Introduction to Derivative Securities

AF5351 Derivative Securities

Shixiang Xia
Overview
• Introduction to derivatives markets
• Uses of derivatives
• Types of major derivative securities
• Options diagrams

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Introduction
• A derivative is an instrument whose value depends on the value of an
underlying variable/asset.
– Interest rate or foreign exchange rate
– Index value such as a stock index value
– Commodity price
– Common stock
– Etc.

• Thus, the value of a derivative is ‘derived’ from another variable.

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Introduction
⚫ Derivatives markets are very useful, perhaps even essential, parts of
the financial system
– hedging or risk management
– speculate or strive for enhanced returns
– price discovery - insight into future prices of commodities

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Derivatives & Risk
⚫ Derivative markets neither create nor destroy wealth - they
provide a means to transfer risk
– zero sum game in that one party’s gains are equal to another party’s losses
– participants can choose the level of risk they wish to take on using
derivatives
– with this efficient allocation of risk, investors are willing to supply more funds
to the financial markets, which enables firms to raise capital at reasonable
costs $10 borrow 90,= total $100
goes up 10% = $110
$110 - 90 = $20 (100% profit)

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Derivatives & Risk
⚫ Derivatives are powerful instruments
⚫ They typically contain a high degree of leverage, meaning that small
price changes can lead to large gains and losses
⚫ This high degree of leverage makes them effective but also
‘dangerous’ when misused.

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The Basic Derivatives
Futures Options
✓Calls
Forward ✓Puts
Derivatives

Swaps
✓Interest rate swap
✓Foreign currency swap

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Derivative Markets
• Exchange-traded futures and options
– standardized products
– trading floor or computerized trading
– virtually no credit risk

• Over-the-Counter forwards, options, & swaps

– often non-standard (customized) products
– telephone (dealer) market
– some credit risk

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Uses of Derivatives
• To hedge or insure risks, i.e., shift risk.
• To reflect a view on the future direction of the market, i.e., to
speculate.
• To lock in an arbitrage profit.
• To change the nature of an asset or liability.
• To change the nature of an investment without incurring the costs of
selling one portfolio and buying another.

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Types of Derivative Traders

• Hedgers (Risk Shifters)

• Speculators (Risk Takers)
• Arbitraguers (Alchemists)

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Hedging
⚫ If someone bears an economic risk and uses the futures market or
other derivatives to reduce that risk, the person is a hedger

⚫ Hedging is a prudent business practice; today a prudent manager

has an obligation to understand and apply risk management
techniques including the use of derivatives

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Hedging examples

• (1). A US company will pay £10 million for imports from Britain in 3
months and decides to hedge foreign exchange risk using a long
position in a forward contract

• (2). An investor owns 1,000 Microsoft shares currently worth $28 per
share. A two-month put with a strike price of $27.50 costs $1. The
investor decides to hedge by buying 10 contracts

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Value of Microsoft Shares with and
without Hedging
Value of Holding ($)
40,000

35,000

No Hedging

Hedging

30,000

25,000

20,000
20 25 30 35 40
Stock Price ($)

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Speculation
⚫ A person or firm who accepts the risk the hedger does not want to
take is a speculator

⚫ Speculators believe the potential return outweighs the risk

⚫ The primary purpose of derivatives markets is not speculation. Rather,

they permit or enable the transfer of risk between market
participants as they desire without the need to trade the underlying

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Speculation example

• An investor with $2,000 to invest feels that a stock price will

increase over the next 2 months. The current stock price is $20 and
the price of a 2-month call option with a strike of 22.50 is $1

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Hedgers and Speculators

Risk Transfer
Hedgers Speculators

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Arbitrage
⚫ Arbitrage is the existence of a riskless profit

⚫ Arbitrage opportunities are quickly exploited and eliminated in

efficient markets
– Arbitrage then contributes to the efficiency of markets

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Arbitrage
⚫ Persons actively engaged in seeking out minor pricing
discrepancies are called arbitrageurs
⚫ Arbitrageurs keep prices in the marketplace efficient
– An efficient
market is one in which securities are priced in accordance
with their perceived level of risk and their potential return
⚫ The pricing of options incorporates this concept of arbitrage

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Arbitrage example

• A stock price is quoted as £100 in London and $150 in New York

• The current exchange rate is $1.5300/£
• What is the arbitrage opportunity, assuming no transaction cost?

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Danger

• Traders can switch from being hedgers to speculators or from being

arbitrageurs to speculators
• It is important to set up controls to ensure that trades are using
derivatives in for their intended purpose

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Dangers: Example of Barings Bank
Disaster, 1995
• Nick Leeson, a trader in the Singapore office, was employed to exploit arbitrage
opportunities between the Nikkei 225 futures prices traded on exchanges in
Singapore and Japan
• He started to move from trading as an arbitrageur to become a speculator without
letting the head office in London know
• At some point he made some losses, which he was able to hide from the head office
for a while
• Subsequently he started to take bigger speculative positions in the hope to recover
his previous losses
• By the time his activity was uncovered his total loss accounted for almost $1 billion
• Barings bank (over 200 years old) was bankrupt
• Nick Leeson was sentenced to 6.5 years in prison in Singapore
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The Importance of this Subject - I
• The sheer magnitude of size of this market, in itself, makes this an interesting topic.

• Firms and individuals face financial risks that are greater than ever.

• Derivative markets allow participants to shed, or hedge, risk.

• Derivative markets allow participants to take risk, i.e., speculate.

• Using derivatives allows individuals and firms to create payoff patterns that are
compatible with their beliefs and degree of risk aversion, at a low cost.

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 The Importance of this Subject - II
• You will understand the vital linkage between the underlying market (aka the spot
market or the cash market) and the derivative market.
• You will see that the price of the derivative depends on the price of the underlying
asset.
• You will see what caused many derivative “disasters” of recent times: i.e., Baring’s
Bank, Long Term Capital Management.
• You will avoid derivative disasters:
– you will learn to avoid using derivatives when you do not understand their risks
– you will learn how to use derivatives correctly because you will understand their
risks and rewards.

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The Importance of this Subject - III
A broad range of institutions can make productive use of derivative assets:
⚫ Financial institutions
– Investment houses
– Asset-liability managers at banks
– Bank trust officers
– Mortgage officers
– Pension fund managers
⚫ Corporations - oil & gas, metals, forestry etc.
⚫ Individual investors/speculators

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Studying Derivatives
⚫ The study of derivatives involves a vocabulary that essentially becomes a new
language
– Implied volatility
– Delta hedging
– Short straddle
– Near/In/At/Out of-the-money
– Gamma neutrality
– Etc.

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Forward Contracts - I
• A forward contract gives the owner the right and obligation to buy a
specified asset on a specified date at a specified price.

• The seller of the forward contract has the right and obligation to sell
the asset on the date for the price.

• At the end of the forward contract, at “delivery,” ownership of the good is

transferred and payment is made from the purchaser to the seller.

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Forward Contracts - II
• Generally, no money changes hands on the origination date of
the forward contract.
• However, collateral may be demanded.
• Delivery options may exist concerning
– the quality of the asset
– the quantity of the asset
– the delivery date
– the delivery location.
• If your position has value, you face the risk that your counterparty will
default.

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 Forward Contracts - III
• On August 27, 2002, you enter into an agreement to buy £1 million in
six months at a forward exchange rate of $1.5028/ £. The spot
exchange rate is $1.5250/£.
• This obligates the trader to pay $1,502,800 for £1 million on
February 27, 2003.
• What happens if the spot exchange rate on February 27, 2003 is
$1.60/£? $1.40/£?
Buyer will gain when 1.60 and lose when 1.40

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Forward Contracts - IV
Profit Profit

change in
forward price

change in
forward price

Profit Diagram for a

Profit Diagram for a short
long forward position
forward position

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Futures vs. Forwards - I
Forward could have credit risk
• Futures are similar to forwards, except: forwards are traded in OTC

– Futures trade on futures exchanges (CME, CBOT, ICE, etc.).

– Futures are standardized contracts
• this increases their liquidity
• but sometimes firms prefer precise, custom made (OTC) forward contracts

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Futures vs. Forwards - II
– Default risk for futures is lower because:
• The clearinghouse of the exchange guarantees payments.
• An initial margin is required.
• Futures contracts are “marked to market” daily (daily resettlement)

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Large Global Futures Exchanges
• Eurex (Germany & Switzerland)
• Chicago Mercantile Exchange (U.S.)
• Chicago Board of Trade (U.S.)
• BM&F (Brazil)
• NY Mercantile Exchange (U.S.)
• Tokyo Commodity Exchange (Japan)
• London Metal Exchange (UK)
• Paris Bourse SA (France)
• Sydney Futures Exchange (Australia)

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Futures/Forward Contracts – History
(optional)
⚫ Forward contracts on agricultural products began in the 1840’s
– producer made agreements to sell a commodity to a buyer at a price
set today for delivery on a date following the harvest
– arrangements between individual producers and buyers - contracts
not traded
– by 1870’s these forward contracts had become standardized (grade,
quantity and time of delivery) and began to be traded according to
the rules established by the Chicago Board of Trade (CBT)

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Futures/Forward Contracts – History
(optional)
⚫ 1891 the Minneapolis Grain Exchange organized the first
complete clearinghouse system
– the clearinghouse acts as the third party to all transactions on the
exchange
– designed to ensure contract integrity
⚫ buyers/sellers required to post margins with the clearinghouse
⚫ daily settlement of open positions - became known as the mark-market system

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Futures/Forward Contracts – History
(optional)
⚫ Key point is that commodity futures (evolving from forward contracts)
developed in response to an economic need by suppliers and users of various
agricultural goods initially and later other goods/commodities - e.g metals and
energy contracts
⚫ Financial futures - fixed income, stock index and currency futures markets
were established in the 70’s and 80’s - facilitated the sale of financial
instruments and risk (of price uncertainty) in financial markets

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Swaps
⚫ Swaps are arrangements in which two parties exchange cash flows
or payments for a certain time
⚫ The swap market is very large, with trillions of dollars outstanding in
swap agreements
⚫ Currency swaps
⚫ Interest rate swaps
⚫ Commodity & other swaps - e.g. crude oil

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Interest Rate Swap

⚫ In an interest rate swap, one firm pays a fixed interest rate on a

sum of money and receives from some other firm a floating
interest rate on the same sum

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An Example of a ‘Plain Vanilla’ Interest
Rate Swap
• I agree to pay you 8% of $40 million each year for the next five years.
• You agree to pay me whatever 1-year LIBOR is (times $40 million) for each of the
next five years.
• $40 million is the notional principal. neither you and me will pay $40 million

• If LIBOR > 8%, you pay me: (LIBOR - 8%) * $40 million
• If LIBOR < 8%, I pay you: (8% - LIBOR) * $40 million
• I am long five Forward Rate Agreements (FRAs), with delivery dates at the end of
each of the next five years.
• You are short five Forward Rate Agreements (FRAs), with delivery dates at the end
of each of the next five years.

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Swaps
• Credit risk only involves the Present Value of the remaining expected
cash flows from the swap.

• Credit risk does NOT involve the notional principal.

• Only the party that expects to be paid the remaining net cash flows
faces current default risk.

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Foreign Currency Swap
⚫ In a foreign currency swap, two firms initially trade one
currency for another
⚫ Subsequently, the two firms exchange interest payments, one
based on a foreign interest rate and the other based on a U.S.
interest rate
⚫ Finally, the two firms re-exchange the two currencies

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Commodity Swap

⚫ Similar to an interest rate swap in that one party agrees to pay a

fixed price for a notional quantity of the commodity while the
other party agrees to pay a floating price or market price on the
payment date(s)

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Options

⚫ An option is the right, but not obligation, to either buy or sell

something at a set price, within a set period of time

⚫ You can exercise an option if you wish, but you do not have to do so

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Call Options
• A call option is a contract that gives the owner of the call option the right, but not the
obligation, to buy an underlying asset, at a fixed price (K), on (or sometimes before) a
pre-specified day, which is known as the expiration day.

• The seller of a call option, the call writer, is obligated to deliver, or sell, the underlying
asset at a fixed price, on (or sometimes before) expiration day (T).

• The fixed price, K, is called the strike price, or the exercise price.

• Because they separate rights from obligations, call options have value.

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Put Options
• A put option is a contract that gives the owner of the put option the right, but not the
obligation, to sell an underlying asset, at a fixed price (K), on (or sometimes before) a
pre-specified day, which is known as the expiration day.

• The seller of a put option, the put writer, is obligated to buy, the underlying asset at a
fixed price, on (or sometimes before) expiration day (T).

• The fixed price, K, is called the strike price, or the exercise price.

• Because they separate rights from obligations, put options have value.

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Options Exchanges
⚫ Chicago Board of Trade
⚫ Chicago Mercantile Exchange
⚫ New York Mercantile Exchange
⚫ Montreal Exchange
⚫ Philadelphia exchange - currency options
⚫ London International Financial Futures Exchange (LIFFE)
⚫ London Traded Options Market (LTOM)
⚫ Others- Australia, Switzerland, etc.
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Option Contracts – History (optional)
⚫ Chicago Board Options Exchange (CBOE) opened in April of
1973
– call options on 16 common stocks
⚫ The widespread acceptance of exchange-traded options is
commonly regarded as one of the more significant and successful
investment innovations of the 1970’s
⚫ Today we have option exchanges around the world trading
contracts on various financial instruments and commodities

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 Options vs. Futures
⚫ Both options and futures contracts exist on a wide variety of assets
– Options trade on individual stocks, on market indexes, on metals, interest
rates, or on futures contracts you dont have to buy or sell the underlying assets for options
you have the obligations to buy or sell the asset for futures
– Futures contracts trade on agricultural commodities such as wheat, live cattle,
precious metals such as gold and silver and energy such as crude oil, gas and
heating oil, foreign currencies, U.S. Treasury bonds, and stock market indexes

⚫ The underlying asset is that which you have the right to buy or sell (with
options) or the obligation to buy or deliver (with futures)

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Options vs. Futures
• Recall that a futures contract is an obligation to deliver or purchase a specific
commodity as a predetermined time & price
• An option contract gives the holder the option to buy or sell a specific
commodity at a predetermined time & price
• Only the purchaser (long position) of the contract gets the option. The seller
(short position) has to obligation to buy/sell if the option is exercised.
• An option, however, does have an up front cost (the price of the option)

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Options vs. Futures
⚫ Options are securities and are regulated by the Securities and Exchange
Commission (SEC) in the U.S

⚫ Futures contracts are regulated by the Commodity Futures Trading

Commission (CFTC) in the U.S.

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 “Vanilla” Options

• Any option is defined by four characteristics: commodity, size,

exercise (strike) price, and term.
• A call option gives the holder the option to purchase a commodity
at the strike price
• A put option gives the holder the option to sell a commodity at the
strike price

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Payoff Diagram for a Long Call Position,
at Expiration
Expiration Day Value, CT

45o
0
K ST

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Profit Diagram for a Long Call Position,
at Expiration
We lower the payoff diagram by the call
price (or premium), to get the profit diagram
Profit

0
call premium K ST

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Profit Diagram for a Short Call Position,
at Expiration

Profit

Call premium
0
K ST

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Payoff diagram for a long put position,
at expiration
K
Value on
Expiration
Day, PT

0
K ST

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Profit Diagram for a Long Put Position,
at Expiration
Lower the payoff diagram by
Profit
the put price, or put premium,
to get the profit diagram

0
K put premium S T

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Profit Diagram for a Short Put Position,
at Expiration Payoff

Profit

0
K ST

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Using Options in Risk Management, I:
Options Provide Insurance
Suppose a firm’s value is ‘exposed’ to the risk
that some price will decrease

ΔV

ΔP

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Suppose the Firm Buys An at-the-money
Put Option
ΔV

Underlying
Exposure

ΔP
Long Put

Recall: The firm is exposed to the risk that a price will decline

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This is the Resulting “Net” Exposure
Underlying
ΔV Exposure

ΔP
Net Exposure Long Put

Buying the put = buying insurance

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Using Options in Risk Management, II:
Options Provide Insurance
Suppose a firm’s value is ‘exposed’ to the risk
that some price will increase

ΔV

ΔP

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Buying a call option provides insurance against
an increase in the price of an underlying
security, an increase that would hurt the firm.
ΔV

Long Call

ΔP
Underlying Risk
Exposure

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The resulting Net Payoff Profile of Adding a
Long Call Option to a ‘Short’ Underlying Risk
Position
Note that the firm is “hedged” if prices rise, but
participates in the benefits should prices decline
ΔV
Underlying Risk
Exposure
Long Call
insurance premium/ call price

ΔP

Resulting Net Exposure

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Forwards and Futures and Financial
Engineering
• You will see that all derivatives can be replicated by a combination of the
underlying asset and borrowing/lending.

• For example: Long Forward = Borrow and Buy the Underlying Asset.

• Because Futures and Swaps are portfolios of Forwards, they also can be replicated
using the underlying asset and borrowing/lending.

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Options and Financial Engineering
• Options can be replicated by dynamically trading the underlying asset and
borrowing/lending.

• Note that a position in a futures contract or a forward contract can be substituted for
the position in the underlying asset.
long call sell put
– Example I: Buy a Call and Write a Put = Long Underlying (or forward/futures).
– Example II: Write a Call and Buy a Put = Short Underlying (or forward/futures).

Example I: underlying
long call

short put

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Buy a Call and Write a Put = Long
Underlying
profit profit
Buy Call

K
0 =
K ST ST

Underlying
Write Put price

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Showing that Buying a Call and Writing a
Put = Long Underlying
• Let: K=40; S=40; C=4; P=3; CF0 = -1
• Then, at expiration (time T):

Profit
ST CT PT CFT CF0 + CFT
38 0 -2 -2 -3
39 0 -1 -1 -2
40 0 0 0 -1
41 1 0 1 0 ST
42 2 0 2 1

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