Chapter 1.

Introduction

2
Outline

Introduction

Forward Contracts

Futures Contracts

Options

Swaps

Derivatives and Risk-Management: Some Comments

Appendix: Interest-Rate Conventions

3
Introduction

4
Objectives

This segment
Introduces the major classes of derivative securities
Forwards
Futures
Options
Swaps
Discusses their broad characteristics and points of distinction.
Discusses their uses at a general level.
The objective is introductory: to lay the foundations for the
detailed analysis of derivative securities.

5
Derivatives

A derivative security is a financial security whose value depends on

(or derives from) other, more fundamental, underlying financial
variables such as the price of a stock, an interest rate, an index level, a
commodity price or an exchange rate.
There are three basic classes of derivative securities:
Futures & forwards.
Swaps.
Options.

6
Basic Distinctions - I

 Forward contracts are those where two parties agree to a specified

trade at a specified point in the future.
 Defining characteristic: Both parties commit to taking part in the trade or
exchange specified in the contract.
 Futures and swaps are variants on the theme:
 Futures contracts are forward contracts where buyers and sellers
trade through an exchange rather than bilaterally.
 Swaps are akin to forward contracts in which the parties commit to
a series of exchanges at several dates in the future.

7
Basic Distinctions – II

 Options: Characterized by optionality concerning the specified trade.

 One party, the option holder, retains the right to enforce or opt out
of the trade.
 The other party, the option writer, has a contingent obligation to
take part in the trade.
 Call option: Option holder has the right, but not the obligation, to buy
the underlying asset at the price specified in the contract.
 Option writer has a contingent obligation to participate in the
specified trade as the seller.
 Put option: Holder has the right, but not the obligation, to sell the
underlying asset at the price specified in the contract.
 Option writer has a contingent obligation to participate in the
specified trade as the buyer.

8
Derivatives are BIG Business ...
BIS estimates of market size (in trillions of USD):

9
... and a Rapidly Growing One
BIS estimates of market size (in trillions of USD):

10
Risk-Management Roles - I

These classes of derivatives serve important, but different, purposes.

Futures, forwards and swaps enable investors to lock in cash flows
from future transactions.
Thus, they are instruments for hedging risk.
"Hedging" is the offsetting of an existing cash-flow risk.
Example 1 A company that needs to procure crude oil in one month
can use a one-month crude oil futures contract to lock in a price for the
oil.
Example 2 A company that has borrowed at floating interest rates
and wishes to lock in fixed interest rate payments instead can enter
into a swap where it commits to exchanging fixed interest rate
payments for floating ones.

11
Risk-Management Roles - II

 Options provide one-sided protection.

 The option confers a right without an obligation. As a consequence:
 Call  Protection against price increase.
 Put  Protection against price decrease.
 Example Suppose a company needs to procure oil in one month.
 If the company buys a call option, it has the right to buy oil at the "strike
price" specified in the contract.
 If the price of oil in one month is lower than the strike price, the company
can opt out of the contract.
 Thus, the company can take advantage of price decreases but is
protected against price increases.
 In short, options provide financial insurance.

12
Outline for Remaining Discussion

The rest of the material defines these classes of instruments more

formally.
Order of coverage:
Forwards
Futures
Options
Swaps

13
Forward Contracts

14
Forward Contracts

 The building block of most other derivatives, forwards are thousands of

years old.
 A forward contract is a bilateral agreement
 between two counterparties
 a buyer (or "long position"), and
 a seller (or "short position")
 to trade in a specified quantity
 of a specified good (the "underlying")
 at a specified price (the "delivery price")
 on a specified date (the "maturity date") in the future.
 The delivery price is related to, but not quite the same thing as, the
"forward price." The forward price will be defined shortly.

15
Forwards: Characteristics

 Important characteristics of a forward contract:

 Bilateral contract Negotiated directly by seller and buyer.
 Customizable Terms of the contract can be "tailored."
 Credit Risk There is possible default risk for both parties.
 Unllateral Reversal Neither party can unilaterally transfer its
obligations in the contract to a third party.
Futures & forwards differ on precisely these characteristics as we see shortly.

16
The Role of Forwards: Hedging

 Forwards enable buyers and sellers to lock-in a price for a future market
transaction.
 Thus, they address a basic economic need: hedging.
 Demand for such hedging arises everywhere. Examples:
 Currency forwards: lock-in an exchange rate for a future transaction to
eliminate exchange-rate risk.
 Interest-rate forwards (a.k.a. forward-rate agreements): lock-in an
interest rate today for a future borrowing/investment to eliminate
interest-rate risk.
 Commodity forwards: lock-in a price for a future sale or purchase of
commodity to eliminate commodity price risk.

17
BUT...

 An obvious but important point: The elimination of cash flow uncertainty

using a forward does not come "for free."
 A forward contract involves a trade at a price that may be "off-market," i.e.,
that may differ from the actual spot price of the underlying at maturity.
 Depending on whether the agreed-upon delivery price is higher or lower than
the spot price at maturity, one party will gain and the other party lose from
the transaction.

18
An Example

 A US-based exporter anticipates €200 million of exports and hedges

against fluctuations in the exchange rate by selling €200 million forward
at $1.30/€.
 Benefit? Cash-flow certainty: receipts in $ are known.
 Cost? Exchange-rate fluctuations may lead to ex-post regret.
 Exchange rate at maturity is $1.40/€.
 Exporter loses $0.10/€ for a total loss of $20 million on the
hedging strategy.
 Exchange rate at maturity is $1.20/€.
 Exporter gains $0.10/€ for a total gain of $20 million on the
hedging strategy.

19
Forward Contracts: Payoffs
 Forward to buy XYZ stock at F = 100 at date T.
 Let ST denote the price of XYZ on date T.

20
Forwards are "Linear" Derivatives

 ST : Spot price at maturity of forward contract.

 F : Delivery price locked-in on forward contract.

21
The Forward Price

 We have seen what is meant by the delivery price in a forward contract.

 What is meant by a forward price?
 The forward price is a breakeven delivery price: it is the delivery
price that would make the contract have zero value to both parties
at inception.
 Intuitively, it is the price at which neither party would be willing to
pay anything to enter into the contract.

22
The Forward Price and the Delivery Price
 At inception of the contract, the delivery price is set equal to the forward
price.
 Thus, at inception, the forward price and delivery price are the same.
 As time moves on, the forward price will typically change, but the delivery
price in a contract, of course, remains fixed.
 So while a forward contract necessarily has zero value at inception, the value
of the contract could become positive or negative as time moves on.
 That is, the locked-in delivery price may look favorable or unfavorable
compared to the forward price on a fresh contract with the same
maturity.

23
The Forward Price

Is the forward price a well-defined concept?

 Not obvious.
 It is obvious that
If the delivery price is set too high relative to the spot, the contract
will have positive value to the short (and negative value to the long).
If the delivery price is set too low relative to the spot, the situation is
reversed.
 But it is not obvious that there is only a single breakeven price. It appears
plausible that two people with different information or outlooks about the
market, or with different risk-aversion, can disagree on what is a
breakeven price.

24
Futures Contracts

25
Futures Contracts

A futures contract is like a forward contract except that it is traded on an

organized exchange.
This results in some important differences. In a futures contract:
 Buyers and sellers deal through the exchange, not directly.
 Contract terms are standardized.
 Default risk is borne by the exchange, and not by the individual
parties to the contract.
 "Margin accounts" (a.k.a "performance bonds") are used to manage
default risk.
 Either party can reverse its position at any time by closing out its
contract.

26
Forwards vs. Futures

27
Options

28
Basic Definitions

An option is a financial security that gives the holder the right to buy or sell
a specified quantity of a specified asset at a specified price on or before a
specified date.

 Buy = Call option. Sell = Put option

 On/before: American. Only on: European
 Specified price = Strike or exercise price
 Specified date = Maturity or expiration date
 Specified asset = "underlying"
 Buyer = holder = long position
 Seller = writer = short position

29
Broad Categories of Options

 Exchange-traded options:

Stocks (American).
Futures (American).
Indices (European & American)
Currencies (European and American)
 OTC options:

Vanilla (standard calls/puts as defined above).

Exotic (everything else—e.g., Asians, barriers).
 Others (e.g., embedded options such as convertible bonds or
callable bonds).

30
Options as Financial Insurance

 As we have noted above, option provides financial insurance.

 The holder of the option has the right, but not the obligation, to take part
in the trade specified in the option.
 This right will be exercised only if it is in the holder's interest to do so.
 This means the holder can profit, but cannot lose, from the exercise
decision.

31
Put Options as Insurance: Example
 Cisco stock is currently at $24.75. An investor plans to sell Cisco stock she
holds in a month's time, and is concerned that the price could fall over that
period.
 Buying a one-month put option on Cisco with a strike of K will provide her
with insurance against the price falling below K.
 For example, suppose she buys a one-month put with a strike of K =
22.50.
 If the price falls below $22.50, the put can be exercised and the
stock sold for $22.50.
 If the price increases beyond $22.50, the put can be allowed to
lapse and the stock sold at the higher price.
 In general, puts provide potential sellers of the underlying with insurance
against declines in the underlying's price.
 The higher the strike (or the longer the maturity), the greater the
amount of insurance provided by the put.

32
Call Options as Insurance: Example

 Apple stock is currently trading at $218. An investor is planning to buy the

stock in a month's time, and is concerned that the price could rise sharply
over that period.
 Buying a one-month call on Apple with a strike of K protects the investor
from an increase in Apple's price above K.
 For example, suppose he buys a one-month call with a strike of K = 225.
 If the price increases beyond $225, the call can be exercised and the
stock purchased for $225.
 If the price falls below $225, the option can be allowed to lapse and the
stock purchased at the lower price.
 In general, calls provide potential buyers of the underlying with protection
against increases in the underlying's price.

 The lower the strike (or the longer the maturity), the greater the amount
of insurance provided by the call.

33
The Provider of this Insurance

 The writer of the option provides this insurance to the holder: The writer is
obligated to take part in the trade if the holder should so decide.
 In exchange, writer receives a fee called the option price or the option
premium.

34
Swaps

35
What are Swaps?

 A swap is a bilateral contract between two counterparties that calls for

periodic exchanges of cash flows on specified dates and calculated
using specified rules.
 The contract specifies the dates (say, T1, T2, ... , Tn ) on which cash
flows will be exchanged.
 The contract also specifies the rules according to which the cash flows
due from each counterparty on these dates are calculated.
 The frequency of payments for the two counterparties need not
be the same.
 For example, one counterparty could be required to make semi-
annual payments, while the other makes quarterly payments.

https://www.youtube.com/watch?v=v_Fe-nSJZpc
36
Categories of Swaps

 Swaps are differentiated by the underlying markets to which payments

on one or both legs are linked.
 The largest chunk of the swaps market is occupied by interest-rate
swaps, in which each leg of the swap is tied to a specific interest rate
index.
 Other important categories of swaps include:
 Currency swaps, in which the two legs of the swaps are linked
to payments in different currencies.
 Equity swaps, in which one leg (or both legs) of the swap are
linked to an equity price or equity index.
 Commodity swaps, in which one leg of the swap is linked to a
commodity price.
 Credit-risk linked swaps (especially credit-default swaps) in
which one leg of the swap is linked to occurrence of a credit event
(e.g., default) on a specified reference entity.

37
What do Swaps Achieve?

 Swaps are among the most versatile of financial instruments with new
uses being discovered (invented?) almost every day.
 One of the sources of swap utility comes from the fact that swaps
enable converting exposure to one market to exposure to another
market.
 Example 1 Consider a 3-year equity swap in which
 One counterparty pays the returns on the S&P 500 on a given
notional principal P.
 The other counterparty pays a fixed rate of interest r on the
same principal P.
 The first counterparty in this swap is exchanging equity-market returns
for interest-rate returns over this three-year horizon. The second
counter party is doing the opposite exchange.

38
What do Swaps Achieve?

 Example 2 Consider an interest-rate swap in which

 One counterparty pays a floating interest-rate (e.g., Libor) on a given
notional principal P.
 The other counterparty pays a fixed rate of interest r on the same
principal P.
 Such a swap enables converting floating interest-rate exposure to floating
interest-rate exposure (and vice versa).

39
What do Swaps Achieve?

 Example 3 Consider a currency swap in which

 One counterparty makes US dollar payments based on USD-Libor.
 The other makes Japanese yen payments based on JPY-Libor.
 The swap enables converting floating rate USD exposure to floating-rate
JPY exposure and vice versa.

40
Linking Different Markets

 As a corollary, swaps provide a pricing link between different markets.

 Consider the equity swap in Example 1.
 At inception, the fixed rate r in the equity swap is set so that the
swap has zero value to both parties, i.e., so that the PV of the cash
flows expected from the equity leg is equal to the PV of the cash
flows from the interest rate leg.
 This means the interest rate r represents the market's "fair price"
for converting equity returns into fixed-income returns.
 Thus equity swaps also provide a pricing link between the equity and
fixed-income markets: the swap not only enables transferring equity
risk into interest-rate risk, it also specifies the price at which this
transfer can be done.

41
Linking Different Markets

 Similarly:
 Interest-rate swaps provide a link between different interest-rate
markets, for example, the fixed-rate at which floating-rate
exposure can be converted to fixed-rate exposure.
 Currency swaps provide a link between interest-rate markets
indifferent currencies, for example, the EUR fixed rate at which
USD floating-rate exposure can be converted to EUR fixed-rate
exposure.

42
Derivatives and Risk-Management:
Some Comments

43
Derivatives and Risk-Management

 Derivatives can be used to hedge or obtain insurance against existing

risk exposures.
 We examine derivatives use in various contexts throughout the book.
 Here, we use a simple example to make a simple preliminary point: that
derivatives do not offer a panacea in managing risk.
 There are pros and cons to every derivatives strategy (including
to the strategy of using no derivatives).
 That is, there is no dominant alternative that is better in all
conditions.

44
A Simple Example

 Suppose it is currently December, and a US-based company learns that

it will be receiving €25 million in March.
 As a US-based organization, the company needs to convert the euros
into dollars upon receipt, so is exposed to changes in the exchange
rate.
 The company has (at least) three choices:
 Do nothing, i.e., retain full exposure to changes in exchange
rates.
 Use a forward/futures contract to lock in an exchange rate
today.
 Buy a put option on the euro that guarantees a floor exchange
rate.

45
Comparing the Alternatives

 We compare outcomes under these three alternatives using three

relevant criteria:
1. Cash-flow uncertainty under the strategy.
2. Up-front cost of the strategy.
3. Exercise-time (or lock-in) regret from the strategy.
 Assume the following:
 The company can lock in an exchange rate of $1.0328/€ using CME
March futures contracts.
 The company can buy put options on the euro with a strike of
$1.03/€ and expiring in March at a total cost of $422,500.

46
The Alternatives Compared

The table below presents the outcomes (in US$) under the three alternatives
in two scenarios:

A "low" exchange rate (relative to the locked-in rate) of $0.9928/€.

A "high" exchange rate of $1.0728/€.

47
The Alternatives Compared

1. Cash flow uncertainty

 Maximal for the do-nothing alternative.
 Intermediate for the option contract.
 Least for the futures contract.
2. Up-Front Cost
 Zero for the do-nothing and futures contract alternatives.
 Substantial ($422,500) for the options contract.
3. Exercise-Time Regret None with the options contract, but possible with the
others:
 If $1.0728/€. The futures contract has ex-post regret (not hedging would
have been better).
 If $0.9928/€. The do-nothing contract has ex-post regret: hedging would
have been better.

48
The Best Alternative?

► There is none: Each strategy has its pros and cons.

49
Appendix: Interest-Rate Conventions

50
Interest-Rate Convention

 One important preliminary issue is the interest-rate convention we use.

 Any convention may be used—the choice is really one of convenience.
Different interest-rate conventions are simply different mechanisms for
converting sums of money due in the future into present values today,
or investments made today into future values due at maturity.
 As long as we obtain the correct present values and future values, it
doesn't matter what convention we use.

51
Moving Between Conventions

 Interest rates expressed under different conventions will not of course

be the same (just as a person's height measured in inches is not the
same as her height measured in centimeters).
 But just as we can always convert height from centimeters to inches and
vice versa, we can always move between the conventions and express a
given situation in any interest rate convention that we want.
 The key thing is to remember that an interest rate convention is simply
a mechanism for telling us how to compute present values of future
amounts (or future values of present investments).

52
Two Specific Conventions

 For specificity, we use one of two conventions in the numerical

illustrations:
 Continuous-compounding.
 The money-market convention.

 We discuss each below and also how to go from one convention to the
other.
 Remark The main body of the text uses mainly continuous-
compounding. The money-market convention is introduced in the
Exercises section in Chapter 3, and is used in several other chapters in
the book.

53
Continuous–Compounding

 The continuous-compounding convention is commonly used in theoretical

work in modern Finance.
 If the T-year continuously-compounded interest rate is r :

 $A invested for T years grows to $e rT A by time T.

 The present value of $A receivable at time T is PV (A) = e —rT A.

 Continuous-compounding has several technical advantages which is why it is

popular with modelers and is commonly used in finance textbooks.

54
Money-Market Convention

 The other convention we use is the money market convention.

 In the US money-market, an interest rate of ℓ over a horizon [0,T ] means
that the interest payable per dollar of principal is

 where d is the actual number of days in the horizon [0,T ].

 For example, if the 3-month interest rate is 5% and there are 91 calendar
days in the 3-month horizon, then the interest received per dollar of
investment is

 Actual/360 is popular in other countries too, though some countries (such as

Britain) use Actual/365.

55
Money-Market Convention

 Under the Actual/360 convention, an amount A invested over [0,T ] at

the rate ℓ grows by time T to

 Conversely, the present value of A receivable at T is

56
Moving Between Conventions

 Suppose an investment of $1 made today will be worth $1.03 in three

months.

1. If the interest rate ℓ is expressed in the Actual/360 convention and

the three-month horizon has 91 days in it, what is ℓ ?

2. If the interest rate r is expressed in the continuous-compounding

convention and we treat three months as 1/4 years, what is r ?

57
Moving Between Conventions

 Consider an investment of $1 over a horizon of one month.

1. If the interest rate ℓ expressed in the Actual/360 convention is 4%

and the one-month horizon has 31 days in it, to what does the
invested amount grow to?

2. If you had to express the same outcome using a continuous-

compounding convention, and we treat one month as 1/12 of a year,
what is the continuously-compounded rate r ?

58
Moving Between Conventions

 Consider an investment of $1 over a horizon of one month.

1. If the interest rate r expressed in the continuously–

compounded terms is 4% and we treat the one month horizon
as 1/12 of a year, to what does the invested amount grow?

2. If you had to express the same outcome using an Actual/360

convention and the one month horizon has 31 days in it, what
is the rate ℓ ?

59