swaption, probably an investment bank, would need to have a 10.5 year (maturity of the option plus maturity of the swap) credit line available to the insurance company. Swaption
A Receivers Swaption is the right to enter into an interest rate swap as the receiver of the fixed interest rate. A Payers swaption is the right to enter into an interest rate swap as the payer of the fixed interest rate.

Naturally since these are options not forwards or futures, the buyer would have to pay for a swaption. The premium would be expressed as a number of basis points of the notional amount of the underlying swap. For example, the receivers swaption above might have cost the insurance company 250 basis points I.e. 2.50% of the USD100,000,000.

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Option Valuation
We now have an idea of what options are and why they have value. We have seen uses for options in many different product areas. Now its time for us to get serious about determining the value from a theoretical point of view. Well look at three ways to value an option: Discrete Distribution Binomial Model Black-Scholes Formula Of the three approaches, only the binomial model is suitable for valuing American-style options. We are going to restrict the discussion mostly to just European-style since we want to concentrate on the underlying ideas. It is also true though, that in the over-the-counter market most options traded are European-style. Right now we will look at the Discrete Distribution method and leave the others for a future section. We have already seen that an option has two kinds of value forward value and volatility value. So our starting point for valuing options is with the forward price of the underlying. Where does this come from? In the case of arbitrage-pricing, the forward price is simply the theoretical futures/forward price we discussed previously. In the case of price-discovery markets, we get the forward price by observation. The forward price is "in the centre" of the forward distribution, which describes the probability distribution of the underlying at expiry. Any probability distribution is "allowed" to be the distribution of the underlying at expiry, but in practice, nearly everyone uses either a normal or lognormal distribution. Well give a simple example and then take up the difference between these two distributions later. But the main fact is that if we use either one of these types of distributions, the only parameter we need other than the forward price, is the volatility of the underlying. Discrete Distribution This distribution is one that we made up for the sole purpose of explaining the idea of valuing options and to highlight some of the main issues. In this distribution we assume that the underlying can only be at one of five possible values at expiry. Why five? Because that number is big enough to give us a realistic idea of what the option value should be and small enough to do the calculations "by hand". We could use more values, but it would just make the calculations more arduous without aiding our understanding.

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In the distribution, the forward is at the centre, as we agreed. The five values are equally spaced along the axis at intervals of length I, which is determined by the volatility. Where did the probabilities of 1/12th, 1/6th, 1/2, 1/6th and 1/12th come from? See the discussion at the end of this section. With these probabilities I, the interval on the axis, is equal to where s is the volatility and t is the time to expiry. Why the square root of the time to expiry? See the second discussion at the end of this section! Example Gold is trading for 350 per ounce. USD interest rates are 4% and the volatility of gold is 10%. If we wanted to value a 1 year option on gold, our first step would be to construct the probability distribution of the gold price in one years time. Step 1 Determine the 1 year forward price

Since the interest rate to borrow USD is 4.00% we can calculate the forward price as: 350 + 0.04 x 350 = 364 In doing this we have ignored any additional costs such as storage and insurance. Step 2 The interval is Determine the interval to be used on the x axis = 364 x 0.10 x 1 = 36.4

Notice that we have used the forward price in the formula not the spot price. We will try to be consistent about this in all the discussions that use the discrete distribution method. Step 3 Graph the Distribution

Now that we have the distribution at expiry, we can value any European-style option. Step 4 Superimpose the value graph of the option on the expiry distribution

Lets start with the 350 Call. This is the right to buy gold for 350 per ounce at expiry. The blue line shows the value at expiry of the 350 Call

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Gold 350 C

291.20 0

327.60 0

364.00 14.00

400.40 50.40

436.80 86.80

Expected Value: 14.00 x 1/2 + 50.40 x 1/6 + 86.80 x 1/12 = 22.63 This is the value of the option at expiry. Its value today would be the present value of this: Present Value of Expected Future Value = 22.63 / (1+0.04) = 21.76 That was easy! How about trying the 400 Call?

Gold 375 P Gold 400 C

291.20 83.80 291.20 0

327.60 47.40 327.60 0

364.00 11.00 364.00 0

400.40 0 400.40 0.40

436.80 0 436.80 36.80

Expected Value: 0.40 x 1/6 + 36.80 x 1/12 = 3.13 Present Value of Expected Future Value = 3.13 / 1.04 = 3.01

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How about a put? Lets value the 375 Put:

Gold 375 P

291.20 83.80

327.60 47.40

364.00 11.00

400.40 0

436.80 0

Expected Value: 83.80 x 1/12 + 47.40 x 1/6 + 11 x 1/2 = 20.38 Present Value of Expected Future Value = 20.38 / 1.04 = 19.60 By now youre probably catching on that this is very easy. Also you probably dont want to do any more of them. So well just show you some of the values we calculated: Strike
300 325 350 364 375 400 425

Call
62.24 40.21 21.76 11.67 9.02 3.01 0.95

Put
0.71 2.71 8.30 11.67 19.60 37.63 59.60

Remember that an option has two kinds of value? Forward value and volatility value. Lets look at the 350 Call. This option gives you the right to buy the forward for 350. But the forward is currently priced at 364. So the value of the 350 Call just considered as an "off-market" forward is 14. But this is a value at expiry in one year. The present value of this is 14 / 1.04 = 13.46. The rest of the value of the 350 Call is volatility value: Volatility Value = 21.76 13.46 = 8.30. Now isnt that curious? The volatility value of the 350 Call is the same as the value of the 350 Put? Is that a coincidence? You must be joking! There are very few coincidences in finance1. Lets look at the relationship between the 350 call and the 350 Put:

There are also very few jokes, but here is my favourite: an economist died and went to heaven.

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The 350 Put is shown on the same graph as the 350 Call. Now what is the advantage to buying the 350 Call instead of buying the forward? The forward is trading at 364 so you could buy it for that price. You would have to pay at least 13.46 today to buy the 350 Call since it has that much value as a substitute for buying the forward. What other value does it have? If you buy the forward for 364 and the gold price ends up at 327.60 you will have a loss of 36.40. If you buy the 350 Call you will lose what you paid for it, but you have no additional losses. Compared to the forward, you do not have the loss of 350 327.60 = 22.40. Also if the gold price expires at 291.20 the forward has a loss of 350 291.20 = 58.80 compared to the 350 Call. So the call prevents a possible expected loss of 22.40 x 1/6 + 58.80 x 1/12 = 8.63 Avoiding this expected loss is worth paying 8.63 / 1.04 = 8.30 today. Didnt we just value the 350 Put? Yes, because the total value of the 350 Put is the present value of its Expected Future Value. But the 350 Put has value in the future exactly when the gold price ends up below 350, i.e. when you are better off with the 350 Call than with the forward. We have just discovered a great truth: The protection value of an in-the-money option is equal to the total value of the corresponding out-of-the-money option. As a simple exercise, check this for the 400 Call and Put. It should be true that: 400 Put = present value of (400 364) + 400 Call At-The-Money Options One last point. Suppose we set the strike price equal to the forward price. In this case the strike would be 364. We would call these options At-the-money forward. If an option is forward value plus volatility value, what about these options? Since the strike price equals the forward price, both options have forward value equal to 0. So they are nothing but volatility value. If the volatility value of options at the same strike is the same, which is implied by our "great truth", then the 364 Call and Put must have the same value. It is easy to verify that this is true. You might think this is due to the symmetric nature of our distribution but you will see in the homework that it is true no matter what the underlying distribution is. Options on other underlyings When we are considering only European-style options, it is just the distribution at expiry of the option that matters. Since the first step is to find the price of the forward, the only difference in valuing options on different underlyings is in how we determine that forward price. In most cases we use arbitrage pricing in which we determine the forward based on the costs and benefits of the underlying using the risk-free interest rate. This is what we did above in the case of gold. As a

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general rule European-style options, even if they are nominally options on the spot underlying, are priced as if they were options on the forward or future. American-style Options The case of American-style options is a little more difficult. We are not going to discuss until much later how American options are valued but we will note some characteristics of these options. An American-style option can be exercised at any time up to and including the day on which the option expires. One fact that follows from this is that an American-style option can not be valued or priced lower than the parity in the option relative to the spot price. For example if gold is trading at 360 per ounce, the 300 American-style Call on gold could not be priced lower than USD60. Suppose for example that you could buy this option for USD55. Then you could buy the option, immediately exercise it and simultaneously sell gold in the market for 360. This would give you a risk-free profit of USD5. Sometimes the parity to the spot price is called "intrinsic value". Later on we will discuss this concept more thoroughly but we prefer not to use that term and simply refer to the difference between the spot price and the strike price as the value of parity. As was the case with forward value, only one of the two options at a particular strike will have parity value. Think of parity value as the value you could capture if you were able to immediately exercise the option and trade the resulting underlying position at the current market price. So if you exercise the 375 Put on gold when gold is trading for 360, you sell gold for USD375, then you buy it at the market price of 360, capturing a price difference of USD15. So the 375 American-style put on gold cannot be priced lower than USD15 if gold is trading for USD360. Most of the options traded on organised exchanges are American-style. We will defer the discussion of why someone would want to exercise an option prior to expiry, except in the unlikely situation of the option trading under parity. The probabilities of the distribution For any distribution the probabilities must be positive and add up to 1. If we want our distribution to have just five values and to be symmetric around the mean then it must look like:

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Where we have let a be the probability in the middle, b is the probability that the return is one interval below the mean (F = forward price) or above the mean and c is the probability the return is two intervals below or above the mean. So:

Then the variance of the distribution is:

If we want the standard deviation to be I then we want the variance to be I2. This means:

If we combine this with the equation above for a, we get:

And that is as far as we can go! There are many (infinitely many) 5 point distributions that are symmetric around their mean and have their standard deviation equal to the interval on the x-axis. We chose one of them by letting c = 1/12. But if you want you could choose c = 0.10, then a = 0.60 and then b = 0.10. Or you could let c = 0.05, then a = 0.30 and b = 0.30. We chose the one we did because it "looked" more like a normal distribution1. There is no "right" distribution. That may be an unsatisfactory answer but that is how the markets work as well. Even if we all agree that returns are normally distributed and that the forward is in the centre, we may not agree on the volatility. So different people could get different values for options. That is not a problem unless someone insists that they are right and everyone else is wrong. In that case they will either end up buying a lot of options (if they think the value is more than everyone else does) or selling a lot of options (if they think they are not worth as much as everyone else does). Good luck to such a person! If they are trading for a bank they are likely to exceed their risk limits very fast. Volatility is very much a price-discovery market. The different banks that trade options will quickly discover the market consensus number for volatility. In order to be competitive they find it better to "go along" and quote prices in line with each other than to attempt "volatility arbitrage". At least this is true as a general rule. Some traders will take positions based on their view of volatility, selling it when they think it is expensive and buying it when they think it is cheap. But they realise that this is a risk position not an arbitrage.

Well, there is a little more to it. If you calculate the kurtosis of this distribution you will see that it is 3, just like the kurtosis of a normal distribution. If you dont know what kurtosis is, dont read this footnote.

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The Square Root of Time A surrealistic phrase isnt it? The square root of time shows up in option valuation because of the way in which volatility grows over time. Lets see if we can make it more understandable. Suppose we start with a share price of 1 and suppose that after one period the share returns either +1% or 1% with equal probability. So the expected return on the share is 0%. What is the volatility? Before we calculate it lets recall the ideas of variance and standard deviation. The variance of a random variable (like the return on a share) is defined to be the expected value of the square of the differences between the variable and its mean value:

where the xis are the different values the random variable can be and the pis are the probabilities of those different values. In our case there are only two values, +1 and 1, with probabilities both equal to 1/2. Then the standard deviation is defined to be the square root of the variance. What are these measures "about"? Variance is used to measure how much the individual values of the variable (stock return) differ from the average value. If there were no differences, i.e. if we knew for certain what the return would be over the next period, then the variance would be 0. The more variable the values, the greater the variance. But even more, the variance "penalises" larger differences more than small ones. For example a difference of 0.50 away from the mean, when squared becomes 0.25 (smaller), while a difference of 2 becomes 4 (larger). Taking the square root makes the measurement have the same unit (%) as the variable itself. "Squared percent" doesnt make a lot of sense, does it? So back to our example. The stock return is +1% or 1% with probabilities of 1/2 for each. The variance and standard deviation are:

So the standard deviation for one period is 1%. We can picture the distribution as:

Now lets go one more period. In the second period the share can also return 1% or +1%, starting from where it was at the end of the first period. So after two periods, the share has returned a total of 2%, 0% or +2%, with probabilities 1/4, 1/2 and 1/4. We are tacitly assuming that the return in the second period is independent of the return in the first period, i.e. the return in the second period is

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no more and no less likely to be +1% if the return in the first period was +1% than if the first period return was 1%. If this is not true we have a relationship called "auto-correlation" in the returns, which we will discuss much later on. If there is this independence of returns, then the probability of two specific consecutive returns is the product of their individual probabilities: Period 1 Return -1 -1 +1 +1 The distribution is now: Period 2 Return -1 +1 -1 +1 Total Return -2 0 0 +2 Probability /2 x 1/2 = 1/4 1 /2 x 1/2 = 1/4 1 /2 x 1/2 = 1/4 1 /2 x 1/2 = 1/4
1

And what about the variance and the standard deviation?

and there it is: the square root of time! In fact if we let the share continue to return 1% or +1% every period with equal probabilities, then for a time of t periods:

Scaling In our example the share returned just +1% or 1%. What if the return had been +2% or 2% instead? In general if the return is or every period, then the volatility (standard deviation) over t periods is:

If we agree to measure t in years and let be the annualised volatility, then this expression represents the volatility of the return for a period of t years. As an interesting example, suppose the annualised volatility is 20%, i.e. = 20%. Then the volatility of the return for a 3 month period is:

This sometimes surprises people since it says that the volatility to be expected over 1/4 of a year is 1/2 of the annualised volatility. Many people expect the annualised volatility to be 4 times as great as the volatility over a 3 month period, whereas this says it is only twice as great. The reason it is not 4 times as large can be seen from our analysis above: each period the share return can go down or up;

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over two consecutive periods it is twice as likely to be back where it started as it is to have moved up twice or down twice. So the volatility over two consecutive periods is not twice as great as over a single period. It is, in fact, proportional to the "square root of time". With luck you now have a better understanding of this important relationship. Price Volatility Volatility is expressed as a percentage of the return. But if we want the volatility of the price, it is:

where P is the price. For example if a share has a price of 50 and an annualised volatility of 30%, then the volatility of its price is 0.30 x 50 = 15, expressed in price terms, e.g. dollars or pence. Exercise Draw the distribution for 3 periods and the distribution for 4 periods and determine the variance and standard deviation of the return for each of these. Assume that the 1 period return remains at +1% or 1% with equal probabilities and that the returns in different periods are independent of one another.

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Synthetics
The word synthetics conjures up the ideas of "artificial", "man-made", "not-the-real-thing". Maybe even "a poor substitute", "fake" and "cheap". But synthetics are frequently easier to produce and work nearly as well as the real thing. Sometimes people cant even tell them apart. So lets approach the idea of synthetics in the derivatives world with an open mind. Come to think of it, futures are somewhat synthetic themselves arent they? If you buy a futures contract on a currency or bond, you get the exposure to the price of the currency or bond but you havent bought the "real" thing. So what would you make of a "synthetic" future? Seems like a copy of a copy. Nonetheless if you consider the position of being long a call and short a put at the same strike price, what you have is indeed a synthetic future! Lets have a look. Suppose Future = 100 100 C = 4 100 P = 4 and we buy the call and sell the put. Graphically our position looks like:

Net the premium:

They "look" the same dont they? We have drawn the profit/loss graphs at expiry. So it looks like if we buy the 100 Call for 4 and sell the 100 Put for 4 today, then at expiry our profit or loss will be exactly the same as if we bought the future for 100 today. You may want to say that sentence to yourself several times until you really understand it. Notice that the cash flows for the two positions are exactly the same as well. Since the call and the put are the same price, we pay no cash today. As you know, when you buy a future you also pay no cash. At expiry, if the future is above 100 we would exercise our call and receive F 100, but this is the same as the accumulated mark-to-market profit on the long future. If the future is below 100, we

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would be assigned on our short put and have to pay 100 F, but once again, this is the same as the accumulated mark-to-market loss on the long future. Because of margining of the futures, there may be some timing differences in the flows into and out of margin accounts but these are unpredictable at the start so do not affect the value of the positions. Lets try some other possibilities. Suppose we buy the 100 Put for 4 and buy the future for 100. What does our P/L graph look like at expiry?

So buying a Future for 100 and buying the 100 Put for 4 looks like buying a 100 Call for 4. Is this right? Well, if we have the position +P and +F, then if the future is above 100 at expiry, our put is worthless and we receive the mark-to-market of F 100. But that is the same payoff as the 100 Call. If the future is below 100 then we sell the future for 100 by exercising our 100 Put. Since we bought the future for 100 the gain on exercising the put exactly offsets the loss in our margin account. So the position is worth 0 in total. But, again, that is the same as the value of the 100 Call. We paid 4 for the position so at all values of the future our position is worth 4 points less than the parity in the 100 Call. So it is true that +100 Put for 4 and +F for 100 is equivalent to being long the 100 Call for 4. You can probably guess whats coming next: suppose we buy the 100 Call for 4 and sell the future for 100. Lets look and this time well let you check that your eyes do not deceive you.

Can you describe the picture in a sentence? Try it, then look at the footnote1. We hope that you have absorbed all this and are impatient to move on. So now we will make it a little harder. Suppose: Future = 100 95 Call = 7 Time to expiry = 1 year Interest Rates = 10.00%
1

"Buying the 100 Call for 4 and selling the future for 100 is equivalent to buying the 100 Put for 4."

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Question: What is the value of the 95 Put? This is a review question since we already know that the value of the out-of-the-money option is the volatility value of the in-the-money option. So the value of the 95 Put must be:

What did we do? We took the present value of parity to the future out of the in- the-money option. What is left must be its volatility value, i.e. the value of the 95 Put. Lets try analysing the synthetic positions again: Synthetic Future: +95 Call -95 Put +95 Call -Future Synthetic Call: +95 Put +Future

Synthetic Put:

In each case we trade the future for 100 and buy/sell the options for their given values. Synthetic Future +Synthetic Future

Now have we succeeded in confusing you? You probably dont have any difficulty with the graph except for the breakeven at 99.55. Where did that come from? Well, we bought the 95 Call for 7 and sold the 95 Put for 2.45. So our cash flow on the trade was to pay 4.55. In order to breakeven, the 95 Call, which we are long, must be worth 4.55 at expiry. This will be true if the future is at 99.55. Synthetic Call +Synthetic 95 Call

What happened here? We bought the 95 Put for 2.45 and bought the future for 100. So at expiry, if the future ends at 95, we will have a 5 point loss on the future as well as having paid 2.45 for the put. So our total loss at a price of 95 is 7.45. In order to breakeven, the future will need to be 7.45 points above the 95 strike, i.e. 102.45. Synthetic Put +Synthetic 95 Put

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We have a breakeven now at 93, because we bought the 95 Call for 7 and sold the future at 100. If the future is above 95, we lose 2 since we exercise the call and buy the future for 95 but we sold it for 100, a 5 point profit; however, we paid 7 for the call; if the future is below 95 we lose our 7 points on the call but we make 100 Future on our short futures position. At 93 this is worth 7 so it offsets the price we paid for the call. You may want to take a deep breath and think about these pictures for a minute. To ease into the next part of the analysis lets put the profit and loss graphs of the real and the synthetic positions next to one another. + Real Future +Synthetic Future

+ Real 95 Call

+Synthetic 95 Call

+ Real 95 Put

+Synthetic 95 Put

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Now it may occur to you that these pictures imply there is something unfair or a little bit wrong in the pricing. It looks like we have bought the future synthetically for 99.55, while we would have to pay 100 for the real thing. Then the synthetic call seems to cost us 0.45 more than the real one and finally the synthetic put appears to cost 0.45 less than the real one. Whats going on?! We forgot about, or at least werent thinking about, the timing of the cash flows. When we buy the real future for 100 there is no immediate cash flow. But when we buy the synthetic future, how do we do it? We buy the call for 7 and sell the put for 2.45. So we pay out 4.55 today. How much will this cost us by expiry? Since interest rates are assumed to be 10% and the time to expiry is 1 year, the financing of the option premium costs us 0.45! So the total cost of the synthetic future is 5.00 by expiry and our true breakeven, considering the cost to carry the position, is 100. Similarly, consider buying the synthetic call. We buy the future for 100 and buy the 95 put for 2.45. The carry on the premium we pay is 0.25, so buying the synthetic call actually costs us 7.70 when held to expiry. What about the real call? We pay 7.00 for it today but the carry cost of the premium is 0.70 so it also costs us 7.70 to expiry. Lastly, what about the synthetic put? The real put costs 2.45 plus carry of 0.25 for a total of 2.70. To buy the synthetic put we buy the 95 Call for 7 and sell the future at 100. The carry cost of the long option is 0.70 so the P/L of the position at expiry if the future is at 95, is 2.70. So effectively, the real put and the synthetic put cost us the same amount. In fact its true that in every case, once we include the carry on net option premium, the P/L on the real position and the synthetic position are exactly the same. There is a shorthand notation to represent this: Position Synthetic Future +CP Real Future Synthetic Call +P+F Real Call +C Synthetic Put +CF Real Put In our first example: F = 100 100 C = 4 100 P = 4 Lets assume r = 10% and time = 1 year Position Synthetic Future +CP Real Future Synthetic Call +P+F Real Call +C Price 100 100 Total Cost 100 100 Price X+CP F Total Cost X + C P + (C P) x r x t F

F+PX C

+F + P X + P x r x t C+Cxrxt

X+CF P

X+CF+Cxrxt P+Pxrxt :

4 4

4.40 4.40

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Synthetic Put +CF Real Put

4 4

4.40 4.40

In our second example: F = 100 95 C = 7 95 P = 2.45 r = 10% and time = 1 year Synthetic Future +CP Real Future Synthetic Call +P+F Real Call +C Synthetic Put +CF Real Put

99.55 100

100 100

7.45 7

7.70 7.70

2 2.45

2.70 2.70

Make sure you understand all of the relationships and cash flows shown above. Otherwise you are doomed! Note that in every case, if we look at the total cost at expiry, Cost of Synthetic = Cost of Real If instead we look at present value, then if all the options are properly priced relative to each other, as they are in our examples: Options On Futures
Synthetic Future Real Future Real Call Synthetic Call Synthetic Put Real Put Conversion Value = (P C) x r x t = (P C) x r x t = (P C) x r x t =(P C) x r x t

Put-Call Parity
As is highlighted in the box above, the number (P C) x r x t is called the conversion value. The conversion value is a relative value relationship between properly priced European options at the same strike. Sometimes we write the relationship as: Put-Call Parity
Synthetic Future Real Future Real Call Synthetic Call Synthetic Put Real Put Conversion Value = (P C) x r x t = (P C) x r x t = (P C) x r x t =(P C) x r x t

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Conversions1
Suppose you own a call but would rather own the put at the same strike. If the call is deep in the money it sometimes happens that there is no liquidity in the option, i.e. no one is interested in buying it. However, you might be able to get someone to do the following trade: Your side of the trade Sell the Call Buy the Put Buy the Future Their side of the trade Buy the Call Sell the Put Sell the Future

Why would someone be willing to do this trade but not simply buy the call? Because, unless they really want the call, they are going to have to hedge the position. To hedge it they would have to sell futures. But then they just end up long the synthetic put so they still have risk. If they simultaneously sell the put, they have a risk-neutral position. But what about you? You now own the put but you also own the future. That was not what you wanted. You just wanted to sell the call and buy the put instead. But now you can just sell your future. Even if there is no liquidity in a deep in-the-money call, there is usually no problem with trading futures. So if you sell the future you just end up long the put. You have "converted" your call into a put. The trade you did: Sell the Call, Buy the Put and Buy the Future is called a conversion. From the point of view of someone who simply does the conversion without consideration of any other positions they may have in the options, the cash flows are:

Lets illustrate using these values: Future = 100 Strike 95 100 105 Call 7 4 2.45 Time = 1 year Put 2.45 4 7 Interest Rate = 10% CV -0.45 0.00 0.45

This part can be skipped over if you are encountering this idea for the first time or if you feel faint.

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The cash flows on the 95 Strike Conversion:

There are no cash flows on the 100 Strike conversion since the Call and the Put are the same value and the Strike and the Future are also the same. The cash flows on the 105 Strike Conversion:

This shows that when you do the conversion you either pay more later than you received today or receive more later than you paid today. Sort of like either borrowing money or lending money. In fact its just like borrowing or lending money! There is no price risk in a conversion using European options. Since the cash flows are certain, they must be related by the risk-free interest rate.

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Risk Parameters
The value of an option is sensitive to a number of different market values. In fact any variable we used to determine the value of the option must be a source of risk. If we think back to how we derived the value of an option we realise there were two steps: Determine the value of the Forward Determine the distribution at expiry The forward for many underlyings is determined by spot + basis and the basis is in turn dependent on the costs and benefits of the underlying. Costs are usually primarily interest and benefits come from dividends (equities), coupons (bonds), and the ability to invest the underlying (currencies). So, just from determining the forward, we have several variables: Spot price Risk-free interest rate Dividends, coupons, etc. Time

We can simplify this a bit by first calculating the forward, F and solving the equation for a single "net" interest rate that relates the spot and the forward: Spot x ( 1 + rct) = F And we will call rc the "carry" rate on the underlying. Equity Example Stock XYZ is priced at USD25 and will pay a dividend of 0.10 in 89 days, if the risk-free rate is 5.00%, find the 90 day forward on XYZ and the carry rate for the 90 days.

So the carry rate is 3.40%. Another way we could have seen this is that the dividend is 1.60% of the stock price on an annualised basis (0.10/25 x 4 = 0.0160). Since the financing rate for the stock is 5.00%, the cost to carry the stock must be 5.00% - 1.60% = 3.40%. Bond Example Company RSTs 8.00% bond is trading for 120.00 and has just paid its annual coupon. The repo rate for the bond is 4.00%. Find the 60 day forward for this bond and determine the carry rate. The repo rate is on an actual/360 day basis and the coupon accrues on an actual/365 basis. F = 120 + 120 x 0.0400 x 60/360 8 x 60/365 = 119.48 Notice that the forward price for the bond is less than the spot price due to the low repo rate compared to the high coupon. Dont be surprised when the "carry" rate turns out to be negative.

The carry rate is 2.58%. We have chosen to express the rate on an actual/360 basis.

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Currency Example EUR | GBP = 0.6500; interest rates for 90 days in the UK are 4.00% (a/365) and in the Euro zone are 2.50% (a/360). Find the 90 day forward on EUR | GBP and the carry rate.

The carry rate, which we have chosen to express as an actual/360 rate, is 2.12%. Parameters of the distribution Now that we have the forward we can turn to the problem of determining the distribution around the forward. We have already talked about this and we know that the remaining parameter we need is the volatility , the annualised standard deviation. Once we have the volatility, the interval on the x-axis for our distribution will be

where F is the forward and t is the time to expiry. The distribution which we will use to value the options is:

Using this discrete distribution makes it a matter of simple arithmetic to value any European option. But of course we give up a lot of realism since we know that the price of the underlying at expiry could be more variable than just one of five values. Also this distribution implies that price has a "normal" distribution. In reality most models (but not all) assume that it is the return on the underlying that is normal. We will show later on how to deal with normal returns. Right now we want to use this more simplified situation to illustrate the crucial notions of risk measures. In summary, we know that the value of an option is determined by a number of characteristics of both the underlying and the interest rate environment spot price, costs and benefits of the underlying, the risk-free interest rate, time and volatility.

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Any change in the level of these parameters will bring about a change in the value of options. We are going to investigate now exactly how this happens and why it matters.

Delta Price Risk

Lets start with the simple distribution above with the Forward at 100. Lets value the 110 Call: 10 x 1/6 + 30 x 1/12 = 4.17 We would ordinarily present value this number but we are going to ignore the carry on the option for now. Suppose the Forward price changes to 95. What is the value of the 110 Call now?

Notice that we did not change the interval on the x-axis, we just moved the distribution so that it is centred at the new forward price. This is not perfectly correct but we want to stay focused on the main points. 110 Call = 5 x 1/6 + 25 x 1/12 = 2.92 So if the forward decreases by 5 points, the option decreases by 1.25.

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Delta
The change in the value of the option that results from a change in the price of the underlying is called delta.

in this case

We say the option is a "25 delta". Delta is usually expressed as a percentage. So the delta of a call option can be any number between 0 and 100. But what if the Forward went up instead of down? Suppose the Forward moves to 105.

What is the value of the 110 Call now? 110 C = 15 x 1/6 + 35 x 1/12 = 5.42 What was delta?

So delta is 25 when the forward moves up as well. Delta is considered by option traders to be the most important of all the risk measures. Delta risk is the most carefully controlled of their risks because movements in the underlying price could otherwise lead to large changes in the traders options P/L. Lets see why. Suppose that you are trading options and you believe your value for the 110 Call, 4.17 but it happens that the option is trading in the market for 3.75. This looks like a great buying opportunity for you. So suppose you pay the market price of 3.75. You must expect to make a profit of 4.17 3.75 = 0.42. But when will you make it? You need a plan. The reason for the buying opportunity is because, in your view, the market is underpricing the option. So you would expect to make your profit when the market realises its mistake and agrees with you on the options value. Why are you so sure that this will happen? We know that when we get to expiry the option will be worth either 0 or

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parity to the spot price. At expiry everyone agrees on the options value. With luck this agreement will occur earlier than expiry. In fact lets suppose that the Forward moves to 95 and the market changes its price for the option to 2.92, which is just what you think it is worth. What happens if you now take the position off, i.e. sell the option back to the market? You paid 3.75 for the option and you sell it for 2.92 for a loss of 0.83 not much of a trade was it? You expected to make a profit but you actually made a loss. Unlucky? Maybe. Before we explain what happened, lets see how the situation differs if the Forward moves up to 105 instead. Now the option is worth 5.42. If it is also trading in the market for 5.42, you could sell it and make a profit of 1.67. So you were unlucky before if the spot moves down you lose 0.83 and if the spot moves up you make 1.67. But that means your trade was exposed to the directional movement in the forward price. Well, of course it was. You own a call option. If the price of the underlying increases, your option is worth more and if it decreases your option is worth less. Since you know that to start with you should hedge. Hedge:
To decrease the sensitivity of a position to the movement in the price or level of a market value

Suppose that at the same time we bought the option we simultaneously sold 25% of the underlying? Why sell and why 25%? We sell because then when the forward moves down we will make a profit on our short forward. This will help to offset the loss on our option. Of course when the forward moves up we will lose on our short forward and this will offset the gain on our option. That is the nature of hedging it reduces risk but also limits profits. Lets see how we make out: Forward moves to 95 and the option trades at its theoretical value of 2.92 Option Profit/Loss = 2.92 3.75 = -0.83 Forward P/L = (100 95) x 0.25 = +1.25 Net P/l = 0.42 Forward moves to 105 and the option trades at its theoretical value of 5.42 Option Profit/Loss = 5.42 3.75 = 1.67 Forward P/L = (100 105) x 0.25 = -1.25 Net P/l = 0.42 So we make the same profit, 0.42, which is just what we expected whether the forward moves up or down. We successfully hedged our trade. Notice that what we hedged was the trade itself not the option. What do we mean by that? Trade A. Buy an option worth 2.00 for 1.75 B. Buy an option worth 2.00 for 2.00 C. Sell an option worth 2.00 for 2.25 Value of the Trade 0.25 0 0.25

Trades have values just like an option has value. Someone who trades options for a living wants to hedge the value of their trades. In that way they can make their expected profit with very little volatility (risk). You would hedge both A and B by selling some of the forward. In the case of A you would hope to lock-in your expected profit of 0.25. What about B? There is no expected profit so why hedge? Because you could sustain a loss if the forward moves down. In fact the option could become worthless and you would lose your entire 2.00. Maybe you should not have done the trade, but once

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you have done it you need to hedge it if you are a trader. For C, you would be buying some of the underlying as a hedge. You are short the option so if the Forward moves down you make money but if the Forward moves up you lose money. So the correct hedge is to buy some of the forward to offset your loss on the upside. Delta-Neutral We could also look at a trade as a portfolio: if we buy a Call and sell some of the underlying our portfolio has two components the long Call and the short underlying. Each component of the portfolio has a delta. The delta of a long call is positive and the delta of a short underlying is negative. The delta of the portfolio is the sum of the deltas of its components. So if our call has a delta of +25 and we sell 25 deltas of the underlying, then the total delta of our portfolio is +25 25 = 0. We say that we are now delta-neutral. Hedging a Put What about the 110 Put? Its value with the forward at 100 is: 110 Put = 10 x 1/2+ 30 x 1/6 + 50 x 1/12 = 14.17 What would be the correct hedge? This time the option gains value as the forward moves down and loses value as the forward moves up. So we would need to buy some of the forward to hedge the option value. What is delta for the 110 Put?

You should verify the value of the 110 Put at the forward prices of 105 and 95. Notice that the delta of the put is negative, as we expected. This means we should buy some of the forward to hedge a long put position and sell some of the forward to hedge a short put position. You will not have failed to see that the delta of the call minus the delta of the put equals 100%. If you think back to our discussion of synthetics, you will remember that a long call together with a short put is equivalent to a long forward. So the combined delta should be equal to the delta of the forward, which is clearly 100% as the forward moves one to one with itself. A word of caution we ignored the effect of interest rates to keep things simple. When we re-introduce carry on the options and the spot there will be some subtle changes in our value for delta. But the basic principle stays the same change in the price of the underlying is a fundamental risk to an option position. Traders are acutely aware of this risk and manage it rigorously.

Tau1 - Volatility Risk


Volatility is the most controversial input to an option value. It is the one variable that traders and end users of options may disagree on. In addition there are many different definitions and ways of measuring and predicting volatility. All of these issues we will leave for future discussions. Right now we only want to concentrate on the effect of volatility on the value of an option. Fortunately this is easy to understand. Volatility directly affects the distribution of the spot at expiry. Recall that in our distributions, the interval on the x-axis is . Lets assume that in our distribution, time to expiry is one year. Then the volatility must be 20% since the interval on the axis is 20.

There is no standard notation for this risk parameter. We use Tau at UBS but others may use Vega.

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Recall that the (future) value of the 110 Call is 4.17. Suppose that the volatility is actually just 15. How does the distribution change and the value of the option?

110 Call = 5 x 1/6 + 20 x 1/12 = 2.50 So the option value has decreased by 1.67. TAU
The change in the value of an option that results from a change in volatility is called Tau.

in this case

The option changes by 0.33 for every 1% change in volatility. Note that the 1% change means an absolute change of 1%, i.e. from 20 to 19 or from 20 to 21, not a relative change, i.e. 1% of 20, which would only be 0.20%.

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What about the 110 Put? Its value using the above distribution is 12.50.

which is the same as the tau for the 110 Call. But this does not surprise you does it? Of course not! You know that the volatility value of the call and put at the same strike are equal. So it is no surprise that the sensitivity of the call and put to a change in volatility is identical. What if the volatility were 25 instead of 20? You can check that the tau is still 0.33.

Theta Time Risk


The way an option value changes as time changes is the most complicated of the risk measures to analyse. This is because time changes both the forward value and the volatility value of an option. We will split these two changes so we can understand what changes in time do to an option. Suppose Spot = 100 Rate = 10% Time = 1 year Volatility = 15% Then the forward is 100 + 0.10 x 100 = 110 and the interval on the x-axis would be 0.15 x 110 = 16.50. So our distribution is:

Lets value the 105 Call and the 105 Put (once again we will ignore carry on the options): 105 Call = 5 x 1/2 + 21.5 x 1/6 + 38 x 1/12 = 9.25 105 Put = 11.5 x 1/6 + 28 x 1/12 = 4.25 Also note that 105 Put = 105 Call Parity to Forward = 9.25 5.00, just as it should be. What happens when the time to expiry changes? Lets move the clock forward one month, so that the time to expiry is just 11 months. Lets suppose the spot price is still 100, that interest rates are still 10% and volatility is still 15%. Then the forward must be: 100 + 100 x 0.10 x 11/12 = 109.2 and the interval on the x-axis is:

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Lets re-value those options: 105 Call = 4.2 x 1/2 + 19.9 x 1/6 + 35.6 x 1/12 = 8.38 105 Put = 11.5 x 1/6 + 27.2 x 1/12 = 4.18 What has happened? Both options are worth less now than they were. Lets look first at the 105 Call. It was worth 9.25, now it is worth 8.38 so it has lost 0.87 in value. Theta
The change in the option value that results from a change in the time to expiry is called theta, and is usually referred to as decay.

in the case of the 105 Call

Theta is one of the more difficult risk measures to interpret because there is no natural "unit" of time to measure it with. The 10.44 here means 10.44 per year. Theta, like all the risk measures, is a rate of change, not change itself. To get theta to represent change we need to multiply it by a time interval. This is just like measuring distance from speed and time. If you drive a car at 50 miles per hour, that measures how fast you are travelling not how far you have gone. To get distance we need to multiply the speed by a time. So if you drive that car at 50 mph for 3 hours, you travel 150 miles. If we multiply theta by 0.10, we would get the amount the option would be expected to decay in 1/10th of a year = 1.044. Probably what would make the most sense is to multiply it by 1/12 and get 0.87, the amount it did decay in one month. Traders often think in terms of "overnight" decay i.e. one days worth of decay. So you could multiply theta by 1/252, since there are about 252 trading days in a year. Then we would get 10.44 = 0.04. This means the option is decaying at the rate of 4 cents per day. That does not answer the question of what decayed and why. The 105 Call is the in-the-money option, because the forward price is greater than the strike price. Therefore, it has both forward value and volatility value. So lets look at what happened to those two components:

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105 Call Forward Value Volatility Value

One year 9.25 5 4.25

11 months 8.38 4.20 4.18

Decay 0.87 0.80 0.07

So the decay in the value of the 105 Call consists of the decay in the forward value, due to the decrease in the forward price and the decay in the volatility value due to less volatility (dispersion) in the distribution. What about the 105 Put? Since it is out-of-the-money, it only has volatility value. So that is the only thing that can decay. And, of course, the decay in the volatility value of the in-the-money 105 Call exactly equals the decay in the total value of the 105 Put. This is just our "great truth" once again! One year 4.25 0 4.25 11 months 4.18 0 4.18 Decay 0.07 0.00 0.07

105 Put Forward Value Volatility Value Theta for the Put:

A last note on Theta Theta represents how much the option value changes as the time to expiry changes. We recognise that as time to expiry gets closer, the option will lose value unless something happens to offset the natural decay. Because theta is regarded as "bad", traders often prefer to use negative values for theta. This amounts to measuring the change in the option value as the time to expiry decreases. It doesnt really matter whether you think of theta as a positive number or a negative one, just remember what it means.

Gamma Changes in Delta


This brings us to the last of the risk measures that we will discuss and the one the traders like talking about the most. In fact every time you hear an option trader talking it seems like one out of every two words they say is gamma. (The other word varies depending on how good a day theyre having). What is gamma? First, lets review delta. Delta is the change in an options value that results from a change in the price of the underlying.

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With the distribution shown the 100 Put is worth 6.67 (ignoring carry on the option). We know that if we buy the 100 Put for its theoretical value, 6.67, we should not make or lose money. But we also know that in order to lock-in the value of this trade, which is 0, we need to hedge. Rather than try to calculate delta, lets just use 50% and see how we make out. We often do this in Education, because if it doesnt work out we can always go back and change it! Too bad traders dont have that flexibility. Lets move the forward up to 105 and see what the value of our position is. Remember we are long the 100 Put and long 1/2 of the underlying (thats the 50% for delta) since the put will lose value when the underlying moves up.

The 100 Put is now worth 15 x 1/6 + 35 x 1/12 = 5.42. The value of our position is: Option P/L: 5.42 6.67 = -1.25 Forward P/L (105 100) x 1/2 = 2.50 Net P/L 1.25 Oops! We made money. Well maybe delta was wrong? Lets move the forward down to 95 and see what happens there.

Now the 100 Put is worth: 5 x 1/2 + 25 x 1/6 + 45 x 1/12 = 10.42 Option P/L: 10.42 6.67 = 3.75 Forward P/L: (95 105) x 1/2 = -2.50 Net P/L = 1.25

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Looks like we did it again! Whether the forward moves up to 105 or down to 95, we make 1.25 on a trade that was supposed to be worth 0. The reason for this is gamma. Gamma
Gamma is the change in the delta of an option that results from a change in the price of the underlying.

We used 50% for the delta of our 100 Put. That meant that we expected the put value to change by half of the movement in the forward. Lets see how the put value actually changed Forward = 105

So when the forward moved from 100 to 105 our option only lost 25% of the move in the forward. Forward = 95

So when the forward moved from 100 to 95, our option gained 75% of the move in the forward. What this means is that as the forward moved up, we were over-hedged by 25% since we were long 50% of the forward; when the forward moved down we were under-hedged by 25% since we were long just 50% of the forward. In both cases the 25% difference was to our benefit and we made a profit of 0.25 x 5 = 1.25 because of it. Our original delta of 50 was correct because we did not know which way the forward was going to move. So initially we were hedged properly by being long half the forward amount. But when the forward moved we became un-hedged. That is exactly the effect of gamma our delta changed. How much was gamma?

Our delta changed, on average, by 5 for every one point move in the forward. You can check the value of gamma for the 100 Call and you will see that it is also 5. Gamma is positive for both calls and puts. As the spot price moves up the delta of a call, which is positive, gets larger since the call acts more and more like the underlying. But as the spot price moves up, the delta of a put, which is negative gets closer to 0 since it acts less and less like a short underlying. Traders generally like to be "long" gamma since movement in the underlying helps their position. But there is always a trade-off. The way a trader gets long gamma is to buy options. Options cost money and they decay, as we saw when we discussed theta. The traders often say that theta is what they pay to be long gamma.

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Summary Traders have to be aware of their risks when they deal in options. Investors should be aware also of how the values and the exposures in their portfolios will change as spot price, time and volatility change, particularly if their portfolios include options. The basic measures of risk are: Delta the change in the value of an option for a change in the price of the underlying Tau or Vega the change in the option value for a change in volatility Theta the change in the option value for a change in time to expiry Gamma the change in the delta of an option for a change in the price of the underlying A last comment Many times in this discussion we have said we would take up various topics "later", that we would defer further discussion "for now". We actually didnt get to take up many of those topics. To do so would have made this much longer and taken us into areas that are best discussed in a course for people who are really interested in knowing about options in great depth or who need to know them for their jobs. If you are not in that group, you have probably learned enough about options to last you a lifetime. But if you are in the group of avid learners (and we hope you are), then look for future publications from our group and plan to attend our courses. Well look forward to seeing you.

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The UBS Financial Markets Education Department is pleased to provide educational presentations and materials to its valued clients without charge as a gesture of goodwill. These presentations and materials are provided by UBS for informational purposes only and without regard to the investment objectives, financial situation or particular needs of any specific recipient. The presentations and materials should not be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. UBS makes no representation or warranty regarding the accuracy or completeness of any information provided and accepts no liability for any loss of any nature whatsoever arising from the direct or indirect use of this information. These presentations and materials may use information obtained from sources believed to be reliable but such information is not guaranteed as being accurate, nor is it a complete statement or summary of the securities markets or developments. Presentations and materials should not be regarded by recipients as a substitute for the exercise of their own judgement or professional investment advice. Any opinions expressed in these presentations and materials are subject to change without notice and UBS is not under any obligation to update or keep current the information contained herein. Financial derivative products are not suitable for all investors and legal and regulatory restrictions may apply to the use of such instruments in different jurisdictions. Therefore UBS strongly recommends that investors always inquire into relevant legal and regulatory requirements and practices before entering into any investment activities. This has been prepared by UBS Limited, UBS AG or an affiliate thereof.

2003. All rights reserved. No part of this material may be reproduced or distributed in any manner without the written permission of UBS AG. UBS AG specifically prohibits the re-distribution of this material, via the Internet or otherwise, and accepts no liability whatsoever for the actions of third parties in this respect.

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