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ASB4417/4817 Financial Engineering

Lecture 1: Introduction
Gwion Williams

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What is a Derivative?
• A derivative is an instrument whose value
depends on, or is derived from, the value
of another asset.
• Examples: futures, forwards, swaps,
options, exotics…

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Why Derivatives Are Important
• Derivatives play a key role in transferring risks in the
economy
• The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc
• Many financial transactions have embedded
derivatives
• The real options approach to assessing capital
investment decisions has become widely accepted

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How Derivatives Are Traded
• On exchanges such as the Chicago Board
Options Exchange
• In the over-the-counter (OTC) market
where traders working for banks, fund
managers and corporate treasurers
contact each other directly

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Size of OTC and Exchange-Traded Markets

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
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000 counterparties • Unwinding these transactions has been challenging for both the Lehman liquidators and their counterparties 6 . This was the biggest bankruptcy in US history • Lehman was an active participant in the OTC derivatives markets and got into financial difficulties because it took high risks and found it was unable to roll over its short term funding • It had hundreds of thousands of transactions outstanding with about 8.The Lehman Bankruptcy • Lehman’s filed for bankruptcy on September 15. 2008.

How Derivatives are Used • To hedge risks • To speculate (take a view on the future direction of the market) • To lock in an arbitrage profit • To change the nature of a liability • To change the nature of an investment without incurring the costs of selling one portfolio and buying another 7 .

4415 6-month forward 1.4411 1-month forward 1.4408 1.4407 Offer 1. May 24.4422 8 .Foreign Exchange Quotes for GBP.4416 1.4413 3-month forward 1. 2010 Spot Bid 1.4410 1.

e. it is the delivery price that would make the contract worth exactly zero) • The forward price may be different for contracts of different maturities (as shown by the table) 9 ..Forward Price • The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.

Terminology • The party that has agreed to buy has what is termed a long position • The party that has agreed to sell has what is termed a short position 10 .

442.Class Exercise • On May 24.200 for £1 million on November 24. 2010 • What are the possible outcomes? • HINT – consider different market conditions in 6 months 11 .4422 • This obligates the corporation to pay $1. 2010 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.

ST 12 .Profit from a Long Forward Position (K= delivery price=forward price at time contract is entered into) Profit K Price of Underlying at Maturity.

Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into) Profit K Price of Underlying at Maturity. ST 13 .

Futures Contracts • Agreement to buy or sell an asset for a certain price at a certain time • Similar to forward contract • Whereas a forward contract is traded OTC. a futures contract is traded on an exchange • Less risk involved compared to forwards: exchange traded means guarantee of contract being honored 14 .

Exchanges Trading Futures • CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade) • NYSE Euronext • BM&F (Sao Paulo. Brazil) • TIFFE (Tokyo) • and many more (see list at end of book) 15 .

currencies and Treasury bonds 16 . copper. gold.Types of underlying assets in futures contracts • Commodities: – Pork bellies. oil. wool. sugar. live cattle. • Financial assets: – Stock indices.

500 @ 1.000 bbl. of gold @ US$1400/oz. in April 17 .Examples of Futures Contracts Agreement to: – Buy 100 oz.4500 US$/£ in March – Sell 1. in December – Sell £62. of oil @ US$90/bbl.

400 The 1-year quoted futures price of gold is US$1.500 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity? 18 .Class Exercise 2 Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$1.

400 .The 1-year quoted futures price of gold is US$1.The spot price of gold is US$1.400 .Gold: Another Arbitrage Opportunity? Suppose that: .The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity? 19 .

470 • Enter long into futures contract to buy back in 1 year at $1.400 at 5% for 1 year = $1.400 • Invest $1. Gold: Another Arbitrage Opportunity? • Sell short gold at spot of $1.2.400 • After 1 year you gross $70 (note that we have ignored the borrowing cost of the short position in the gold) 20 .

The quoted 1-year futures price of - - oil is US$125 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity? 21 . Oil: An Arbitrage Opportunity? Suppose that: .The spot price of oil is US$95 .1.

and r =0.The Forward Price of Oil If the spot price of gold is S and the forward price for a contract deliverable in T years is F.05 so that F = 95(1+0.75 22 . then F = S (1+r )T where r is the 1-year (domestic currency) risk-free rate of interest. S = 95.05) = $99. In our examples. T = 1.

use to buy oil.9 = $101.1. Oil: An Arbitrage Opportunity? • Borrow $95 at 5%. then pay back loan in 1 year time $99.9 • Sell 1 year futures $125 • Total cost $99.35 23 .75 • Storage cost 2% of $95 = $1.65 • Receive $125 • Profit = $23.75 + $1.

Options • A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) • A put option is an option to sell a certain asset by a certain date for a certain price (the strike price) • Traded both OTC and on exchange 24 .

which are agreed on by both counterparties 25 .American vs European Options • An American option can be exercised at any time during its life • A European option can be exercised only at maturity • Most exchange traded are American options • Exchange traded equity options are usually an agreement to buy or sell 100 shares. • OTC options can have virtually any condition.

70 26 .75 2.60 41.20 4.00 540 4.80 52.10 24.90 31.25) Source: CBOE Strike Price Jul 17 2010 Bid Jul 17 2010 Offer Sep 18 2010 Bid Sep 18 2010 Offer Dec 18 2010 Bid Dec 18 2010 Offer 460 43.10 7.00 23.60 29.10 19.00 39.00 51.40 8.40 50.30 40.00 9.30 29. 2010.80 480 28.30 520 9.30 500 17.70 13.80 17.00 17.40 28.00 560 1.40 16.30 44. Stock Price is bid 497.40 12.90 53.40 32.30 19.40 64.Google Call Option Prices (June 15.70 40. offer 497.07.90 63.

07.30 35.60 52. offer 497.50 540 46. Stock Price is bid 497. 2010.70 70.90 56.30 47.80 54.70 22.60 15.00 27 .20 26.80 43.60 42.30 66.90 32.20 560 64.90 41.30 11.Google Put Option Prices (June 15.00 71.20 54.30 6.30 480 11.00 27.70 33.50 20.00 30.60 33.00 520 31.00 500 19.30 78.90 66.60 80.70 16. Source: CBOE Strike Price Jul 17 2010 Bid Jul 17 2010 Offer Sep 18 2010 Bid Sep 18 2010 Offer Dec 18 2010 Bid Dec 18 2010 Offer 460 6.25).10 64.20 43.20 22.

this is for an option to buy one share.200 to buy contract • You now have the right to buy 100 Google shares at $520 each on December 18th 2010. i) Google < $520 ii) Google =$530 iii) Google = $600 28 .00. but exchange traded are on 100 shares • So you need $3.Class exercise • You want to buy one December call option on Google with strike of $520 • Offer price is $32. • Consider 3 market scenarios after 6 months.

220 (You’ve sold the put contract) • If Google share price remains above $480 by 18th September.220.Alternative strategy • Sell one September put option with strike price of $480 • Price is $22.780 total loss when accounting for the cash inflow from selling of put 29 .000.20 for 1 (remember you have to agree on 100 shares) • Cash inflow = $2. because the trader will not exercise the put option • If shares = $420 at maturity You must buy 100 shares at $480 = $48. but they are only worth $420 = $3. you will earn $2.

Options vs Futures/Forwards • A futures/forward contract gives the holder the obligation to buy or sell at a certain price • An option gives the holder the right to buy or sell at a certain price but not the obligation 30 .

Forward/futures payoffs 31 .

Option payoffs 32 .

What can derivatives be used for • Hedging • Speculating • Arbitrage 33 .

Hedge example using forward • A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract 34 .

Foreign Exchange Quotes for GBP. May 24.4410 1. 2010 Spot Bid 1.4407 Offer 1.4411 1-month forward 1.4415 6-month forward 1.4422 35 .4408 1.4413 3-month forward 1.4416 1.

000 = £10.000.000.4415.415.000! • Scenario 2: Ex rate is 1.000 is only worth $13.Hedge example using forward • Exporter can hedge against FX risks with a 3-month forward contract • 3-month offer quote is 1. • Scenario 1: Ex rate is 1. company is glad it has hedged otherwise it would have cost them $15.000 to deliver the £10m • Risk vs reward… 36 . company will wish it had not hedged because.3 on 24 Aug.000.000. but company is locked in at $14. • £10.5.000. in effect this fixes the prices to be paid to $14.000 • The hedge can work in favour of the company or not.415.

The investor decides to hedge by buying 10 contracts • This investor is concerned about Microsoft share loosing value • Remember exchange traded options must be bought by the 100s.50 costs $1. A two-month put with a strike price of $27.000 Microsoft shares currently worth $28 per share..Hedge example using options • An investor owns 1.000 37 . • 10 contracts = put option on 1.000 shares • Total cost of hedge is $1.

50.Hedge example using options • Hedge costs $1.000 but guarantees sale of shares for $27. the investor will exercise option.000 worse off if share price is above $27. but investor will still get back more than $26. option will not be exercised. and sell shares for $27. • Taking into account option cost = $26. investor will get $27. • Due to cost of the hedge.000 (taking option cost into account.50 • If share price falls below $27.50 38 .00.50.500… • If at $28.500. investor will always be $1.500 for investor • If share price stays above $27.

000 20 25 30 35 40 39 .000 Stock Price ($) 20.000 Hedging 25.000 No Hedging 30.Value of Microsoft Shares with and without Hedging 40.000 Value of Holding ($) 35.

whilst allowing benefit from favourable price movements • Downside of option is the cost/premium • Forwards/futures have no upfront cost/premium 40 . because there is limited downfall.Forwards/futures vs options • Forwards/futures neutralise risk by fixing the price paid or received for underlying asset • Option contracts provide insurance.

000 to invest feels that a stock price will increase over the next 2 months.Speculation Class exercise • An investor with $2. The current stock price is $20 and the price of a 2-month call option with a strike of 22.50 is $1 • What are the strategies? • Consider i) Buying shares ii) Buying call options 41 .

whilst Futures are settled daily • Futures are rarely held till maturity 42 . counterparty may not have financial resources to honor contract • Forwards are settled at maturity.Margins • A margin is cash or marketable securities deposited by an investor with his or her broker • The balance in the margin account is adjusted to reflect daily settlement • Margins minimize the possibility of a loss through a default on a contract • Forwards are different. there are risks.

Review of Option Types • A call is an option to buy • A put is an option to sell • A European option can be exercised only at the end of its life • An American option can be exercised at any time 43 .

Option Positions • • • • Long call Long put Short call Short put 44 .

option life = 2 months 30 Profit ($) 20 10 70 0 -5 80 90 100 Terminal stock price ($) 110 120 130 45 . strike price = $100.Long Call Profit from buying one European call option: option price = $5.

Short Call Profit from writing one European call option: option price = $5. strike price = $100 Profit ($) 5 0 -10 110 120 130 70 80 90 100 Terminal stock price ($) -20 -30 46 .

Long Put Profit from buying a European put option: option price = $7. strike price = $70 30 Profit ($) 20 10 0 -7 Terminal stock price ($) 40 50 60 70 80 90 100 47 .

Short Put Profit from writing a European put option: option price = $7. strike price = $70 Profit ($) 7 0 40 50 Terminal stock price ($) 60 70 80 90 100 -10 -20 -30 48 .

0) ST Payoff K Payoff = max(K . ST = Price of asset at maturity Payoff Payoff Payoff = max(ST – K. 0) K ST Payoff = -max(K . 0) ST 49 .ST.ST.Payoffs from Options What is the Option Position in Each Case? K = Strike price. 0) K K ST Payoff Payoff = -max(ST – K.

Assets Underlying Exchange-Traded Options • • • • Stocks Foreign Currency Stock Indices Futures 50 .

Specification of Exchange-Traded Options • • • • Expiration date Strike price European or American Call or Put (option class) 51 .

Terminology Moneyness : – At-the-money option – In-the-money option – Out-of-the-money option Calls: ATM – Strike = Spot ITM – Strike < Spot OTM – Strike > Spot Puts: ATM – Strike = Spot ITM – Strike > Spot OTM – Strike < Spot 52 .

90 31.10 24.70 40.90 63.80 52.80 480 28.00 17.40 28.30 520 9.00 23.90 53.00 51.70 53 .10 7.40 50.30 44.00 9.40 64.40 8.60 29.10 19.75 2.40 16.60 41.70 13. offer 497.30 500 17.30 29.00 560 1. Stock Price is bid 497.Google Call Option Prices (June 15.07. 2010.30 40.40 32.30 19.25) Source: CBOE Strike Price Jul 17 2010 Bid Jul 17 2010 Offer Sep 18 2010 Bid Sep 18 2010 Offer Dec 18 2010 Bid Dec 18 2010 Offer 460 43.00 540 4.00 39.20 4.40 12.80 17.

Source: CBOE Strike Price Jul 17 2010 Bid Jul 17 2010 Offer Sep 18 2010 Bid Sep 18 2010 Offer Dec 18 2010 Bid Dec 18 2010 Offer 460 6.00 54 .70 70.70 16.30 78.90 41.25).70 33.50 540 46.60 33. offer 497.07.00 27.00 71.70 22.80 54.3 page 9.90 56.80 43.60 80.30 6.30 480 11.60 42. Stock Price is bid 497.30 66.20 54.00 30.00 520 31.30 35.50 20.60 15.20 26.10 64.20 43.30 47.60 52.90 66.30 11.20 560 64.20 22. See Table 1. 2010.00 500 19.Google Put Option Prices (June 15.90 32.