Topic 1: Introduction to

Derivatives

What Is a Derivative?
Definition
A contract between two parties which has a
value determined by the price/value of
something else . (something else =
underlying).
Usually can be constructed from other
products.
Underlying
Stock prices, interest rates, FX, oil price,
weather, mortgage payment, credit card
payment.
Types

A Simple Example
Consider a bet on the Chicago Bulls:
If the Bulls win by 10 or more, you
receive (and the bookie pays) $100
If the Bulls lose, or win by less than 10,
you pay (and the bookie receives) $100

This is a derivative:
Contract to exchange cash flows
Underlying index: Bulls score
opponents score
3

Exchange Traded Derivative

Contracts
Contracts proliferated in the last three
decades

Derivatives: New and Big

Markets
A n n u a l v o lu m e , M illio n s o f c o n tra c ts

450
CBT
CME
NYMEX

400
350
300
250
200
150
100
50
0
1970

1975

1980

1985

1990

1995

2000

2005

2010

Over-the-counter traded derivatives: even

more!
1-5

What were the drivers behind this proliferation?

1.6

Increased Volatility
Oil prices:
19512005

$/ rate:
19512005

1-7

The Role of Financial

Markets
Risk sharing: the lucky share with unlucky.
Insurance companies and individual
communities have traditionally helped each
other to share risks
Markets make risk-sharing more efficient
Diversifiable risks vanish
Non-diversifiable risks are reallocated (using
derivatives)
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Forward Example
The treasurer of an airline company
today enters into a long forward
contract to buy 1 million barrels of oil
in 12 months at $90 per barrel
This obligates the airline to pay $90
million for 1 million barrels of oil in
one year
A forward contract is an agreement
to buy or sell an asset at a certain
time in the future for a certain price
9

Futures Example
Like forward contract, a futures contract is
an agreement to buy or sell an asset at a
certain time in the future for a certain
price
Examples: today (at time t=0) Agreement
to:
buy 100 oz. of gold @ US$1400/oz. in
December (NYMEX)
sell 62,500 @ 1.6200 US$/ in March (CME)
sell 1,000 bbl. of oil @ US$89/bbl. in April
(NYMEX)
10

Forward and Future Contracts

Definition: a binding agreement (obligation) to
buy/sell an underlying asset in the future, at a
price set today
Futures contracts are the same as forwards in
principle except for some institutional and pricing
differences.
Forward contract is traded OTC, a futures contract
is traded on an exchange
Forward contracts are popular on currencies and
interest rates. While future contracts
are popular
Expiration
on commodities,
indexes.
Today
date

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Side note: Over-the-counter (OTC)

Market
Over-the-counter market is an important
alternative to exchanges.
Advantage: flexible in terms of contract
Disadvantage: credit risk: contract will not be
honored

It is a telephone and computer-linked

network of dealers who do not physically
meet.
Trades are usually between financial
institutions, corporate treasurers, and fund
managers.
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Terminology and Notation

The party that has agreed to buy
has what is termed a long
position
The party that has agreed to sell
has what is termed a short
position
Maturity: T
Underlying spot prices: S, spot price
at T: ST
Forward price: F, Futures price: f
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Example
On January 20, 2011 the treasurer of
an airline company enters into a long
forward contract to buy 1 million
barrels of oil in 12 months at $90 per
barrel
What is the payoff if?
Spot oil price, ST , in Jan 2012 is $60
Spot oil price ST , in Jan 2012 is $150
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Payoff from a
Long Forward Position
Payoff

Payoff= ST F0,T

Price of Underlying
90=F
at Maturity, ST

ST : spot price at maturity

F0,T: forward price
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Payoff from a
Short Forward Position
Payoff

Payoff = F - ST

90
=F

Price of Underlying
at Maturity, ST

ST : spot price at maturity

F: forward price
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Payoff on a Forward
Contract
Payoff for a contract is its value at
expiration
Payoff for
Long forward = Spot price at expiration
Forward price = ST F0,T
Short forward = Forward price Spot price at
expiration = F0,T ST
(note the time script)
Q: Payoff of long forward + payoff of short
forward =?
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Options
The buyer has the option to buy/sell an asset in
the future, at a price set today
For the buyer, preserves the upside potential,
while at the same time eliminating the
unpleasant downside, nonbinding
The seller of a call option is obligated to deliver
if asked
Today

Expiration date

or
at buyers choosing
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Options
A call option is an option to buy a
certain asset by a certain date for a
certain price (the strike price)
A put option is an option to sell a
certain asset by a certain date for a
certain price (the strike price)
The seller of a call/put option is
obligated to sell/buy if asked
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Call Options, example

We enter into a contract that gives us the
right to buy HSBC stock at 85HKD a share
one month after today, what will we do if
after one month, ST = 125?
after one month, ST = 75?

What does the other party do if

after one month, ST = 125?
after one month, ST = 75?
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Options payoff: Call

C(T)

Long call payoff

at maturity
C(T)

Written (short) call

payoff at maturity

S(T)
K

Call (T)=max[0, ST -K]

S(T)

- Call (T)=- max[0, ST -K]

21

Put Options, example

We enter into a contract that gives us the
right to sell HSBC stock at 60HKD a share
one month after today, what will we do if
after one month, ST = 80?
after one month, ST = 50?

What does the other party do if

after one month, ST = 80?
after one month, ST = 50?
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Options payoff: Put

P(T)

Put payoff
at maturity
P(T)

Written put payoff at

maturity

S(T)
K

S(T)
K

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Payoff of Options
If a call is held to maturity, its payoff at
maturity is:
Call (T)=max[0, S(T)-K]
If a put is held to maturity, its payoff at
maturity is:
Put (T) = max[0,K-S(T)]
The written (short) option payoff is just the
negative of the bought (long) option
payoff. (The long position payoff is always
positive.)
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Definition and Terminology

Strike (or exercise) price: the amount paid by the
option buyer for the asset if he/she decides to
exercise
Expiration: the date by which the option must be
exercised or become worthless
Exercise: the act of paying the strike price to buy
the asset
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
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before expiration

Options vs Futures/Forwards
The holder of futures/forward contract has
the obligation to buy or sell at a certain
price at certain time.
An option gives the buyer the right to buy or
sell at a certain price at certain time
When the contract is signed, the value of
future/forward contract is zero, as time
goes, the value of the contract can either
positive or negative
For the party who long the options, the
value of options is always positive26 before
expiration.

Ways Derivatives are Used

To hedge risks: spot + derivative
To speculate (take a view on the future
direction of the market), may derivative
only
Make risk transfer (and speculation, and
investment) cheaper.
Lump many transactions together
Avoid regulatory constraints
To lock in an arbitrage profit
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Hedging Examples
An investor owns 1,000 ABC Co. shares
currently worth $28 per share. A twomonth put with a strike price of $27.50
costs $1. The investor decides to hedge
by buying 10 contracts. (Each put contract
gives your right to sell 100 shares of
stock.)

28

Value of ABC Co. Shares with and

without Hedging
40,000

Value of
Holding ($)

35,000
No Hedging
30,000

Hedging

25,000
Stock Price ($)
20,000
20

25

30

35

40
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Speculation Example
An investor with $2,000 to invest feels
that Amazons 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 $20 is $1
What are the alternative strategies?

30

Speculation Example
What are the returns of each strategy if
stock price goes up to $25 next 2
months

What are the returns of each strategy if

stock price goes down to $18 next 2
months

31

Making risk transfer cheaper

Portfolio manager wants to follow the policy
of lower risk in falling markets.
Problem: constant rebalancing is
expensive in time and commissions.
Solution: buy long-term put option on
portfolio.
Acquirer wants to build stake in target
company.
Problem: mandatory disclosure and / or
tender offer required if stake exceeds
threshold.
Solution: go long OTC equity swap or cash32
settled forward.

Arbitrage
An arbitrage is any trading strategy
requiring no cash input that has some
probability of making profits, with no risk
of loss.
A portfolio with a zero price and a
strictly positive payoff, or
One with a negative price and a nonnegative payoff

33

Arbitrage Example
A stock price is quoted as 100 in London
and $172 in New York
The current exchange rate is 1.5800$/
What is the arbitrage opportunity?

If lots of people use the above arbitrage

strategy, will the arbitrage opportunity
last for long time?

34

The No-Arbitrage Principle

(NAP)
In an efficiently functioning financial
market arbitrage opportunities
cannot exist (for very long).
This No-Arbitrage Principle implies that:
Two securities (or portfolios, or
strategies) that have the same
payoff must have the same price.
If they don't, we create an arbitrage by
buying the cheap one and selling the
expensive one.
35

How can we value derivatives? Or how do

we value anything?
Really only two choices:
Economic theory: Deduce fundamental value
from some theory of investor attitude towards
risk & reward.
e.g. the CAPM
Pricing by analogy: look for other products a
lot like it, and use their price. (Relative Pricing)
Just like selling your flat

Our methodology to value derivatives is

the one of relative pricing.
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Pricing by analogy
Often we can find candidates that
Are very similar to the derivative
Have precise values
So those values ought to be the
value of our derivative.
Why?
Using no arbitrage principal to value
derivative
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Conclusion
What are the derivatives
Futures, Forwards, Options
Definition, payoff, obligation/right of
buyer and seller

Ways derivatives used

Hedge, Speculate, Transfer Risk,
Arbitrage

How to price derivatives?

No Arbitrage Principles
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Quiz
Which of the following is not a
derivative instrument?
(a) Contract to sell corn
(b) Option agreement to buy land
(c) Installment sales agreement
(d) Mortgage backed security

39

Quiz
Options and futures are zero sum game,
what dose this statement mean?

40