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INTRODUCTION TO DERIVATIVE MARKET: FUTURES AND FORWARDS

,
OPTIONS, SWAPS, FLOORS AND CAPS

By: Alemayohu Workine PGR/029/09
Betelhem Birhanu PGR/028/09
Nigus and
Gizachew

A Masters of Business Administration Student Assignment to be submitted to
Instructor: Dr. Kidane K.

Debre Berhan University
College of Business and Economics
Department of management
Masters of Business Administration

November, 2017
Debre Berhan, Ethiopia

CHAPTER SIX

INTRODUCTION TO DERIVATIVE MARKET

Introduction

Derivative securities, or more simply derivatives, play a large and increasingly important role in
financial markets. These are securities whose prices are determined by, or “derive from,” the
prices of other securities. These assets are also called contingent claims because their payoffs are
contingent on the prices of other securities. Options and futures contracts are both derivative
securities. We will see that their payoffs depend on the value of other securities. Swaps, which
we will see in future, also are derivatives. Because the value of derivatives depends on the value
of other securities, they can be powerful tools for both hedging and speculation. We will
investigate these applications in this chapter, starting with futures and forwards.

DERIVATIVE MARKET
There is a clear distinction between real assets, which are essentially tangible items, and financial
assets, which are pieces of paper describing legal claims. Financial assets can be further
subdivided into primary and derivative assets. A primary asset (sometimes called a primitive
asset) is a security that was originally sold by a business or government to raise money, and a
primary asset represents a claim on the assets of the issuer. Thus, stocks and bonds are primary
financial assets (D. Jordan and W. Miller, 2009).
In contrast, as the name suggests, a derivative asset is a financial asset that is derived from an
existing primary asset rather than issued by a business or government to raise capital. As we will
see, derivative assets usually represent claims either on other financial assets, such as shares of
stock or even other derivative assets, or on the future price of a real asset such as gold. Beyond
this, it is difficult to give a general definition of the term “derivative asset” because there are so
many different types, and new ones are created almost every day. On the most basic level,
however, any financial asset that is not a primary asset is a derivative asset (Ibid).
To give a simple example of a derivative asset, imagine that you and a friend buy 1,000 shares of
a dividend-paying stock, from Weyerhaeuser stock. You each put up half the money and you
agree to sell your stock in one year. Furthermore, the two of you agree that you will get all the
dividends paid while your friend gets all the gains or absorbs all the losses on the 1,000 shares.

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the terms of the contract. With less risk. They are over-the-counter (OTC) contracts. Exchange-traded derivatives (futures and options. the dividend-only shares that you hold and the no-dividend shares held by your friend.This simple arrangement takes a primary asset. buyers and sellers mutually benefit and commerce is stimulated. a forward contract is a formal agreement between a buyer and a seller who both commit to a commodity transaction at a future date at a price set by negotiation today. Jordan and W. 2016). Swaps however are quite different in nature and operation (P. the seller of the contract is obliged to deliver the asset at the forward price. A forward contract obliges its purchaser to buy a given amount of a specified asset at some stated time in the future at the forward price. and creates two derivative assets. and there are many variations on this basic theme. shares of Weyerhaeuser stock. Howells and K. Bain. Contracts differ from those in forward foreign exchange in the form of operation of the market. Futures and Forwards Forward Contract By definition. and the likelihood of their leading to delivery of the underlying product. Derivatives are instruments that allow market agents to gamble on movements in the prices of other instruments without being required to trade in the instruments themselves. both buyer and seller remove price uncertainty as a source of risk. Miller. Similarly. options and swaps – and myriad variations upon them. Forward contracts are not traded on exchanges. A crucial difference is that a derivatives contract is a tradable instrument and can be sold on to a third party. Non-delivery forwards (NDF) are settled at maturity and no delivery of primary assets is assumed (Martin Haugh. The profit or loss from a forward contract depends 3 . Forwards are privately negotiated between two parties and they are not liquid. By setting a price today. which are traded through financial futures exchanges) are dealt with here. The genius of forward contracting is that it allows a producer to sell a product to a willing buyer before it is actually produced. Derivative assets such as these actually exist. 2009). There are three major types of financial derivatives – futures. Forward contracts are widely used in foreign exchange markets. 2007). They are not OTC business. This principle has been understood and practiced for centuries (D.

e. The forward contract is settled at maturity. So in order to protect himself from the rise in prices Birhanu enters into a contract with the TV dealer that 3 months from now he will buy the TV for $ 10. Futures Contracts In many ways. the T-Bill has 9 months to maturity. however.  Examples of forward contracts Birhanu wants to buy a TV. For example. This means that in order to take a position in a forward contract. This is the risk that one party to the forward contract will default on its obligations. Other Examples of forward contracts include:  A forward contract for delivery (i. He can only buy it 3 months hence.)  A forward contract for the sale of gold with maturity 1 year. they have a number of weaknesses. 2016). because forward contracts are not exchange-traded. The dealer will deliver the asset to Birhanu at the end of three months and Birhanu in turn will pay cash equivalent to the TV price on delivery. While forwards markets have proved very useful for both hedging and investment purposes.000. purchase) of a non-dividend paying stock with maturity 6 months. Second. Finally. which costs $ 10. Forward contracts are settled only at maturity (Ibid). there is also counter party risk. One thing you 4 . in addition to the financial risk of forward contract. A futures contract is just an agreement made today regarding the terms of a trade that will take place later. (This means that upon delivery.on the difference between the forward price and the spot price of the asset on the day the forward contract matures. These problems have been eliminated to a large extent through the introduction of futures markets (Martin Haugh. fears that prices of televisions will rise 3 months from now. a futures contract is the simplest of all financial assets. forward markets are not organized through an exchange.  A forward contract for delivery of a 9-month T-Bill with maturity 3 months. What Birhanu is doing is that he is locking the current price of a TV for a forward contract. This is the double coincidence of wants problem. suppose you know that you will want to buy 100 ounces of gold in six months.  A forward contract for delivery of 10m Euro (in exchange for dollars) with maturity 6 months. First. you must first and someone willing to take the opposite position. He.000 but he has no cash to buy it outright. there can sometimes be problems with price transparency and liquidity.

the underlying asset is a real asset. The difference is that. while the seller of financial futures contract delivers the instrument for specified price. you and the seller agree that six months from now. and guarantee all transactions that occur in their exchanges (Jeff Madura. The agreement that you have created is a futures contract. Jordan and W. or money market instruments. Suppose that gold is actually selling for $450 per ounce in six months. A financial futures contract is a standardized agreement to deliver or receive a specified amount of specified financial instrument at specified price and date. currencies. $400 per ounce in six months for the 100 ounces of gold. if gold is selling for $350. four months. usually stocks. and you would have a gain if you sold it. The contract still has two months to run. With your futures contract. on the other hand. If market participants generally believe that gold will be worth more than $400 when the contract matures in two months. In other words. and you want out of the contract? The answer is that you can sell your contract to someone else. If. Thus. typically either an agricultural product (such as cattle or wheat) or a natural resource product (such as gold or oil) (D.000 for 100 ounces of gold (D. no money changes hands today (Ibid). 2009). you will exchange $40. 0000) 5 . With commodity futures. Financial futures contracts are traded on organized exchanges. market participants think gold will not be worth $400. the underlying asset is intangible. with financial futures. The buyer of financial futures buys the financial instrument. However. which establish and enforce rules for such trading. After entering into the futures contract. say. bonds. then your contract is valuable. There are two broad categories of futures contracts: financial futures and commodity futures. 2009). settle. Miller.could do is to strike a deal today with a seller in which you promise to pay. then you would have a loss on the contract if you sold it because you would have to pay someone else to take it off your hands. then you benefit from having entered into the futures contract because you have to pay only $400 per ounce. They clear. Notice that with your futures contract. Futures exchanges provide an organized market place where futures contract can be traded. Jordan and W. say. If this occurs. a futures contract is essentially a bet on the future price of whatever is being bought or sold. what happens if you change your mind in. You would generally have a gain or a loss when you sell. you have locked in the price of gold six months from now. you lose because you are forced to pay $400 per ounce. Miller.

Finally. For commodity futures. 2. Treasury note and bond futures. The identity of the underlying commodity or financial instrument. delivery normally entails sending a warehouse receipt for the appropriate quantity of the underlying commodity. The futures maturity date. After delivery. The futures contract size.S.000 in par value notes or bonds. also called the expiration date. Fourth. This is stating the obvious. The delivery or settlement procedure. a standard gold futures contract specifies a contract size of 100 troy ounces. we must know the specific terms of the contract. Second. but it is important that the obvious is clearly understood in financial transactions. the contract also obligates the buyer to accept the gold delivery and pay the negotiated futures price for the delivered gold. the delivery process must be specified. For U. 4. the standard contract size for gold futures is 100 troy ounces. futures contracts must stipulate at least the following five contract terms: 1. In turn. This means that a single gold futures contract obligates the seller to deliver 100 troy ounces of gold to the buyer at contract maturity.Futures contract features Futures are contracts and. 2009). As stated earlier. respectively. First. the buyer pays warehouse storage costs until the commodity is sold or otherwise disposed. the futures price must be mutually agreed on by the buyer and seller. The futures price. the size of the contract must be specified. For example. a futures contract requires that the underlying commodity or financial instrument be clearly identified. the standard contract size is $100. 6 . in practice. In general. Contract maturity is the date on which the seller is obligated to make delivery and the buyer is obligated to make payment. because it is the price that the buyer will pay and the seller will receive for delivery at contract maturity (D. The third contract term that must be stated is the maturity date. Standardized futures contracts have a set contract size specified according to the particular underlying instrument. 5. Jordan and W. The futures price is quite important. Miller. 3. To properly understand a futures contract. exchange-traded futures contracts are standardized to facilitate convenience in trading and price reporting.

the market price of gold is $820 per ounce. The most convenient way to speculate is to use futures contracts. Selling a futures contract is often called “going short. If you believe that gold prices will increase.” or establishing a short position. Miller. 2009). and three months later. You think that gold will be selling for much more than $800 three months from now. So. When you do. pay $800 per ounce. The opposite is true for a speculator who is short (Ibid). A speculator accepts price risk in an attempt to profit on the direction of prices. suppose you believe the price of gold will go up. or 10. Your profit is $20 per ounce. To illustrate the basics of speculating.000 × $800 = $8. you can speculate by selling gold futures (D. Buying a futures contract is often referred to as “going long. you have an $8 million long gold position. $800 per ounce. if you think gold prices will decrease. Speculating with futures Suppose you are thinking about speculating on commodity prices because you believe that you can accurately forecast future prices. A speculator who is long benefits from price increases and loses from price decreases.000 troy ounces of gold. Your three-month futures contracts have just expired. so you go long 100 gold contracts that expire in three months.000. In futures jargon. suppose the current price for delivery in three months is $800 per ounce (this $800 is called the “futures” price). to fulfill the terms of your long futures position. so 100 contracts represents 10. then you can speculate on this belief by buying gold futures.000 ounces of gold with a total contract value of 10.000 × $20 = $200.” or establishing a long position. you will pay some brokerage commissions and taxes out of this profit. Alternatively. Suppose your belief turns out to be correct. Speculators can go long or short futures contracts. Of course. a viable futures market cannot exist without participation by both hedgers and speculators. you are obligated to take delivery of gold and pay the agreed-upon price. 7 .000.000. Jordan and W. In particular. and immediately sell the gold at the market price of $820 per ounce.Futures Markets Strategies The major economic purpose of futures contracts is to allow hedgers to transfer risk to speculators. Each gold contract represents 100 troy ounces. you accept delivery of 10. Therefore.

In addition.90 = $798. you would gain $168. An important point is that your gains from futures speculation depend on accurate forecasts of the direction of future prices.50 per gallon. 2009). futures speculation can lead to substantial gains and losses.000.000. $775 per ounce. if heating oil prices rose by 40 cents per gallon. futures speculation can lead to substantial gains and losses. As this gold example shows. Once again. 2.000 × $25 = $250. you would lose $25 per ounce.000 × $. Suppose you go long 10 contracts at a futures price of $1. say.Suppose your belief turns out to be incorrect and gold prices fall.000 (less applicable commissions) instead.000 troy ounces at the agreed-upon price of $800 per ounce. suppose you own a regional heating oil distributorship and must keep a large pre heating season inventory of heating oil of. You believe that this will cause heating oil prices to rise. You can speculate on this belief by going long heating oil futures. You must ask yourself: Is it easy to forecast price changes? Consider another example of commodity speculation. This represents a long position with a total contract value of 10 × 42. you will pay some brokerage commissions. or 10 × 42. $1. this heating oil inventory represents a long position in the underlying commodity. For example. we mean that firms purchase and store goods for later resale at market prices. By a working inventory.000.40 =$168. Miller. say. HEDGING WITH FUTURES PRICE RISK Many businesses face price risk when their activities require them to hold a working inventory.000 gallons. Price risk is the risk that the firm will not be able to sell its goods at a price sufficiently higher than the acquisition cost.1 million gallons. The standard contract size for heating oil is 42. You will lose money in this case because you are obligated to buy the 10.90 per gallon. or 10. your loss before commissions would be 40 cents per gallon. The important point from this example is that your gains from futures speculation depend on you making more accurate weather forecasts than other traders (D. Jordan and W. Suppose you analyze weather patterns and you are convinced that the coming winter months will be colder than usual. If the price of heating oil at contract maturity is.000 × $1. In futures market jargon. 8 . say. If gold prices fell to. Of course.

the value of this heating oil inventory can be protected by taking a short position in heating oil futures contracts. the value of the heating oil you have to sell goes down. Hedgers look to add a futures market position to their position in the underlying asset that will provide cash to the hedgers when their position in the underlying asset declines in value. Hedgers often say they are “selling” futures contracts when they are initiating a short position. AN EXAMPLE OF A SHORT HEDGE One of the first questions a hedger has to answer is how many futures contracts are needed to shift risk. the value of the heating oil you have in inventory goes up in value. 9 .000.100. Because you wish to full hedge 2. the hedger is said to have a full hedge.000 = 50 heating oil contracts. However. Because you are using this short position for hedging purposes. In the case of your heating oil enterprise. you have created a short hedge. and not in the business of speculating on heating oil prices.000 gallons per contract. futures position to the position in the underlying asset. you need to sell 2.000/42. Heating oil futures contracts are traded on the New York Mercantile Exchange (NYM) and the standard contract size for heating oil futures is 42. You can think about this using a portfolio approach. Your risk is not trivial. A person or company that wants to shift price risk to others is called a hedger. the heating oil you have in inventory represents a long position in the underlying asset. you decide to remove this price risk from your business operations.If heating oil prices go up. change in value of your short futures position. changes in the value of your long position in the underlying asset are offset by an approximately equal. but opposite.1 million gallons. Because you are in the business of distributing heating oil. When a hedger has an equal. but if heating oil prices fall. Therefore. THE MECHANICS OF SHIFTING PRICE RISK An important function of futures markets is that they allow firms that have price risk to shift it to others who want price risk. Hedgers transfer price risk by taking a futures market position that is the opposite of their existing position in the underlying asset. but opposite. This question has many answers. the cost of adding a futures position is that the futures position draws down cash when the position in the underlying asset generates value. and most can be found in a course devoted to futures contracts and other derivatives. because even a 15-cent per gallon fluctuation in the price of heating oil will cause your inventory to change in value by $315. However. With a short hedge in place. a reasonable hedging strategy is known as a full hedge.

570.100. This means that for a wide range of heating oil selling prices. your pretax profit will be $.000.000/2. you have no futures gain or loss. In the blue line represents your pretax profit per gallon of heating oil for a wide range of possible heating oil selling prices.410. The cost of the heating oil is 2. the purple line remains steady at a value of $. which is $1. 10 .56.000 = $.000.1 summarizes three possible outcomes: heating oil prices remain steady. The cost of the heating oil is 2.180.90 per gallon.000 × $2. The red line represents your futures market gains or losses.50. In this case.1 million gallons of heating oil is $1.16 per gallon. In Figure 14.70 = $3. your pretax profit will remain steady for a wide range of prices.000 × $1. or $1. You view this risk as unacceptable and decide to hedge by selling 50 heating oil futures contracts at a price of $1. revenues are 2.000 = $. As you can see in Table 14. you can forecast your pretax profit per gallon of heating oil.100.50) × 42.30 per gallon.000/2.10 = $4. your pretax futures profit is $840. market conditions in your distribution area were such that you could sell your heating oil to your customers at a price 20 cents higher than the prevailing futures price.40.000.56 per gallon. However. Subtracting this cost and the debt payment of $500. your pretax profit per gallon of heating oil will only be $.730.000 × $1.000 from revenues results in an un hedged pretax profit of $340.000 to the unhedged pretax profit of $340.Suppose the average acquisition price of your 2. you have to make a debt payment of $500. If futures prices fall to $1. your futures gain is $.100.90 -$1. In fact.100. Revenues are 2.2.16. Table 14. If futures prices remain unchanged at $1. We illustrate this result in Figure 14. However.000. suppose heating oil prices fall by $.000 from revenue results in a pretax profit of $1. To see this.2. they increase by $.000. if you had a short hedge in place. or $340.000.30 = $2.000 because ($1.1.730.100.000 × $1.100. Adding $840.90.180.000/2. and that today’s futures price for delivery during your heating season is $1.56 per gallon.40.40.30 = $2.000 × 50 = $840. To help finance your inventory purchases.000. Note that heating oil futures prices and futures contract gains (losses) appear across the top and on the right side of the graph. Given these numbers.90.000.180. During the heating season.000.100. In the past. and they decrease by $. you borrowed money.000 results in a hedged pretax profit of $1. if heating oil prices decrease by $. your pretax profit remains unchanged if you employ the short hedge.56 in all three cases.40.180.000 = $. Subtracting this cost and the debt payment of $500.40.

Note that the firm does not go into the market and establish a short position in the underlying asset. to buy an underlying asset at a fixed price for a specified time. The price you pay to purchase an option. for example. and a great deal is known about them (D. Jordan and W. The most familiar options are stock options. You give the seller $100 to hold the car for one week. you find a better deal elsewhere. This exposure is what gives rise to the saying that the firm is effectively “short the underlying.” OPTION CONTRACTS An option contract is an agreement that gives the owner the right. but not the obligation. the specified price at which the underlying asset can be 11 . Suppose. calls and puts. Miller. its planned business activities create situations where the firm is exposed to price increases in the underlying asset. If you change your mind because.000. it is as if the firm is “short” the underlying asset because if the price increases between now and the time at which the firm actually purchases the underlying asset. or else you lose your $100. is called the option premium. to sell an underlying asset at a fixed price for a specified time. You’ll lose your $100. The owner of a call option has the right. The owner of a put option has the right. Futures contracts are also available for gasoline and natural gas. you can just walk away. but not the obligation. You paid the seller $100 for the right. the firm will pay more than it thought. That would be speculating. You and the seller agree that the price will be $3. that you are interested in buying a used car. the $100 in this example. your business activities might dictate you use another common hedge. but plan to acquire it in the future.Your business activities may also include distributing other petroleum products like gasoline and natural gas. Options occur frequently in everyday life. but not the obligation. Options are a very flexible investment tool. and therefore they may be used for hedging purposes. A few other definitions will be useful. but not the obligation. for example. to buy or sell (depending on the type of option) a specific asset at a specific price for a specific period of time based on some option premium (Margin).000. but that is the price you paid for the right. meaning that you have one week to come up with the $3.000 purchase price. Rather. but not the obligation. known as a long hedge. This agreement is a call option. In this case. 2009). Option terminology Options come in two flavors. to buy. to buy the car for $3. First. In fact. Firms that use a long hedge do not currently own the underlying asset.

exercise of the call is optimal at expiration if the stock price exceeds the exercise price because the exercise proceeds will offset at least part of the cost of the option. if IBM remains below $130 by the expiration date.21.18 at the expiration date. Until the expiration date.$2. exercising the option to buy at $130 clearly would make no sense at that moment. in which case the last trading day is the third Thursday).18: Profit = Final value . the proceeds from exercise will just cover the original cost of the call.18 = -$. The investor in the call will clear a profit if IBM is selling above $132.00 . for $2. For example. On December 2. Exchange-traded options expire on the third Friday of the expiration month. if IBM is selling above $130 at expiration. Jordan and W. IBM sells for $127. The expiration day is the last day (in the case of American-style options) or the only day (in the case of European-style options) on which an option may be exercised (D. the striking price. 2010. The expiration day for stock options is the Saturday immediately following the last trading day. On the other hand. 2009).18. the call will be left to expire worthless. Example 2 Profits and Losses on a Put Option 12 . The last trading day for all listed stock options in the United States is the third Friday of the option’s expiration month (except when Friday falls on a holiday. At that stock price. which for this option was January 15. as it will give its holder the right to pay $130 for a stock worth $132. The value of the option on the expiration date would then be Value at expiration = Stock price .Exercise price = $132 .18 Nevertheless. Indeed.$130 = $2 Despite the $2 payoff at expiration. Miller. the option will be exercised.18 on the investment because the initial purchase price was $2.Original investment = $2. Because the stock price is currently less than $130 a share. the call holder still realizes a loss of $. 2009. if IBM sells for $132 on January 15. or the exercise price.bought or sold with an option contract is called the strike price. Example: Profits and Losses on a Call Option Consider the January 2010 expiration call option on a share of IBM with an exercise price of $130 that was selling on December 2. the call holder will find it optimal to exercise. Using an option to buy or sell an asset is called exercising the option. the purchaser of the calls may buy shares of IBM for $130.

an understanding of stock options requires that we know the specific contract terms. the put turns out to be a profitable investment.00 . The option contract size.Now consider the January 2010 expiration put option on IBM with an exercise price of $130.461. If. Miller. the International Securities Exchange.$4. the Options Clearing Corporation steps in and becomes a party to both sides of the trade. 13 .$123 = $7 and the investor’s profit would be $7. Jordan and W. This is a holding period return of $2. the option buyer effectively purchases the option from the OCC. Its value at expiration would be Value at expiration = Exercise price . and the Boston Stock Exchange. also called the striking or exercise price. founded in 1973. Each option investor simply looks to the OCC (D. 2009.21/$4. The strike price. 2009).1% over only 44 days! Apparently. 2. for $4. Once an option trade is made on an options exchange. Options contract Terms Because options are contracts. In general. It entitled its owner to sell a share of IBM for $130 at any time until January 15. In this way.79 = . each investor is free from the worry that the other party will default.79. If the holder of the put buys a share of IBM and immediately exercises the right to sell at $130. The identity of the underlying stock.79.21. options on common stock must stipulate at least the following six contract terms: 1. In other words. and the seller effectively sells the option to the OCC. net proceeds will be $130 .21 = $2.79 for the put has no intention of exercising it immediately. or 46.79 = $2. an investor who pays $4. IBM sells for $123 at expiration. The Options Clearing Corporation (OCC). Philadelphia Stock Exchange. the Chicago Board Options Exchange. NYSE Arca. is the clearing agency for these options exchanges: the American Stock Exchange. The Options Clearing Corporation Option traders who transact on option exchanges have an important ally.$127. on the other hand. Obviously. selling on December 2. 3.Stock price = $130 . put option sellers on December 2 (who were on the other side of the transaction) did not consider this outcome very likely.

must be stipulated. An option cannot be exercised after its expiration date. in the event that a stock option is exercised. you pay the premium at the time of the purchase. 14 . 6. but not the obligation. The option exercise style. also called the option maturity. Second. For stock options. OPTIONS VERSUS FUTURES Our discussion thus far illustrates the two crucial differences between an option contract and a futures contract. if you buy an option contract. The option expiration date. if you sell an option contract. also called the exercise price. Finally. Options on individual stocks are normally American style.4. to buy. The owner of a call option has the right. standard settlement requires delivery of the underlying stock shares several business days after a notice of exercise is made by the option holder. a stock option contract requires that the specific stock issue be clearly identified. First. Third. The fourth contract term that must be stated is the option expiration date. Miller. The strike price is quite important. There are two basic exercise styles: American and European. Fifth. but European options can be exercised only at expiration. and stock index options are usually European style. the size of the contract must be specified. the option becomes worthless. the option’s exercise style determines when the option can be exercised. in financial transactions it is important that the “obvious” is in fact clearly and unambiguously understood by all concerned parties. While this may seem to be stating the obvious. However. The second important difference is that when you buy a futures contract you pay no money at the time of purchase (and you receive none if you sell). the settlement process must be stipulated. The delivery or settlement procedure. If an option is unexercised and its expiration date has passed. you receive the premium at the time of the sale (D. 5. American options can be exercised any time before option expiration. As stated earlier. the standard contract size for stock options is 100 stock shares per option. The first is that the purchaser of a futures contract is obligated to buy the underlying asset at the specified price (and the seller of a futures contract is obligated to sell). the strike price. Jordan and W. 2009). because the strike price is the price that an option holder will pay (in the case of a call option) or receive (in the case of a put option) if the option is exercised.

OPTION WRITING Thus far. in exchange. Similarly. For example. The two parties to an option contract are the buyer and the seller. To the option writer. the option price (or premium) is a cash outflow. only a small number of basic strategies are available. to exercise the option before the option’s expiration date. The premium is $4 per share. Jordan and W. you both have a zero cash flow when 15 . options are contracts. and every contract must link at least two parties. fortunately for us. To the option buyer. you take the seller’s side of the option contract. The seller of an option is called the “writer. To the option buyer. 2009).” and the act of selling an option is referred to as option writing. we have discussed options from the standpoint of the buyer only. Thus. By buying an option you buy the right. For example. a put writer is obligated to buy stock at the option’s strike price if the buyer decides to exercise the put option (Ibid). suppose the current price of IBM stock is $80 per share. option writing involves receiving the option price and. By selling or writing an option. If IBM is at $70. a payoff entails a cash inflow. the option price (or premium) is a cash inflow. but not the obligation. However.Option Payoffs and Profits In fact. also called the option premium. OPTION PAYOFFS It is useful to think about option investment strategies in terms of their initial cash flows and terminal cash flows. However. a payoff entails a cash outflow. a call writer is obligated to sell stock at the option’s strike price if the buyer decides to exercise the call option. We discuss the payoffs from these basic strategies here and in the next section (D. Miller. assuming the obligation to satisfy the buyer’s exercise rights if the option is exercised. there is essentially no limit to the number of different investment strategies available using options. then you experience a cash inflow of $10 per share. The initial cash flow of an option is the price of the option. whereas the writer experiences an outflow of $10 per share. You buy a call option on IBM with a strike price of $80. What are the terminal cash flows for you and the option writer if IBM has a price of $90 when the option expires? What are the terminal cash flows if IBM has a price of $70 when the option expires? If IBM is at $90. the initial cash flow is -$400 for you and +$400 for the option writer. To the writer. and more complicated strategies are built from these. The terminal cash flow of an option is the option’s payoff that could be realized from the exercise privilege. As a result.

just with opposite signs.3 Protective Put Suppose the strike price is X = $100 and the stock is selling at $97 at option expiration. Notice that in both cases the buyer and the seller have the same cash flows. say. You might consider instead investing in stock and purchasing a put option on the stock. Whatever happens to the stock price. Investing in the stock alone seems risky to you because in principle you could lose all the money you invest. $104. Kane and Marcus. 2011). if the stock price is above $100. Jordan and W. The right to sell locks in a minimum portfolio value of $100. Option Strategies An unlimited variety of payoff patterns can be achieved by combining puts and calls with various exercise prices.ST = $100 . On the other hand. The stock is worth $97 and the value of the expiring put option is X .1 shows the total value of your portfolio at option expiration: Example 20. Protective Put Imagine you would like to invest in a stock. 2009).the option expires because it is worthless.$97 = $3 Another way to look at it is that you are holding the stock and a put contract giving you the right to sell the stock for $100. then the right to sell a share at $100 is 16 . but you are unwilling to bear potential losses beyond some given level.” meaning that any gains to the buyer must come at the expense of the seller and vice versa (D. This shows that options are a “zero sum game. We explain in this section the motivation and structure of some of the more popular ones (Bodie. Table 20. Then the value of your total portfolio is $100. Miller. you are guaranteed a payoff at least equal to the put option’s exercise price because the put gives you the right to sell your shares for that price.

ending up with a share of stock worth S T = $104 (Ibid). Suppose the portfolio manager intends to sell all 1. The stock will either double in value if the case is settled favorably or will drop by half if the settlement goes against the 17 . suppose you believe an important court case that will make or break a company is about to be settled.000 shares of stock. 2011). equals the stock value minus the value of the call.000 shares if the share price hits $110.4 Covered Call Assume a pension fund holds 1.worthless. Straddles are useful strategies for investors who believe a stock will move a lot in price but are uncertain about the direction of the move. and a call expiring in 60 days with an exercise price of $110 currently sells for $5. The call value is subtracted because the covered call position involves writing a call to another investor who may exercise it at your expense. T. it would not have realized those profits anyway (Bodie. You allow the put to expire unexercised.000 in extra income. with a current price of $100 per share. and the market is not yet aware of the situation. The value of a covered call position at the expiration of the call. For example. presented in Table 20. X. The call is “covered” because the potential obligation to deliver the stock is covered by the stock held in the portfolio. By writing 10 call contracts (for 100 shares each) the fund can pick up $5.2 . Covered Calls A covered call position is the purchase of a share of stock with a simultaneous sale of a call on that stock. Straddle A long straddle is established by buying both a call and a put on a stock. each with the same exercise price. The fund would lose its share of profits from any movement of the stock price above $110 per share. and the same expiration date. but given that it would have sold its shares at $110. Example 20. Kane and Marcus. Writing an option without an offsetting stock position is called by contrast naked option writing.

and the investor’s outlay for the purchase of both options is lost. The straddle position will do well regardless of the outcome because its value is highest when the stock price makes extreme upward or downward moves from X. whereas another call with identical expiration date. or written. both the call and the put expire worthless. The payoff to this position will be the difference in the value of the call held and the value of the call written. are bets on volatility. Strips and straps are variations of straddles. a middle region where S T is between the two exercise prices. Some options are bought. Conversely. They accept the option premiums now. as in Table 20.company. investors who write straddles selling both a call and a put must believe the stock is less volatile. The worst-case scenario for a straddle is no movement in the stock price. A strip is two puts and one call on a security with the same exercise price and maturity date. is written. therefore. hoping the stock price will not change much before option expiration.4 . Figure 20. Spreads A spread is a combination of two or more call options (or two or more puts) on the same stock with differing exercise prices or times to maturity. Straddle positions.10 illustrates the payoff and profit 18 . but higher exercise price. A money spread involves the purchase of one option and the simultaneous sale of another with a different exercise price. A strap is two calls and one put (Ibid). There are now three instead of two outcomes to distinguish: the lowest-price region where S T is below exercise prices. and a high- price region where S T exceeds both exercise prices. If S T equals X. An investor who establishes a straddle must view the stock as more volatile than the market does. whereas others are sold. Consider a money spread in which one call option is bought at an exercise price X 1. A time spread refers to the sale and purchase of options with differing expiration dates. X 2.

the investor will do no better than $110.000. requires that the investor pay the put premium.000 shares of stock currently selling at $100 per share. which is called a bullish spread because the payoff either increases or is unaffected by stock price increases. The call might sell for roughly the same price as the put. A lower bound of $90 can be placed on the value of the portfolio by buying a protective put with exercise price $90.000.to this strategy. If you are contemplating buying a house for $220. To raise the money to pay for the put. Example 20. and you are unwilling to risk losing more than $20. because at a higher price the stock will be called away. (2) purchasing 2. Your current wealth may be $200. A collar established by (1) purchasing 2. an investor who believes an X = $100 call is cheap compared to an X = $110 call might establish the spread. Thus the investor obtains the downside protection represented by the exercise price of the put by selling her claim to any upside potential beyond the exercise price of the call. which is currently selling at $100 per share. you might set this figure as your goal. Collars A collar is an options strategy that brackets the value of a portfolio between two bounds. even without a strong desire to take a bullish position in the stock (Bodie. 2011). Holders of bullish spreads benefit from stock price increases. however. the investor might write a call option. say. Even if the stock price moves above $110. One motivation for a bullish spread might be that the investor thinks one option is overpriced relative to another.5 Collars A collar would be appropriate for an investor who has a target wealth goal in mind but is unwilling to risk losses beyond a certain level. meaning that the net outlay for the two options positions is approximately zero. For example. This protection. Writing the call limits the portfolio’s upside potential. Suppose that an investor currently is holding a large position in FinCorp stock.000. Kane and Marcus.000 put 19 . with exercise price $110. for example.

to firms that wish to hedge a profit stream that depends on the average price of a commodity over some period of time. and in recent years we have witnessed considerable innovation in the range of option instruments available to investors. Look back Options Look back options have payoffs that depend in part on the minimum or maximum price of the underlying asset during the life of the option. this is reflected in the heavy trading volume in these markets. Success breeds imitation. which now trade in active over the counter markets. down-and in options will not provide a payoff unless the stock price does fall below some barrier at least once during the life of the option. Exotic Options Options markets have been tremendously successful. an Asian call option may have a payoff equal to the average stock price over the last 3 months minus the strike price if that value is positive. Barrier Options Barrier options have payoffs that depend not only on some asset price at option expiration. Similarly. they are therefore called “exotic options.” For example. 2011).” In this section we survey some of the more interesting variants of these new instruments (Bodie. of 20 . Asian-style options are options with payoffs that depend on the average price of the underlying asset during at least some portion of the life of the option.and European-style options.000. a down-and-out option is one type of barrier option that automatically expires worthless if and when the stock price falls below some barrier price.000 calls with exercise price $110 would give you a good chance to realize the $20. Part of this innovation has occurred in the market for customized options. For example. Many of these options have terms that would have been highly unusual even a few years ago. Asian Options You already have been introduced to American. Investors clearly value the portfolio strategies made possible by trading options. instead of the final stock price minus the exercise price. For example.options (20 options contracts) with exercise price $90. but also on whether the underlying asset price has crossed through some “barrier. Kane and Marcus. and (3) writing 2. These options also are referred to as knock-out and knock-in options.000 capital gain without risking a loss of more than $20. Such an option provides (for a price. a look back call option might provide a payoff equal to the maximum stock price during the life of the option minus the exercise price. and zero otherwise. for example. These options may be of interest.

however. providing the call holder with a payoff equal to the one that would accrue if the asset were purchased for X dollars and later sold at what turns out to be its high price. for instance interest rate risk. There are two major types of Swaps: interest rate and currency. These streams or each side of the swap are called the legs of the swap. Swaps are long-term OTC instruments.course) a form of perfect market timing. which allows an investor to fix in advance the exchange rate at which an investment in a foreign currency can be converted back into dollars. a digital call option might pay off a fixed amount of $100 if the stock price at maturity exceeds the exercise price SWAPS Swaps are an agreement between two counter streams to exchange cash flows in the future according to predetermined formulas. also called binary or “bet” options. A good example of such an option is the quanto. Swaps are considered to be interest rate risk management tools because they give an efficient means of adjusting the interest rate exposure of a company’s assets and liabilities. Another use is speculation. have fixed payoffs that depend on whether a condition is satisfied by the price of the underlying asset. Quantos are more interesting. such as exchange-traded interest rate futures and option contracts. The cash flows are calculated over a notional principal amount. Digital Options Digital options. are often capable of achieving the similar results. A great flexibility in setting the terms of the swap agreement makes it a very effective instrument in risk management (Jeff Madura). It should be noted that other financial instruments. An interest rate swaps occur when two parties exchange interest payments periodically. Currency-Translated Options Currency-translated options have either asset or exercise prices denominated in a foreign currency. Therefore. Swaps are often used to hedge certain risks. For example. Currency swaps are agreement to deliver one currency against another. 21 . because the amount of currency that will be translated into dollars depends on the investment performance of the foreign security. The right to translate a fixed amount of foreign currency into dollars at a given exchange rate is a simple foreign exchange option. a quanto in effect provides a random number of options.

S. dollars at an agreed-upon forward price at one single date. rather than agreeing to exchange British pounds for U. a foreign exchange swap would call for an exchange of currencies on several future dates. One party might exchange a variable cash flow equal to $1 million times a short term interest rate for $1 million times a fixed interest rate of 8% for each of the next 7 years. 22 . with well over $500 trillion in swap agreements outstanding (Bodie. Similarly. The parties might exchange $2 million for £1 million in each of the next 5 years.Swaps are multiperiod extensions of forward contracts. For example. 2011). interest rate swaps call for the exchange of a series of cash flows proportional to a given interest rate for a corresponding series of cash flows proportional to a floating interest rate. Kane and Marcus. The swap market is a huge component of the derivatives market.

1st Ed. Cengage Learning.. Jordan and Thomas W. 2016. 2. 4. McGraw- Hill Companies. Bodie. Alex Kane.REFERENCES 1. 2010 3. Martin Haugh Foundations of Financial Engineering. Jeff Madura. Miller Jr. Fundamentals of Investments. 9th Ed. Investments. Bradford D. 9th Ed. 5th Ed. 2010. 23 . Financial Markets and Institutions. 2011. Alan Marcus. McGraw-Hill Irwin.