Universidad Carlos III de Madrid 9/2/2010

Topic 8 Derivative Products

Table of contents:

8.1 Introduction

Topic 8- 8.2 Types of Derivatives

Derivative Products •Forward
•Future
•Options
Copyright of Spanish version from María Gutiérrez,
David Moreno and Luis Teijeiro
Translation into English by Francisco Romero

Universidad Carlos III 8.3 Pricing Principles

Financial Economics •Forward Price
•Put-Call Parity

Topic 8 Derivative products

Objectives: 8.1 Introduction
Derivative: investment whose value depends on the value
of another asset (the underlying asset).
1. To be familiar with the different types of derivatives.
 e.g.: forward contracts, future contracts, options and
2. To understand how to use them for risk
other contracts/bets linked to the value of assets.
management.
3. To understand how the derivatives market works.
4. To compute the payoffs of the buyer/seller of such How are they valued or priced?
products.  Two main principles: replicating portfolio and arbitrage.

5. To understand the principles for pricing derivatives:  The main studies, dated back to 1973 were made by

portfolio replication and arbitrage. Black and Scholes.

6. To be able to value a forward contract.  This enabled the development of the derivatives market,
as investors were willing to assume counterparty risk.

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8.1 Introduction 8.1 Introduction

What are they used for? Why do they get such bad press?
 To speculate and to manage risks of individuals, corporations and
investment funds.
 While risk management implies reducing risks,
 As we know, there are two types of risk: speculation amplifies them. The former is not relevant
 Market risk, which individuals can hardly eliminate but corporations
for the media.
can manage using derivatives.
 (e.g.: macroeconomic risks like interest rates or exchange rates related risks)  Derivative pricing is complicated.
 Specific risk, which is easily diversifiable for an individual investor, but
cannot easily be managed with derivatives, even if in some cases
insurance can be used.
 (e.g.: fire, theft)

 Risk management (hedging) has expanded due to:

 Increased competition and globalization. why?

 The development of derivative markets.

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8.2 Types of derivatives: FORWARD CONTRACT 3.2 Types of derivatives: FORWARD

Example: a vineyard owner agrees with a
FORWARD CONTRACT: agreement between two parties which implies that:
wholesaler to sell his harvest in a year
 The buyer is obliged to purchase an asset on a future date and at a pre- from now at €0.5/kilo.
determined price.
One year later, the price is €0.75:
 The seller is obliged to sell the asset on this future date and at such pre-  The owner does not earn this extra €0.25/
Precio del suLargo
0
0.1
-0.5
-0.4
Corto
0.5
0.4
k= 0.5
Payments at settlement
determined price. 0.2 -0.3 date
0.3
kilo. 0.3
0,6 -0.2 0.2
0.4 -0.1 0.1
 It is the wholesaler who earns it. 0,4
0.5 0 0

• The buyer (seller) is long (short) in the forward contract. One year later, the price is €0.40:
0.6
0,2 0.1 -0.1
Paymets

0.7 0.2 -0.2 Largo

0
0.8 0.3 -0.3
• The asset of reference is called underlying asset (St)  The owner earns €0.1/kilo. -0,2
0.9
1
-0,4
0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9
0.4
0.5
-0.4
-0.5
Corto

• The future date of the operation is the settlement/maturity or  The wholesaler does not earn this extra -0,6
Underlying price at settlement date

delivery date (T) €0.1/kilo.

• The pre-determined price is the forward price (K). In any case:

 The owner has a guarantee to receive a
• Value of forward contract at time t (Ft)
€0.5/kilo income (cost for the wholesaler).
Their positions move in opposite
directions.

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8.2 Types of derivatives: FUTURE CONTRACT 8.2 Types of derivatives: FUTURE CONTRACT

FUTURE: it is a special type of forward contract that is negotiated in The future contracts have the following characteristics as opposed
organized exchanges. to forward contracts:
• Only for certain assets (oil, oranges, IBEX35, Treasury Bonds,
currencies...), with specific amounts and maturities.
a) The contracts are traded on an
• Types of Futures according to the underlying asset: organized exchange (like the CBOT) Due to a) and b) a high number of
buyers and sellers will participate
Agriculture Futures (Soft Commodities)
Commodities) These contracts are very LIQUID
COMMODITIES
High competition between market
FUTURES
Metal Futures b) The contracts are standardized: participants to lower prices
By specifying size, underlying asset quality, Contracts can be cancelled before
delivery date… maturity
Energy Futures

Interest Rate Futures

c) There is a clearing house and a daily
Insolvency and counterparty
Currency Futures
settlement system.
FINANCIAL risks of forward contracts at
maturity are eliminated
FUTURES
Shares and Index Futures
9 10

8.2 Types of derivatives: FUTURE 8.2 Types of derivatives: OPTIONS

MEFF (Futures and Options Spanish official market) EUROPEAN OPTIONS:
http://www.meff.es/ing/indexi.htm  An European call option gives the buyer the right (not the obligation)
to buy an underlying asset for a certain price (strike) at a specific date
in the future.
10/07/2009 10:26 Spot Futures • What happens to the seller of the call option?
Underlying asset last +/- % Maturity Last +/- % Contracts  An European put option gives the buyer the right (not the obligation)
Contrato s/ IBEX-35 9.420,5 -0,24 17 Jul 9.415,0 -0,2 2972 to sell an underlying asset for a certain price (strike) at a specific time
ACERINOX 12,43 0,57 - in the future.
B. POPULAR 5,76 -0,43 18 Sep 5,60 -3,28 5 • What happens to the seller of the put option?
BBVA 8,77 0,11 18 Sep 8,75 -0,23 22
BME 20,37 -0,73 - • Call (Ct) and Put (Pt) prices
GAS NATURAL 12,10 0,17 - • Underlying asset price (St)
IBERDROLA 5,34 0,47 18 Sep 5,31 -0,19 10
• Strike or exercise price (E)
INDITEX 33,48 -0,03 -
REPSOL YPF 15,15 -0,03 18 Sep 15,20 0,13 73
• Expiration date (T)
SANTANDER 8,28 0,36 18 Sep 8,11 -0,25 368
TELEFONICA 15,70 -0,66 18 Sep 15,67 -1,01 4
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8.2 Types of derivatives: OPTIONS 8.2 Types of derivatives: OPTIONS

Example: Call Option
 Peter thinks oil price will spike next year. Price within Peter's
Peter's Bank's earnings Peter's Final Bank's Final
earnings in one in one option in result for one result for one Peter's total Bank's total

 He buys 100 European call options on barrels of Brent oil for $45 each and a year
35
36
decision
do not exercise
do not exercise
option in a year
0
0
a year
0
0
option
-6
-6
option
6
6
result
-600
-600
result
600
600
expiration date in one year 37 do not exercise 0 0 -6 6 -600 600

 The option price charged by the seller (a bank) is $6 38

39
do not exercise
do not exercise
0
0
0
0
-6
-6
6
6
-600
-600
600
600

 How much do they earn if the barrel price rises to $55? To $50? To $40? 40
41
42
do not exercise
do not exercise
do not exercise
0
0
0
0
0
0
-6
-6
-6
6
6
6
-600
-600
-600
600
600
600
43 do not exercise 0 0 -6 6 -600 600
44 do not exercise 0 0 -6 6 -600 600
45 exercise 0 0 -6 6 -600 600
46 exercise 1 -1 -5 5 -500 500
47 exercise 2 -2 -4 4 -400 400
48 exercise 3 -3 -3 3 -300 300
49 exercise 4 -4 -2 2 -200 200
50 exercise 5 -5 -1 1 -100 100
51 exercise 6 -6 0 0 0 0
52 exercise 7 -7 1 -1 100 -100
53 exercise 8 -8 2 -2 200 -200
54 exercise 9 -9 3 -3 300 -300
55 exercise 10 -10 4 -4 400 -400
56 exercise 11 -11 5 -5 500 -500
57 exercise 12 -12 6 -6 600 -600
58 exercise 13 -13 7 -7 700 -700
59 exercise 14 -14 8 -8 800 -800
60 exercise 15 -15 9 -9 900 -900

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8.2 Types of derivatives: OPTIONS 8.2 Types of derivatives: OPTIONS

Call payments at T (long) Call Total Result at T (long)
10 10
Example: Put Option
 A farmer thinks that the price of wheat will tumble next year.
8 8

6 6

4 4
 He buys a Put option with strike price of €500/ton and expiration date in a
2
2
year.
0

-2
35 40 45 50 55 60
0

-2
35 40 45 50 55 60  Each put option costs €40
-4 -4  How much would the farmer earn if the price of wheat/ton reaches €580
-6 -6 within a year? And what if it’s $485? And $400?
-8 Underlying price at T (ST) -8 Underlying price at T (ST)

Call payments at T (short) Call Total result at T (short)

10 10

8 8

6 6

4 4

2 2

0 0
35 40 45 50 55 60 35 40 45 50 55 60
-2 -2

-4 -4

-6 -6

-8 Underlying price at T (ST) -8 Underlying price at T (ST)

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8.2 Types of derivatives: OPTIONS 8.2 Types of derivatives: OPTIONS

MEFF
We need to take into account that the farmer will sell his crop in the market, Market session: 10/07/2009
and that he is using options to hedge his position. It is therefore interesting to TELEFÓNICA
see the total result (put + production sold) 11:43
SPOT
 The price in a year is €580, he sells the crop for €580. Last C hange %Change Open High Low Liquidity Yesterday

 Net result 580-40=540 15,65 -0,15 -0,95 15,71 15,75 15,64 - 15,80
 The price in a year is €485, he sells the crop for €485.
FUTURE 58
 Net result 485-25=460 TEF CC PC PV CV Last Total High Lo w Yesterday

18-sep-09 10 15,63 15,68 75 15,65 58 15,68 15,65 15,83

 The price in a year is €400, he sells the crop for €400.
18 Dic 09 1 15,39 15,59 100 - - - - 15,38
 Net result 400+60=460
11:43
107 CALL OPTIONS PUT 300
To tal Last CC PC PV CV T EF CC PC PV CV Last Total
Net Result with Purchased (long) Put
Ago 09
Net Result per 5 0,17 200 0,12 0,19 200 16,50 200 0,96 1,06 200 - -
800 op tion
Sep 09
600
- - 200 0,42 0,52 210 16,00 200 0,75 0,83 200 0,79 100
400
200
Paymen ts for
Wheat sold Mar 10
0 100 1,15 100 1,16 1,29 210 15,50 300 1,32 1,48 210 1,34 200
-200 350 400 450 500 550 600 Net Result Mar 10
Wheat delivery price 2 0,30 100 0,18 0,38 100 18,00 100 2,83 3,23 100 - -

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8.2 Types of derivatives: OPTIONS 8.2 Types of derivatives: OPTIONS

Between the date it is issued and the expiration date, the option will be:

A. Pagos Opción de Compra en T (largo) Payoff of put at expiration (long position)

• In the money (ITM): the value of the underlying asset is such that an
Payoff
option eventually exercised at this moment would produce earnings
Valor
Opción
• At the money (ATM): the value of the underlying asset=exercise price
Zona de no
ejercicio
Exercise
No exercise
region
• Out of the money (OTM): the value of the underlying asset is such that an
Zona de
ejercicio 0
region
ST
option eventually exercised at this moment would produce losses
E

0
E ST

Example(Telefónica): Classify the options quoted at 11:43 July 10th 2009

when the value of the underlying asset is 15.65, as ITM, ATM or OTM.

D. Payoff of put at expiration (short position)

C. Payoff of call at expiration (short position)

Payoff Payoff

0
0
No exercise E Exercise ST Exercise
No exercise ST
region region region E
region

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8.3 Pricing Principles

8.2 Types of derivatives: OPTIONS
American options:
• An American call option gives the buyer the right to buy the
underlying asset at a pre-determined price (strike price) and can be
exercised at anytime before expiration.
• What happens to the seller of the American Call?
• An American put option gives the buyer the right to sell the
underlying asset at a pre-determined price (strike price) and can be
exercised at anytime before expiration.
• What happens to the seller of the American put?
• Example: we own an American put option on BBVA shares at €17 strike
price and expiration in 6 months. If today’s BBVA share price is €18, our
option is ITM. Should we exercise it?
Derivatives are priced according to two main principles:
• Portfolio Replication using the underlying asset and the risk-free rate, and
possibly short selling operations.
• No arbitrage opportunities between both portfolios.
In order to be able to follow the ideas above we need to use these concepts:
• What is short selling? Chapter 1
• What is arbitrage? Chapter 1
• What is a replication portfolio?
 If we have two diversified portfolios (no specific risk) with the same market risk
we can say that these portfolios replicate each other.
 If these portfolios have different prices, there is an arbitrage opportunity: buy
the cheaper portfolio and short sell the expensive one.

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8.3 Pricing Principles 8.3 Pricing Principles

Forward pricing: • Example 1: Suppose that today is January 1st 2020 and you have the obligation to buy
 t=0 is the moment when the contract is signed. Compute the value at t of a one share from a company called X in two years for €48 because you bought a forward
contract three years ago. If today’s 2-year risk free interest rate is 5% and the share
forward contract to buy one share (underlying asset) at T of a firm that does price is €59. What price would you sell your forward contract for?
not pay dividends if the forward price is K, the risk-free rate for T − t periods
is rf and the share price is st.
• Forward:
 Value at T: ST − K
 Cost today: Ft?
• Replicating: zero coupon treasury bonds with face value K are sold short
at t, to fund the purchase of the underlying asset. The securities need to be
repurchased in T in order to close out the short position.
 Value at T: ST − K • Example 2: Suppose that today is January 1st 2019 and there is a negotiation to buy a
forward that obliges the holder to buy shares from company X in three years. Today’s 3-
 Cost today: st − K(1+rf )-(T−t) = Ft. No arbitrage value of the forward
year risk free rate is 7% and today’s share price is €39.19 euros. Compute the fprward
price.
At the moment of signing the forward contract, the cost is 0
0 = s0 −K(1 + rf )-T
K = s0(1 + rf )T

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8.3 Pricing Principles
The payoff profiles of a forward contract is a linear function of the
underlying asset.
 This makes the forward’s replicating portfolio simple and stable.
When the function is not linear (as with swaps or options) a dynamic
strategy is needed (the replicating portfolio changes over the time);
in addition, the replicating portfolio will only be an approximation.
 There will be a ’’tracking error’’
In those cases the Binomial valuation model and its continuous-
time version known as Black-Scholes model (1973) will be used
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8.3 Pricing Principles
• The value at expiration (T) of both portfolios needs to be equal:
• Portfolio A: European call option + present value of exercise price
• The value of the portfolio at T: max (ST – E, 0) + E = max (ST , E)
• Portfolio B: European put option + underlying asset
• The value of the portfolio at T: max (E – ST, 0) + ST = max (E , ST)
• By no arbitrage:
Ct + E(1 + rf )−(T-t) = Pt + St
or:
Ct − Pt = St −E(1 + rf )−(T-t)
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8.3 Pricing Principles
Put-call parity
• The pricing principle covered so far can also be applied to options;
another useful tool is the the put-call parity (Stoll 1969) for
European options that do not pay dividends.
• The put-call parity defines an equilibrium relationship between the
price of call and a put option when both options have the same
underlying asset, exercise price and expiration date.
• In equilibrium, the price of a put option plus the price of the
underlying asset (obligation to sell the underlying asset which we
hold today) is equal to the price of a call option plus the present
value of the exercise price (hold the present value of the exercise
price to be able to exercise the call).
26
8.3 Pricing Principles
• Example: Suppose there is a call and a put option on a share whose value today is
11€. The 1-year risk-free interest rate is 5%, E = 10€, and expiration is in one year.
The prices of the options are:
• C = 3€
• P = 2€
• Does the put-call parity hold in this example?
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8.3 Pricing Principles 8.3 Principios de valoración

• If the put-call parity does not hold. How can you benefit from this?

• From the put-call parity it can be shown that we can also replicate a
forward contract with forward price K and maturity at T by creating a
portfolio of a long European call and a short European put, both of
them with the same strike price (E=K), same maturity and with the
same underlying asset as the forward.

• See graph

29 30

8.3 Princing Principles 8.3 Pricing Principles

K= 10
 Put-call parity results:
T=
rf=
3
0.05
Forward and replicating portfolio
payments at T
• 1. The value of an American call on a share that does not pay
S(T)
0
F(T)
-10
C(T)
0
-P(T)
-10
Bono
10
20
dividends is equal to the value of a European call, because it is
15
1
2
-9
-8
0
0
-9
-8
10
10
not worth to exercise the American call before it expires.
10
3
4
-7
-6
0
0
-7
-6
10
10 5
CAt ≥ CEt≥ St −E(1 + rf )−(T-t) > St − E
5 -5 0 -5 10 S
0 (
6 -4 0 -4 10 T
0 5 10 15 20 25
7 -3 0 -3 10
8
9
-2
-1
0
0
-2
-1
10
10
-5

-10
• 2. We can immunize a portfolio of shares creating a “floor”
10 0 0 0 10
-15
(minimum value) by buying a put. The option (its E) will have to
11 1 1 0 10 ST
12 2 2 0 10 be chosen carefully in order to minimize the immunization cost.
13 3 3 0 10
14
15
4
5
4
5
0
0
10
10
20
Long Call and short Put payments at
T St+Pt = Ct +E(1 + rf )−(T-t) ≥ E(1 + rf )−T
16 6 6 0 10 15
17 7 7 0 10
18 8 8 0 10 10
19 9 9 0 10
20 10 10 0 10 5
21 11 11 0 10
0 C
22 12 12 0 10 (
23 13 13 0 10 0 5 10 15 20 25
-5
24 14 14 0 10
25 15 15 0 10 -10

-15
ST
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8.3 Pricing Principles Useful Websites

K= 10
T= 3
Payments at T (underlying asset + long
MEFF
rf= 0.05 put)
S(T) F(T) C(T) -P(T) Bono P(T) Cartera 20
 Mercado Oficial de Futuros y Opciones Financieros en
0 -10 0 -10 10 10 10
1 -9 0 -9 10 9 10
15
España.
2 -8 0 -8 10 8 10 10

3
4
-7
-6
0
0
-7
-6
10
10
7
6
10
10 5  http://www.meff.com/index2.html
5 -5 0 -5 10 5 10 S(T)

LIFF
0 P(T)
6 -4 0 -4 10 4 10 0 5 10 15 20 25 Cartera
7 -3 0 -3 10 3 10 -5

8 -2 0 -2 10 2 10
9 -1 0 -1 10 1 10 -10  London International Financial Futures
10 0 0 0 10 0 10
11
12
1
2
1
2
0
0
10
10
0
0
11
12
-15
ST
 http:// www.liffe-commodities.com
13 3 3 0 10 0 13
14
15
4
5
4
5
0
0
10
10
0
0
14
15
Payments at T (long Call + Rf security)
Chicago Mercantile Exchange
 http:// www.cmegroup.com/market-data/delayed-
16 6 6 0 10 0 16 20

17 7 7 0 10 0 17
15
18 8 8 0 10 0 18
19
20
9
10
9
10
0
0
10
10
0
0
19
20
10 quotes/commodities.html
5
21 11 11 0 10 0 21 C(T)

22 12 12 0 10 0 22 0 Bono
Cartera
23 13 13 0 10 0 23 0 5 10 15 20 25
-5
24 14 14 0 10 0 24
25 15 15 0 10 0 25 -10

-15
ST

33 34

READINGS

Brealey, R.A., Myers, S.C. and Allen (2006). Principles of Corporate

Finance. McGraw Hill, 8th edition
 Chapters 20 and 27

Grinblatt, M. and Titman, S. (2003). Financial Markets and

Corporate Strategy. McGraw Hill
 Chapters 7 and 8.

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