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RMS 2001

Chapter 6
Introduction to Financial Derivatives
6.1 Introduction
There are two classes of securities or instruments in the financial marketplace, they are
Fundamental stocks and bonds
Stocks rights of ownership of the firm.
Bonds the first claim on the firms cash flow.
Derivative A financial instrument or security whose payoffs depend on other financial instruments including fundamental securities and other financial derivative. For examples, gold future
and stock options are financial derivatives. The value of a gold future contract depends upon
the value the gold that underlies the future contract. Also, an option on a share of stock
depends on the value of the underlying stock.

6.2 Fundamental securities


In this section we study in details the two fundamental securities in the financial market: stocks
and bonds.
1. Stocks.
Stock is a share in the ownership of a company. Stock represents a claim on the companys
assets and earnings. As you acquire more stock, your ownership stake in the company becomes
greater. Whether you say shares, equity, or stock, it all means the same thing.
Being a shareholder, you are entitled to a portion of the companys profits and have a claim on
assets. Profits are sometimes paid out in the form of dividends, although it is not guaranteed.
Shareholders claim on assets is only relevant if a company goes bankrupt. In case of liquidation,
shareholders receive whats left after all the creditors have been paid.
Another extremely important feature of stock is its limited liability, which means that, as an
owner of a stock, one is not personally liable if the company is not able to pay its debts. Other
companies such as partnerships are set up so that if the partnership goes bankrupt the creditors
can come after the partners (shareholders) personally and sell off their house, car, furniture,
etc. The maximum value that a stock holder lose is the value of the investment.
2. Bonds.
A Bond is a debt investment in which an investor loans money to an entity (corporate or
governmental) that borrows the funds for a defined period of time at a fixed interest rate.
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Bonds are used by companies, municipalities, states and U.S. and foreign governments to
finance a variety of projects and activities.
The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be
paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest
on bonds is usually paid every six months (semi-annually). Bonds are commonly referred to
as fixed-income securities as the payments are determined at the beginning of the contract.
However, the bond is still associated with credit risk, when the bond issuer fail to make the
full amount of the payments at the specified time.
The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds,
notes and bills, which are collectively referred to as simply Treasuries. Two features of a
bond - credit quality and duration - are the principal determinants of a bonds interest rate.
Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate
and municipals are typically in the three to 10-year range.
Taking on greater risk demands a greater return on the investment. This is the reason why stocks
have historically outperformed other investments such as bonds or savings accounts. Over the long
term, an investment in stocks has historically had an average return of around 10-12
Why does a company issue stock and bonds? The reason is that at some point every company
needs to raise money. To do this, companies can either borrow it from somebody or raise it by selling
part of the company, which is known as issuing stock. A company can borrow by taking a loan
from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing. On the
other hand, issuing stock is called equity financing. Issuing stock is advantageous for the company
because it does not require the company to pay back the money or make interest payments along
the way.

6.3 Derivatives
6.3.1. Common derivatives
Forwards, futures and options and swaps are considered in this course.
1. Forward
A forward contract involves a contract initiated at one time. Performance in accordance with
the terms of the contract occurs at a subsequent time. For example,
A dog fancier offers to buy pup from the breeder. The exchange, however, cannot be completed
at this time, since the pup is too young to be weaned. The fancier and breeder thus agree that
the dog will be delivered in six weeks and that the fancier will pay the $ 400 in six weeks upon
delivery of the puppy.
This contract is not a conditional contract. Both parties are obligated to complete it as agreed.
This puppy example represents a very basic type of forward contract. Here, we consider forward
contract involving an exchange of one asset for another. The price at which the exchange occurs
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is set at the time of the initial contracting. Actual payment and delivery of the good occur
later. The simplicity of the contract make it an useful device to resolve uncertainly about the
future.
2. Futures
A future contract is:
A type of forward contract with highly standardized and closely specified contract terms.
Calls for the exchange of some good at a future data for cash, with the payment of the
good to occur at that future date.
The purchaser undertakes to receive delivery of a good and pay for it (long position).
the seller promises to deliver the good and receive payment (short position)
the price of the good is determined at the initial time of contracting.
The difference between futures contracts and forward contracts are:
Futures contracts always trade on an organized exchange.
Futures contracts are always highly standardized with a specified quantity of a good, and
with a specified delivery data and delivery mechanism.
Performance on future contracts is guaranteed by a clearinghouse a financial institution
associated with the futures exchange that guarantees the financial integrity of the market
to all trades.
All future contracts require that traders post margin in order to trade. Margin is a good
faith deposit made by the prospective futures trader to indicate his or her willingness and
ability to fulfill all financial obligations that may arise from trading futures.
Futures markets are regulated an identifiable government agency, while forward contracts
in general is an unregulated market.
There are four fundamentally different categories of futures contracts
Agricultural and metallurgical contracts.
Grains, oil and meal, livestock, forecast products, textiles, foodstuffs, metals and
petroleum.
Interest-earning assets.
Treasury bills, notes, bonds.
Foreign currencies
Indexes.

3. Options
In common sense, option is a choice. In financial markets, options are a very specific type of
option an option created through a financial contract.
Every option is either a call option or a put option. The owner of a call option has the right to
purchase the underlying good at a specific price, and this right lasts until a specific date. The
owner of the put option has the right to sell the underlying good at a specific price, and this
right lasts until a specific date.
To acquire these rights, owners of the options buy them from other traders by paying the price,
or premium, to a seller. Options are created only by buying or selling. That is, for every owner
of an option, there is a seller. The seller of an option is also known as an option writer. The
seller receives payment for an option from the purchaser. The seller confers rights to the option
owner.
The seller of a call option gives the owner of a call option the right to purchase the underlying
good at a specific price, with this right lasting for a specific time. The seller of a put option
promises to buy the underlying good at a specific price for a specific time, if the owner of the
put option chooses.
Note the asymmetric position and the seller:
The owner of an option has all the right buy pays for the rights.
The seller of an option has all the obligations. The seller undertakes obligations in exchange for payment.
Thus the seller of a call option is not the same as the buyer of a put option, although they
may both give away stocks and receive cash in maturity.
4. Variations of Options
(a) European option
An option that may only exercised on expiration.
(b) American option
An option that may be exercised on any trading day on or before expiry. As it allows
higher flexibility, it is typically more expensive than European option.
(c) Barrier option
The right to exercise depends on the underlying crossing or reaching a given barrier level.
In options start their lives worthless and only become active in the event a predetermined
knock-in barrier price is breached. Out options start their lives active and become null
and void in the event a certain knock-out barrier price is breached.
In either case, if the option expires inactive, then there may be a cash rebate paid out.
This could be nothing, in which case the option ends up worthless, or it could be some
fraction of the premium.
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The four main types of barrier options are:


Up-and-out: spot price starts below the barrier level and has to move up for the
option to be knocked out.
Down-and-out: spot price starts above the barrier level and has to move down for
the option to become null and void.
Up-and-in: spot price starts below the barrier level and has to move up for the
option to become activated.
Down-and-in: spot price starts above the barrier level and has to move down for
the option to become activated.
For each of the above four types of barrier option, there exist put and call options. So
there are eight type of barrier options in total.
(d) Asian option / average value option
The payoff is determined by the average underlying price over some pre-set period of time,
A(T ). Because of the averaging feature, Asian options reduce the volatility inherent in
the option; therefore, Asian options are typically cheaper than European or American
options.
Examples
Fixed strike Asian call
Payoff=M ax(A(T ) K, 0)
Fixed strike Asian put
Payoff=M ax(K A(T ), 0)
The floating strike Asian call
Payoff=M ax(S(T ) kA(T ), 0)
The floating strike Asian put
Payoff=M ax(kA(T ) S(T ), 0)
5. Swaps
Swaps contracts are agreements to exchange a series of cash flows according to prespecified
terms. The underlying asset can be an interest rate, an exchange rate, an equity, a commodity
price or any other index. Typically, swaps are established for longer periods than forwards and
futures.
For example, a 10-year currency swap could involve an agreement to exchange every year 5
million dollars against 3 million pounds over the next ten years, in addition to a principal
amount of 100 million dollars against 50 million pounds at expiration.
Another example is that of a 5-year interest rate swap in which one party pays 8% of the
principal amount of 100 million dollars in exchange for receiving an interest payment indexed
to a floating interest rate. In this case, since both payments are tied to the same principal
amount, there is no exchange of principal at maturity.
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Swaps can be viewed as a portfolio of forward contracts. They can be priced using valuation
formulas for forwards. Our currency swap, for instance, can be viewed as a combination of ten
forward contracts with various face values, maturity dates and rates of exchange.

6.3.2. Option Strategies


By keeping a portfolio of different options, a wide variety of risk and return characteristics can
be obtained for more precise speculative strategies.
1. The Straddle
Option combinations involve the trading two or more options to shape the risk and return
characteristics which allows more precise speculative strategies.
A straddle consists of a call and a put with the same exercise price and the same expiration.
The exercise price is usually chosen around the stock price at time t, St .
The profit/loss for long call and long put at expiration are

c
if ST K
ST K c if ST > K

K ST p if ST K
p
if ST > K

P rof it/Loss of long call =

P rof it/Loss of long put =

Combining the above two equations, we have at expiration


(

P rof it/Loss of long straddle =

K ST c p if ST K
ST K c p if ST > K

Similarly, for a short straddle, we have at expiration


(

P rof it/Loss of put straddle =

c + p K + ST if ST K
c + p ST + K if ST > K

The short trader is betting that the stock price will not be too volatile. The long trader
is betting that the stock price will diverge far from the exercise price.
2. The Strangle
A strangle consists of a call and a put with the same expiration, but the strike price Kc
of the call exceeds that of the put Kp . Usually, Kp < St < Kc
The profit/loss for long call and long put at expiration are
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c
if ST Kc
ST Kc c if ST > Kc

Kp ST p if ST Kp
p
if ST > Kp

P rof it/Lossof longcall =

P rof it/Lossof longput =

Combining the above two equations, we have at expiration

Kp ST c p if
ST Kp
c p
if Kp < ST Kc
P rof it/Lossof longstrangle =

ST Kc c p if
ST > Kc
Similarly, for a short straddle, we have at expiration

Kp + ST + c + p if
ST Kp
c+p
if Kp < ST Kc
P rof it/Lossof putstrangle =

ST + Kc + c + p if
ST > Kc
The short trader is betting that the stock price stay within a fairly wide band. There is
a high probability of a small profit but there is a risk of a very large loss.
3. Bull Spreads
A bull spread is a combination of options designed to profit if the price of the underlying good
rises. In general, a spread position is entered by buying and selling equal number of options
of the same class on the same underlying security but with different strike prices or expiration
dates. To long a bull spread, one
buys a call (c1 ) with a strike price below the stock price St > K1
sells a call (c2 ) with a strike price above the stock price St < K2
Note that c2 < c1 , as the first option provides you the right to purchase at a lower strike
price .
4. Bear Spreads
A bear spread is a combination of options designed to profit if the price of the underlying good
falls. To long a bull spread, one
buys a call (c1 ) with a strike price above the stock price St < K1
sells a call (c2 ) with a strike price below the stock price St > K2
Note that c1 < c2 .
5. Butterfly
Butterfly is a limited risk, non-directional options strategy that is designed to have a large
probability of earning a small limited profit when the stock remains at the same level.
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Figure 1: Option Strategies: Straddle and Strangle

Long 1 call with a strike price of (K a)


Short 2 calls with a strike price of K
Long 1 call with a strike price of (K + a)

6.3.3. The Clearinghouse and margin


The clearinghouse is either a separate corporation or part of the stocks/futures exchange. Each
exchange is closely associate with a particular clearinghouse. The clearinghouse
Ensures that future contracts trade in a smoothly functioning market.
Guarantees that all of the traders in the futures market will honor their obligations
Margin is the funds deposited by the prospectively trader with a broker before trading a futures
contract. It serves as a good faith by the trader and provides a financial safeguard to ensure that
trader will perform on their contract obligations.
There are three terms related to margin
Initial margin.
Initial margin is an initial amount a trader must deposit before trading any futures. It will
be returned to the trader upon proper completion of all obligations associated with a traders
futures position. In most cases, the initial margin may be 5% or less of the underlying commoditys value. The contract is marked-to-the-market. Traders are required to realize any losses in
cash on the day they occur.
Maintenance margin
When the value of the funds on deposit with the broker reaches a certain level, called the
maintenance margin, the trader is required to replenish the margin, bringing to its initial level.
The demand for more margin is called a margin call.
Variation margin
The additional amount the trader must deposit is called the variation margin, which must
always be paid in cash.
Example 1.
Consider an investor holds a long position on a gold future contracts on June 5 to trade 200 ounces
of gold in December. Suppose the current futures price is $400 per ounce. The broker will require
the investor to deposit funds in a margin account. The amount that must be deposited at the time
the contract is entered into is known as the initial margin. Suppose the broker asks for $ 4000. This
practice is referred to as marking to market the account.
Suppose, that by the end of June 5 the futures price has dropped from $400 to $397. The investor
has a loss of $600 (3200). The balance in the margin account would therefore be reduced by $ 600
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Figure 2: Option Strategies: Bull/Bear Spread, Butterfly Spread

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to $ 3400. Similarly, if the price of gold futures rose to $403 by the end of June 5, the balance in the
margin account would be increased by $600 to $4600. This practice is done at the close of trading
on each subsequent day, thus the name mark to market.
The investor is entitled to withdraw any balance in the margin account in excess of the initial
margin. To ensure that the balance in the margin account never becomes negative, a maintenance
margin, which is somewhat lower than the initial margin, is set. If the balance in the margin account
falls below the maintenance margin, the investor receives a margin call and is expected to top up the
margin account to the initial margin level the next day. The extra funds deposited are known as a
variation margin. If the investor does not provide the variation margin, the broker can closes out
the position by selling the contract.
Table 1 illustrates the operation of the margin account for one possible sequence of future prices.
Assume the maintenance margin is $3000. On June 13 the balance in the margin account falls $340
below the maintenance margin level. This drop triggers a margin call from the broker for an addition
$1340 to restore the margin account balance to $4000. Unfortunately, on June 19 the balance in the
margin again falls below the maintenance margin level, and a margin call for $1260 is sent out. The
investor provides this margin by the close of trading on June 20. On June 26 the investor decides
to close out the position by selling the contracts. The future price on that day is $392.3, and the
investor has a cumulative loss of $1540. Note that the investor has excess margin on June 16, 23,
24, 25. Table 1 assumes that the excess is not withdrawn.
Day
June 5
June 6
June 9
June 10
June 11
June 12
June 13
June 16
June 17
June 18
June 19
June 20
June 23
June 24
June 25
June 26

Future price
400
397
396.1
398.2
397.1
396.7
395.4
393.3
393.6
391.8
392.7
387
387
388.1
388.7
391
392.3

Daily gain (loss)

Cumulative gain (loss)

(600)
(180)
420
(220)
(80)
(260)
(420)
60
(360)
180
(1140)
0
220
120
460
260

(600)
(780)
(360)
(580)
(660)
(920)
(1340)
(1280)
(1640)
(1460)
(2600)
(2600)
(2380)
(2260)
(1800)
(1540)

Margin account balance


4000
3400
3220
3640
3420
3340
3080
2660
4080
3700
3880
2740
4000
4220
4340
4800
5060

Margin call

1340

1260

Example 2 .
Besides trading futures, margin account exists as a result of Margin buying, i.e., buying securities
with cash borrowed from a broker. For example, Jane buys a HSBC share for $100, using $20 of her
own money, and $80 borrowed from her broker. The net value (share - loan) is $20. The broker wants
a maintenance margin requirement of $10 to prevent the margin account from becoming negative.
Suppose the share goes down to $85. The net value is now only $5 (net value ($20) - share loss
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of ($15)), and Jane will have repay part of the loan (so that the net value of her position is again
above $10). Otherwise, the broker will sell the share for $85, keep the loan of $80 and return $5 to
Jane.
Suppose the share goes up to $120. Jane may choose to sell the stock to get $120, repay the loan
of $80 and keep $40. Thus she gets $40 with an initial investment of $20, with a rate of return 100%,
which is much higher than the rate of return of the underlying stock ((120 100)/100 = 20%). This
is called leverage effect. Of course, higher return is associated with a higher risk: Margin buying
face the risk losing a large proportion of the investment when one is not able to meet the margin call
and the position is closed by the broker.
Day
1
2
3
4
5
6

Stock price
100
102
105
120
90
95
85

Daily gain (loss)

Cumulative gain (loss)

2
3
15
(30)
5
(10)

2
5
20
(10)
(5)
(15)

Margin account balance


20
22
25
40
10
15
5

Margin call

6.4 The importance of Derivatives


Derivatives are used by investors to achieve the following:
1. Market completeness
In the theory of finance, a complete market is a market in which any and all identifiable payoff
can be obtained by trading the securities available in the market.
Example: A trader would like to purchase a security or a set of securities that would pay off if
and only if the Hang Seng index rose by 10,000 points over the next month.
It is quite difficult to trade any combination of stocks and bonds that would have this payoff.
This market would be deemed incomplete if the financial instruments available in a market
were not sufficiently rich and diverse to permit such a speculation.
complete market is an idealization that is most likely always unobtainable in practice. However,
completeness is a desirable characteristic of a financial market. It can be shown that access to
a complete market increases the welfare of the agents in the economy. The more closely the
market approaches completeness, the better off are the economic agents in the economy.
Financial derivatives play a valuable role in financial markets because they help to move the
market closer to completeness. The market with financial derivatives will allow traders to
more exactly shape the risk and return characteristic of their portfolios, thereby increasing the
welfare of traders and the economy in general.
2. Speculation
Financial derivative have a reputation for being risky. These instruments can prove tremen12

dously risky in the hands of uninformed traders. However,they provide very powerful instruments for knowledgeable traders to expose themselves to calculated and well-understood risks
in pursuit of profit.
A position in one or more financial financial derivatives can permit a careful and artful speculation on
a rise of fall in interest rate
a change in the riskiness of the entire stock market or a single stock.
changing values of the currency exchange rates.
The precision and speculative power of derivatives stems largely from the fact financial derivative help to make the financial market more nearly complete.
3. Risk management
Financial derivative also provide a powerful tool for limiting risks that individuals and firms in
the ordinary conduct of their business.
Examples:
A corporation that is planning to issue bonds faces considerable interest rate risk.
If interest rate rise before the bond is issued, the firm will have to pay considerable more
over the life of the bond. The firm could use interest rate futures to control its exposure
to this risk.
A pension fund with widely diversified holdings in the stock market faces considerable risk
from general fluctuations in stock prices.
The pension fund manage could use options on a stock index to reduce or virtually eliminate that risk exposure.
Successful risk management with derivatives requires a thorough understanding of the principles
that govern the pricing of financial derivatives.

6.5 Pricing of financial instruments


6.5.1 The Concept of Arbitrage
Arbitrage means the possibility to trade to generate a riskless profit without investment.
Example
Suppose shares of IBM trade for $110 on the New York market and for $105 on the Pacific
Exchange.
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A trader could obtain riskless profit by


Transaction
Profit
Buy 1 share of IBM on Pacific Exchange for $105
-$105
Sell 1 share of IBM on New York Exchange for $110 $110
Overall profit
+%5
Because both trades are assumed to occur simultaneously, there is no investment.
In a well-functioning market, such opportunity cannot exist. If they did exist, they would make
all of us fabulously wealthy. The existence of such arbitrage opportunities is equivalent to money
being left on the street without being claimed.
To understand the pricing of derivative instruments, we assume that there are no arbitrage
opportunities. This is called the no-arbitrage principle. We apply this principle to determine the
prices of financial derivatives on the assumption that there are no arbitrage opportunities.
To enjoy the arbitrage opportunity, there is only one rule

Buy Low, Sell High Buy the one that is cheap, sell the one that is expensive

For simplicity, in our study of pricing financial instruments, we make use of the following Assumptions.
1. There is no transaction costs and tax in the market.
2. The market participants can borrow or lend money at the same risk-free rate of interest. In
practice, the U.S. Treasury bills or LIBOR/HIBOR (London/Hong Kong Interbank offered
rate) are regarded as the risk-free rate. Interbank offered rate is the interest rates at which
banks borrow unsecured funds from other banks in the interbank market.
3. The market participant take advantage of arbitrage opportunities as they occur.

6.5.2 Bond pricing


Assume the probability of default is 0, i.e., there is no credit risk associate with the bond. This
may be applied to U.S. Treasury bills or LIBOR/HIBOR (London/Hong Kong Interbank offered
rate). Then the price of a bond is the present value of all the coupon payments and the face value.
"

c
c
1
c
+
+
.
.
.
+
+
P =F
(1 + r) (1 + r)2
(1 + r)T 1 (1 + r)T

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6.5.2 Futures contract pricing


Suppose a future contract on asset S has strike price K at maturity time T . Denote So and ST by
the spot price and the price at maturity of the asset. Assume also the risk free rate over the period
T is r. The future price is given by
f = So K/(1 + r) .

(1)

We can show this by constructing arbitrage portfolio for the case where f > So K/(1 + r) and
f < So K/(1+r). By the assumption of no-arbitrage opportunities, we must have f = So K/(1+r).
Without loss of generality, we can facilitate understanding by taking So = 40, K = 39.9, r = 0.05.
From ??, we have f = 2, we consider two cases: f = 0.5 and f = 3.
f =1
f =3
Action now:
cash flow
Action now:
cash flow
1. long future
-1
1. short future
+3
2. short sell S
+40
2. buy S
-40
borrow from risk free
+37
3. risk free investment
-39
Net cash flow now:
0
Net cash flow now:
0
Action at maturity:
cash flow
Action at maturity:
cash flow
1. close the future contract
-39.9+ST
1. close the future contract +39.9-ST
2. stock holding
ST
2. deliver S for short selling
-ST
3. risk free investment
+39 (1.05) 3. pay back the debt
-37 (1.05)
Net cash flow at T :
1.05
Net cash flow at T
1.05
6.5.2 Option pricing The Binomial Trees
In general, pricing option involves complicated mathematics. For illustration purposes we focus
on a simple case where we are able to price an option. A One-Step Binomial tree model.
Consider the following example
A European call option with strike K=$21 and T =3 months
So = 20 and at the end of 3 months, the stock price will be either 22 or 18.
Risk-free rate is 12%
We try to mimic the payoff of a call option with a portfolio containing certain proportion of stock
and cash. By the assumption of no arbitrage opportunity, if two portfolios have the same payoff
structure at the maturity, they must have the same payoff structure at the beginning (otherwise you
can buy the cheaper one and sell the more expensive one to enjoy a free lunch). Thus we are able to
price the call option by looking at the payoff structure of the portfolio consisting of stock and cash.
Consider two portfolios consisting of
1 A long position in X shares of stocks and $ Y cash.
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Figure 3: One Step Binomial Tree


2 A long position in one call option
Can we calculate the value of X and Y so that they have the same payoff? Let investigate the
two cases at the maturity
If the stock price moves up from 20 to 22, the total value of portfolio 1 is 22X+1.12Y . The
value of portfolio 2 is $1.
If the stock price moves down from 20 to 18, the total value of the portfolio is 18X+1.12Y .
The value of portfolio 2 is $0.
To match the payoff structure of portfolio 1 and 2, we can solve the system of equations
22X + 1.12Y
18X + 1.12Y

= 1
= 0,

which gives X = 0.25, Y = 4.017857.


That is, if we long 0.25 shares of stock and short the call option, the value of the portfolio will
be $ 4.5 at expiration of the option, regardless of the price fluctuation of the stock.
The value of portfolio 1 at the beginning is 20X + Y = 20(0.25) 4.017857 = 0.982. By noarbitrary principle this value should be equal to 4.02. Therefore the call price is
c = 0.982
You may derive the same value of the call price by matching other two portfolios:
1 A long position in shares of stocks and a short position of one call option, with the payoff
of maturity being fixed (i.e. The payoff is the same no matter the stock rises or falls).
2 A certain amount of cash.

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The details is left as an exercise.


6.5.3 Option pricing Two-steps The Binomial Trees
Again, let the risk free rate be 12% and the strike price of the bond be $21.

Figure 4: Two Step Binomial Tree


The price can be computed easily by repeating applications of the one-step Binomial tree.
1 First, work out the option values at the nodes D, E and F.
2 Then, use one-step Binomial tree method to compute the option values at the nodes B and C.
3 Finally, use one-step Binomial tree method to work out the option values at node A.
The method can be generalized to multiple nodes and for put option, American options or other
exotic options.

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