Derivatives

Chapter 2 An Introduction to Forwards and Options

2.1 FORWARD CONTRACTS

• Forward contract: It sets today the terms at which you buy

or sell an asset or commodity at a specific time in the future.
• A forward contract specifies
- The features and quantity of the asset to be delivered
- The delivery logistics, such as time, date, and place
- The price the buyer will pay at the time of delivery
• Futures contract are similar to forward contracts in that
they create an obligation to buy or sell at a predetermined
price at a future date.
- We will discuss the institutional and pricing differences
between forwards and futures in Chapter 5.
Forward Contracts

• The time at which the contract settles is called the

expiration date.
• The asset or commodity on which the forward contract is
based is called the underlying asset.
• The futures in HKEX
- HANG SENG INDEX FUTURES (HSI) Link
- A stock index is the average price of a group of stocks. In
these examples we work with this group price rather than the
price of just one stock.
- Use this futures as an example to understand the following
concepts
Measures of Market Size and Activity
• Textbook pp 4
• Trading volume. This measure counts the number of
financial claims that change hands daily or annually.
• Market value. The market value (or “market cap”) of the
listed financial claims on an exchange is the sum of the
market value of the claims that could be traded. A firm with
1 million shares and a share price of $50 has a market value
of $50 million.
• Notional value. Notional value measures the scale of a
position, usually with reference to some underlying asset.
• Open interest. Open interest measures the total number of
contracts for which counterparties have a future obligation
to perform.
- Each contract will have two counterparties. Open interest
measures contracts, not counterparties.
Long and Short

• Every forward contract has both a party agreeing to buy and

one agreeing to sell.
• Long: you enter into a forward contract that buy an asset or
commodity at a specific time in the future.
• If you long a forward, we can also say you have a long
position in the forward
• Short: you enter into a forward contract that sell an asset or
commodity at a specific time in the future.
• If you short a forward, we can also say you have a short
position in the forward
Measures of Market Size and Activity
Example.
• Suppose there are three traders: A, B and C
• A buy $100 stock from B, trading volume +$100
• A long a forward contract of $100 notional value and B short
the forward contract , trading volume +1, open interest +1,
notional value of trading volume +$100, notional value of
open interest +$100
• After a while
- Case 1: A short a forward, B long a forward, trading volume
+1, open interest -1
- Both of them offset their position
- Case 2: A short a forward, C long a forward, trading volume
+1, open interest unchanged
- A offsets the position, C opens a position
Measures of Market Size and Activity
Price and Market Activity

• Current price
• high, low, open
• previous close, previous settle
• volume
• position
• price quotation
• multiplier: 50
• contract unit: index point*multiplier is the notional value
- generally, contract unit can be in shares (100 shares, each
share $20) or in money ($2000)
- index option contract unit is in money, not in shares
- you are supposed to buy the notional value amount of stocks
Contract Information

• Name
• Code
• Underlying
• Exchange
• Last Trading Date
• Contract Unit
• Settlement Method
Transaction Costs and the Bid-Ask Spread
• Textbook pp 14
• Suppose you want to buy shares of HSBC stock.
• First, there is a commission, which is a transaction fee you
pay your broker.
• Second, the term “stock price” is, surprisingly, imprecise.
There are in fact two prices, a price at which you can buy,
and a price at which you can sell.
• The price at which you can buy is called the offer price or
ask price.
• The price at which you can sell is called the bid price.
• To understand these terms, consider the position of the
broker.
- offer/ask: broker sells, so you buy
- bid: broker buys, so you sell
Transaction Costs and the Bid-Ask Spread
• To buy stock, you contact a broker. Suppose that you wish to
buy immediately at the best available price. If the stock is
not too obscure and your order is not too large, your
purchase will probably be completed in a matter of seconds.
• Where does the stock that you have just bought come from?
- It is possible that at the exact same moment, another
customer called the broker and put in an order to sell.
- More likely, however, a market-maker sold you the stock. As
their name implies, market-makers make markets. If you
want to buy, they sell, and if you want to sell, they buy.
- In order to earn a living, market-makers sell for a high price
and buy for a low price.
• This difference between the price at which you can buy and
the price at which you can sell is called the bid-ask spread.
Transaction Costs and the Bid-Ask Spread

• A market order is an instruction to trade a specific quantity

of the asset immediately, at the best price that is currently
available.
• A limit order is an instruction to trade a specific quantity of
the asset at a specified or better price.
- A limit order to buy 100 shares at $47.50 can be filled at
$47.50 or below.
• A stop-loss order. Suppose you own 100 shares of HSBC. If
you enter a stop-loss order at $45, then your order becomes
a market order to sell once the price falls to $45.
Reading Price Quotes

• Expiration date, underlying asset, notional Value, open

interest
Transaction Costs and the Bid-Ask Spread
15383: average of bid and ask

actually pay 15384

Transaction Costs and the Bid-Ask Spread
這裡buy/sell 不在bank視⾓，⽽在investor視⾓
• Market order:
- the buy order will be filled at 15384
- the sell order will be filled at 15382
• Central limit order book:
- there are 12 existing limit buy orders at 15382
- there are 18 existing limit sell orders at 15384
• Suppose you want to buy it below the the ask
- if you want to buy at 15382, then you order will join the other
12 orders and increase the order number
- if you want to buy at 15383, then you order will be filled
before the 15382 orders. The bid will become 15383
- if you want to buy at 15381, then you order will line up behind
the 15382 orders
Index Futures
The Payoff on a Forward Contract

• The payoff to a contract is the value of the position at

expiration
Payoff to long forward = Spot price at expiration − forward price
Payoff to short forward = Forward price – Spot price at expiration

Example.
• Today: Spot price = $1,000, 6-month forward price = $1,020
• In six months at contract expiration: Spot price = $1,050
• Long position payoff = $1,050 – $1,020 = $30
• Short position payoff = $1,020 – $1,050 = -$30
Payoff Table
Payoff Diagram
• The payoff diagram of forward is a straight line
• The payoff diagram of a long stock is a 45 degree line
• The payoff diagram of a bond (or borrowing or lending) is a
flat line
Comparing a Forward and Outright Purchase

• The S&R forward contract is a way to acquire the index by

paying $1020 after 6 months.
• An alternative way to acquire the index is to purchase it
outright at time 0, paying $1000.
Comparing a Forward and Outright Purchase
• With both positions, we own the index after 6 months.
• The initial investments are different.

1. With the cash index, we invest $1000 initially and then we

own the index.
2. With the forward contract, we invest $0 initially and $1020
after 6 months; then we own the index.
- Invest $1000 in zero-coupon bonds along with the forward
contract. The interest rate is 2%.
- Investment 2 has the same initial investment as Investment 1.
- The payoff is the sum of the payoff of the forward and the
bond
- The payoff diagram of the bond is a flat line at $1020.
• Compare Investment 1 and 2
- these comparisons will be useful for pricing the forward
Comparing a Forward and Outright Purchase
整體向上位移1020

Forward + bond = Spot price at expiration–1020+ 1020

| {z }
| {z }
Forward payoff Bond payoff
Cash Settlement Versus Delivery
• Type of settlement
• Cash settlement: less costly and more practical
• Physical delivery: often avoided due to significant costs

Example. (2.2) Suppose that the S&R index at expiration is $1040.

• Because the forward price is $1020, the long position has a
payoff of $20.
• Similarly, the short position loses $20.
• With cash settlement, the short simply pays $20 to the long,
with no transfer of the physical asset, and hence no
transaction costs.
• It is as if the long paid $1020, acquired the index worth
$1040, and then immediately sold it with no transaction
costs.
Cash Settlement Versus Delivery

• In physical delivery, the long position is supposed to buy the

notional value amount of stocks in the index
- notional value 15377 × 50
- allocate to each stock according to the weight of the index
- 8.68% to buy HSBC, calculate how many shares to buy
- 8.06% to buy BABA, ...
• Clearly cash settlement is more practical and efficient
Cash Settlement Versus Delivery
Credit Risk

• Credit risk of the counter party

• A possibility that the counterparty who owes money fails to
make a payment
• Major issue for over-the-counter contracts
- Credit check, collateral, bank letter of credit
• Less severe for exchange-traded contracts
- Exchange guarantees transactions, requires collateral
• More details in Chapter 5
2.2 CALL OPTIONS

• Call option: a contract where the buyer has the right to buy,
but not the obligation to buy.
• Strike price.or exercise price, of a call option is what the
buyer pays for the asset.
• Exercise.The exercise of a call option is the act of paying the
strike price to receive the asset.
• Expiration. The expiration of the option is the date by which
the option must either be exercised or it becomes worthless.
Exercise Style

• Exercise style specifies when the option can be exercised

- European-style: can be exercised only at expiration date
- American-style: can be exercised at any time before expiration
- Bermudan-style: Can be exercised during specified periods
- European, American, and Bermudan options are bought and
sold worldwide.
Call Option

Example. (2.5) The buyer has purchased a call option. The call
buyer agrees to pay $1000 (strike price) for the S&R index in 6
months (expiration, European style) but is not obligated to do so.
Payoff and Profit for a Purchased Call Option

• Payoff = Max [0, spot price at expiration – strike price]

• If spot price at expiration > strike price. Exercise the option
and buy the underlying asset at a cheaper price. Payoff > 0
• If spot price at expiration < strike price. Do not exercise the
option. Payoff = 0

Example. (2.5)
• If in 6 months the S&R price is $1100, the buyer will pay
$1000 and receive the index. (The buyer exercise the option).
• If the S&R price is $900, the buyer walks away.
Premium

• The buyer either makes money or break even.

• Why would anyone agree to be on the seller side?
• At the time the buyer and seller agree to the contract, the
buyer must pay the seller an initial price, the premium.
- Similar to premium in insurance
• This initial payment compensates the seller for being at a
disadvantage at expiration.
Payoff and Profit for a Purchased Call Option

• Payoff is the cash value of a position at a point in time.

• A profit subtracts from the payoff the future value of the
initial investment in the position.
• Profit = Payoff – future value of option premium
• Why future value?
- Time value of money. It is only possible to compare or
combine values at the same point in time.
• Recall: Forward contract has no initial investment. Payoff =
Profit
Payoff and Profit for a Purchased Call Option

Example. (2.6) Use the same option as in Example 2.5.The

risk-free rate is 2% over 6 months. Assume that the index spot
price is $1000 and that the premium for this call is $93.81.
• The future value of the call premium is $93.81 × 1.02 =
$95.68.
• If the S&R index price at expiration is $1100, the owner will
exercise the option. The payoff is 100.
• The call profit is 100 - 95.68 = 4.32.
• If the S&R index price at expiration is $900. The profit is
-95.68. The buyer loses all the premium.
Payoff and Profit for a Purchased Call Option
Payoff and Profit for a Purchased Call Option

• A call option becomes more profitable when the underlying

asset appreciates in value
Payoff and Profit for a Purchased Call Option

對於purchase call，premium是95.68，exercise
price是1000，只有price達到1000+95.68才有
payoff=0
Payoff and Profit for a Purchased Call Option
• If index price increases above the strike, the call option profit
will increases
• If the underlying asset price at expiration is the stike price,
the profit is still negative because of the premium
• Breakeven price: the underlying asset price at expiration
when profit is zero
• Profit = Payoff of breakeven – future value of option
premium = 0
• breakeven price = strike price + future value of option
premium
• In the example, breakeven = 1000+ 95.68 = 1095.68
• When the underlying asset price at expiration is below
breakeven, we loss money
• When the underlying asset price at expiration is above
breakeven, we make money
Payoff and Profit for a Written Call Option

• Buyer, purchased call, long position

seller write the contract
• Seller, option writer, written call, short position
• Let’s look at the option from the point of view of the seller.
• Payoff = – max [0, spot price at expiration – strike price]
• Profit = Payoff + future value of option premium
Payoff and Profit for a Written Call Option

Example. (2.7) Use the same option as in Example 2.6.

• If the S&R index price at expiration is $1100, the buyer will
exercise the option. Thus, the option writer will have to sell
the index, worth $1100, The payoff is
• - max [ 0, 1100 – 1000] = -100.
• The profit is -100 + 95.68 = -4.32.
• If the S&R index price at expiration is $900. The profit is
95.68. The seller keeps all the premium.
Payoff and Profit for a Written Call Option

1000price後, exercise
2.3 PUT OPTIONS
• A put option is a contract where the seller has the right to
sell, but not the obligation.

Example. (2.8) Suppose that the seller agrees to sell the S&R
index for $1020 (strike price) in 6 months (expiration) but is not
obligated to do so.
• The seller has purchased a put option.
• If in 6 months the S&R price is $1100, the seller will not sell
for $1020 and will walk away.
• If the S&R price is $900, the seller will sell for $1020 and will
earn $120 at that time.

• Don’t get confused: The buyer of the put is a seller of the

index. Similarly, the seller of the put is obligated to buy the
index, should the put buyer decide to sell.
Payoff and Profit for a Purchased Put Option

• Payoff/profit of a purchased (i.e., long) put

- Payoff = max [0, strike price – spot price at expiration]
- Profit = Payoff – future value of option premium
• Payoff/profit of a written (i.e., short) put
- Payoff = – max [0, strike price – spot price at expiration]
- Profit = Payoff + future value of option premium
Payoff and Profit for a Purchased Put Option

Example. (2.9 and 2.10) Consider a put option on the S&R index
with 6 months to expiration and a strike price of $1000. Assume
that the premium for this put is $74.20 and the risk-free rate is
2% over 6 months.
• If the index in 6 months is $1100. It is not worthwhile to sell
the index worth $1100 for the $1000 strike price.
• Payoff = max [0, $1,000 – $1,100] = $0
• Profit = $0 – ($74.20 x 1.02) = – $75.68
• If index value in six months = $900, the seller will exercise
the option and sell for $1000.
• Payoff = max [0, $1,000 – $900] = $100
• Profit = $100 – ($74.20 x 1.02) = $24.32
Payoff and Profit for a Purchased Put Option
Payoff and Profit for a Purchased Put Option

• A put option becomes more profitable when the underlying

asset depreciates in value

purchased put: don’t do anything, but pay premium

Payoff and Profit for a Written Put Option
The “Moneyness” of an Option
• Moneyness describes whether the option payoff would be
positive if the option were exercised immediately.
• The term is used to describe both American and European
options even though European options cannot be exercised
until expiration.
• An in-the-money option is one which would have a positive
payoff if exercised immediately. (but not necessarily positive
profit)
- a call with a strike price less than the asset price
- a put with a strike price greater than the asset price
• An out-of-the-money option is one that would have a
negative payoff if exercised immediately.
• An at-the-money option is one for which the strike price is
approximately equal to the asset price.
2.4 A SUMMARY OF FORWARD AND OPTION
POSITIONS
A SUMMARY OF FORWARD AND OPTION
POSITIONS
A SUMMARY OF FORWARD AND OPTION
POSITIONS
A SUMMARY OF FORWARD AND OPTION
POSITIONS
Which position is the best?

profit
S&R Index in 6 Months long forward long call short put
800 -220 -95.68 -124.32
900 -120 -95.68 -24.32
1000 -20 -95.68 75.68
1100 80 4.32 75.68
1200 180 104.32 75.68
If you are bullish and believe the settlement price will be
• 1000, choose short put
• 1100, choose long forward
• 1200, choose long forward
Which position is the best?
If you believe the settlement price will be 800 with probability
50% or 1200 with probability 50%
• long forward profit = 0.5 × (−220) + 0.5 × 180 = −20
• long call profit = 0.5 × (−95.68) + 0.5 × 104.32 = 4.32
• short put profit = 0.5 × (−124.32) + 0.5 × 75.68 = −24.32
• choose long call
Generally, if you believe the settlement price will follow a
distribution with p.d.f f (s), the profit is a function of the
settlement price p(s), then
the expected profit is p(s)f (s)ds
R

For example, you believe the price follows a normal distribution

s ∼ N(1100, 1002 ), the profit function of long call is
max(0, s − 1000) − 95.68, the expected profit can be computed
numerically
2.6 EXAMPLE: EQUITY-LINKED CDS

• Although options and forwards are important in and of

themselves, they are also commonly used as building blocks
in the construction of new financial instruments.
• For example, banks and insurance companies offer
investment products that allow investors to benefit from a
rise in security prices (e.g., stock index, currency, interest
rate) and that provide a guaranteed return if the market
declines.
2.6 EXAMPLE: EQUITY-LINKED CDS

Example. Citi Bank HK provides market-linked accounts Link

• deposit CNH (CNY offshore) but want to be exposed to USD
- reference currency USD/CNH (similar to the underlying asset
of a derivative), tenor (similar to expiration), barrier (similar to
strike price)
• what is the payoff?
- If USD depreciates beyond the barrier, you make 5% return
- If USD is strong, you get back the principal
EQUITY-LINKED CDS
• A 5.5 year CD with a return linked to the S&P 500
• At maturity, the CD is guaranteed to repay the invested
amount, plus 70% of the return in the S&P 500
• Payoff = 10000×(1+0.7×max[0,S_final/1300−1])
- S_final= value of the S&P 500 after 5.5 years
• Assume you invest $10,000 today when S&P 500 = 1300
• If the index is 1500 after 5.5 years,you receive 10
000×(1+0.7×max[0,1500/1300 −1] = 11076.92
EQUITY-LINKED CDS

• The payoff graph looks like the sum of a bond and a call
option
EQUITY-LINKED CDS

• What is this product?

• It is a deposit and a call option.
• Buy a CD with payoff of 10000
- Payoff =10000
• Buy an at-the-money call option (strike price 1300, notional
value 7000, expiration 5.5 year)
- Payoff = 7000×max[0,S_final/1300−1])
• The sum
- Payoff = 10000×(1+0.7×max[0,S_final/1300−1])
EQUITY-LINKED CDS

• Is this a good deal?

• Suppose effective annual interest rate is 6%. To get a payoff
of 10,000 after 5.5 years in CDs, we just need to invest PV
=10,000/1.06^5.5 = 7258
• After you understand this course, you could have a
home-made equity-linked CD
- Buy 7258 amount of CD
- Buy the above call option with a premium
• If premium + 7258 <10,000, your home-made product is
cheaper than the one offered by the bank
Financial Engineering

• Financial engineering
- In this example: what products to combine? how to
determine the strike price, notional value, expiration, etc?
• Just like engineering, e.g. automobile
- Automobile companies put together different parts: engine,
wheels, exterior, etc
- You cannot do this at home
Financial Engineering
• Just like cooking
- Restaurants put together beef, potato, and curry sauce
together
- You could do thing by yourself
- Of course, there are fancier things that you cannot do that
home. That’s why we need professional chefs (just like finance
professionals).
EQUITY-LINKED CDS

• There are other types

• BEA HK offers a different type of equity linked deposits Link
• Glance the brochure and understand the payoff
• If you are a client that is interested in buying this product,
could you DIY?
• If you are a banker in BEA, how to engineer and provide this
product to clients?