Copyright © Alberto Manconi 2016–today, all rights reserved.

The material in this reader is made available only for personal use
by the students of my Introduction to Options and Futures course at
Bocconi University. This reader or any portion thereof may not be
distributed, reproduced, or used in any manner whatsoever without
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1
Financial Derivatives

The analysis of financial derivatives ranks among the finest

accomplishments of the discipline of financial economics. The initial
breakthroughs of Black and Scholes (1973) and Merton (1973) have
given birth to an entire literature devoted to designing, pricing, and
applying derivative products in a variety of contexts. The crowning
achievement has been perhaps the award of the Nobel prize in eco-
nomics to Robert Merton and Myron Scholes in 1997 (Fisher Black
died before he could be awarded the prize).
At the same time, derivatives have received bad press in recent
years. Scandals such as the downfall of the Long–Term Capital Man-
agement (LTCM) hedge fund, whose board included Scholes and
Merton, the crippling losses inflicted on banks by rogue derivatives
traders (Nick Leeson at Barings in 1995, or Jérôme Kerviel at Société
Générale in 2008), as well as some narratives of the 2008 financial
crisis, fueled criticism of derivative products. Memorably, Warren
Buffett referred to these securities as “financial weapons of mass de-
struction” suggesting that the risks associated with them may out-
weight the benefits.
We cannot do full justice to this fascinating debate in the short
time allocated to our class. That said, I will equip you with the tools
to understand the debate, and to formulate your own opinion based
on solid theoretical ground.

Preparation questions

1. What are financial derivatives, and how are they used?

2. What is leverage, and how to derivatives help create it?

3. What are the risks associated with leverage?

1.1 What are derivatives?

We may not notice it, but we enter derivative contracts all the time.
For instance, suppose you buy a car. The car dealer offers you a
4 introduction to options and futures

price of $20,000, and you agree on it; as you place your order, you
+$2,000 commit to taking delivery of the car in 3 months.
You have just entered a forward contract. The value of the for-
18 20 22 Car price in 3
months ($000)
ward at maturity depends on car price quotes in 3 months’ time, as
–$2,000
illustrated in Fig. 1.1. If the price falls to $18,000, we lose money: We
are committed to paying $2,000 above the market price. If, on the
other hand, the price rises to $22,000, we make money: We can buy
Figure 1.1: Payoff in our forward contract
the car at $2,000 below market prices.
Suppose now that you need some time before you can commit to
buying the car, and pay the dealer a non–refundable $500 to hold the
$20,000 for you for the next 3 months. At the end of that period, that
is, you will have the right, but not the obligation, to buy the car for
20 Car price in 3
months ($000) $20,000. You have just entered an option contract.
–$500
The value of the option at maturity depends, again, on car price
quotes in 3 months’ time, as illustrated in Fig. 1.2. If the price falls to
Figure 1.2: Payoff in our option contract
$18,000, we lose our initial $500 outlay, but we are not committed to
buying the car, i.e. we need not exercise the option. If, on the other
hand, the price rises to $22,000, we make money: We can buy the
care at $2,000 below market prices.
Generalizing from these two examples, we can define a derivative
as a (financial) contract, whose value depends on the future value of
an underlying asset (in our examples, car prices).

1.2 Derivative contracts

In principle, there may be an infinite number of derivatives out there

— the limit is the imagination of financial engineers. Some kinds of
derivatives, however, are very common in practice. They can be used
as building blocks to define other derivatives, and more importantly,
studying them can give you a foundation to one day look at more
complex ones. We will thus concentrate on them in our classes.
Forwards In a forward contract, the buyer and seller agree today on the
delivery of a specified quantity and quality of an asset at a future
date, for a given price. For instance, buyer and seller agree today
to trade 1,248 barrels of Brent crude oil in 3.7 months for a price of
$25,700.
Futures Futures are similar to forwards, except they have a standardized
specification and are typically traded on organized exchanges. For
instance, NYMEX Brent crude oil futures contracts are traded, with
a standard size of 1,000 barrels, with a variety of maturities (quotes
can be found at the CBOE’s webpage). In addition, while in a for-
ward any profits and losses are realized at maturity, futures P&L are
realized daily, in a process known as mark–to–market.
Options Investors who enter a forward or a futures contract commit to
trading at maturity. In contrast, the buyer of a call option contract
obtains the right, but not the obligation, to buy a given asset at a
given strike price. Likewise, the buyer of a put option obtains the
right, but not the obligation, to sell a given asset at a given strike
price. American options give their holders the right to exercise (buy,
 financial derivatives 5

if a call; sell, if a put) at any date until maturity. European options

provide the right to exercise only at maturity.
Swaps involve the periodic exchange of cash flows between two Swaps
parties. An example can be a fixed–for–floating interest rate swap:
We agree to make fixed 5% payments, against receiving LIBOR + 4%
payments, on a given nominal principal, say $1 million.

1.3 Uses and users of derivatives

Why are there derivative products? The key driver is risk. The use
of derivatives as hedging instruments is very ancient, going all the
way back to ancient Egypt apparently. Originally, they were used
to hedge against the volatility in the prices of agricultural products,
such as wheat, rice, grain. Since the 1970s, there has been an ex-
plosion of derivatives on financial assets, such as foreign exchange,
interest rates, stocks. Since at least the 1980s, credit derivatives have
also experienced significant growth.
Hedgers, speculators, and arbitrageurs are the main users of de-
rivatives. When an investor is exposed to a risk they do not want
to bear, they may enter a derivative contract to transfer it to another
party who is willing to accept it. In that case, the investor is a hedger.
This is the use of derivatives we will focus on in our course; we will
examine a number of examples in our classes.
Speculators, on the other hand, are happy to bear risk. They buy
or sell derivative contracts in the hope to profit from future price
changes. Finally, arbitrageurs trade derivatives with the objective of
exploiting mispricing in the market, to make a profit. Sophisticated
investors such as hedge fund engage in arbitrage; such investors can
play an important role in the market, eliminating arbitrage oppor-
tunities. As we are going to see, assuming “no arbitrage” can often
help us define the equilibrium price of derivatives (it plays a cru-
cial role, for instance, in the Black–Scholes–Merton equation). Much
of the trades of hedgers, speculators, and arbitrageurs do not take
place on organized exchanges, as derivatives are, by and large, over
the counter (OTC) products.

1.4 Financial derivatives, leverage, and risk

As we anticipated, financial derivatives have received very bad press,

and there is an ongoing debate, even among the general public, on
the risks associated with these products. So are derivatives “evil”
in some sense? Are they really “financial weapons of mass destruc-
tion”? In fact, derivatives are just versatile financial instrument that,
by virtue of their very versatility, can be abused.
One feature at the center of attention is the leverage that deriva- Leverage
tives can generate. In this context, leverage means the ability to
take large speculative positions with little initial capital. Consider,
for instance, a foreign exchange trader who would like to obtain a
£250,000 exposure to the British pound. She may proceed in two
6 introduction to options and futures

ways. First, she may directly purchase pounds on the (spot) market,
at an exchange rate of, say, $1.4470/£. This requires a payment of
£250,000 × $1.4470/£ = $361,750. Alternatively, she may enter fu-
tures contracts on the $/£ exchange rate. The size of one contract
is £62,500, so she will take a long position on four contracts. En-
tering them involves no initial payment other than a $20,000 margin
account (we’ll discuss what this means in chapter 2), or just over 5%
compared to the capital required for a spot trade.
This may seem like a generally good thing: using derivatives, even
investors who have small initial capital can participate in the market.
The drawback of that is increased risk. For instance, losses matter a
lot more if you have a smaller initial capital. In our example, if the
pound depreciates to $1.4000/£, the investor loses $11,750, or about
3% of her capital. Suppose, on the other hand, that the futures quote
is also $1.4470/£, so that the futures investor also loses $11,750 if
the pound depreciates to $1.4000/£: That would wipe out more than
50% of the investor’s capital. Leverage, therefore, can be associated
with large losses relative to the upfront investment.
This is just as visible with options. Suppose you have a hunch that
IBM stock, currently trading at $20, will rise in value, and you have
$2,000 to invest. You can, of course, buy 100 IBM shares. On the other
hand, you could also buy 20 option contracts with strike price $22.5,
each giving you the right to buy 100 shares, at an option premium
of $1 per stock (i.e. using up your $2,000 capital; we’ll discuss option
pricing at some length in our classes). Suppose now that IBM stock
rises to $27. If you bought 100 shares, you make a profit of $700. If
you bought options, you gain $4.50 on each stock you buy, so that
your profits are 2,000 × $4.50 = $9,000. Suppose, however, that IBM
stocks drop to $15. If you bought 100 shares, you make a loss of $500.
If you bought options, however, you will be unable to exercise them,
thus losing your entire $2,000 initial capital.