MFIN6003 Derivative Securities

Lecture Note Two

HKU Business School

University of Hong Kong

Dr. Huiyan Qiu

2-1
 Outline
Basic derivatives contracts
• Forward contracts; Call options; Put options
Types of positions and payoff / profit diagrams
• Long / Short position
Risk management
• From producer’s and buyer’s perspective
Misuse of derivatives: Barings Bank Case

Reading: Chapter 2, 4
2-2
 Forward Contracts
Forward contract: a binding agreement
(obligation) to buy/sell an underlying asset in the
future, at a price set today

Expiration
Today date

2-3
 Forward Contracts
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 contracts are the same as forwards in principle

except for some institutional and pricing differences.

2-4
 Forward Contracts
Example: a 6-month forward contract on S&R index
(not paying dividend)
• Underlying asset: S&R (Special & Rich) Index
• Spot price of the underlying asset: $1,000
• Forward Price: $1,020
Any contract has two parties: long vs. short.

Commitment Final Payoff

Long forward Agree to buy ST – 1,020
Short forward Agree to sell 1,020 – ST

2-5
 Forward Example
Payoff for a contract is its value at expiration.
In six months at contract expiration:
Case 1: Spot price ST = $1,050
• Long position payoff = $1,050 – $1,020 = $30
• Short position payoff = $1,020 – $1,050 = – $30

Case 2: Spot price ST = $1,000

• Long position payoff = $1,000 – $1,020 = – $20
• Short position payoff = $1,020 – $1,000 = $20
2-6
Payoff Diagram for Forwards

X-axis: S&R index

level 6-month later
Y-axis: payoff for 6-
month forward

6-month forward
price = $1,020

Long: y = x – 1,020
Short: y = 1,020 – x

2-7
 Hang Seng Index Futures
Hang Seng Index Futures Daily market report. Source:
www.hkex.com.hk
HSI - Hang Seng Index Futures HK$50 per index point

Business Day: 25 AUG 2020, TUESDAY

Contract Open Daily Daily Settle- Chg in Contract Contract Volume Open Chg in
Month Price High Low ment Setl High Low Interest OI
Price Price
20-Aug 25,568 25,619 25,327 25,460 -47 26,682 24,050 159,455 83,084 -23,671
20-Sep 25,480 25,523 25,236 25,358 -58 27,470 20,416 62,204 51,076 32,514
20-Dec 25,450 25,488 25,300 25,344 -55 28,523 22,150 867 7,275 -32
21-Mar 25,400 25,400 25,179 25,280 -54 25,400 24,000 153 1079 22

Note: long-dated futures are not included in the table.

2-8
 Payoff for Futures
Suppose that on August 25, 2020, an investor longed one
HSIF contract expiring in September 2020 at the
settlement price of 25,358.
On September 15, 2020, the settlement price is

 If the investor closed the position on September 15, the

payoff for the investor is

2-9
 Forward vs. Outright Purchase
Outright purchase:
• Invest $1,000 in index and own the index.
Forward:
• Invest zero, sign the contract
• Invest $1,020 at expiration and own the index.

Outright purchase – $1,000 – $0

Forward – $0 – $1,020

2-10
 Forward vs. Outright Purchase
Same outcome: own the index at expiration.
Why investing $1,000 now results in the same outcome
as investing $1,020 later?
• $1,000 now = $1,020 six month later
• It implies that the effective 6-month interest rate is 2%.
If we invest $1,000 in risk-free bond together with long
forward position, the cash flows will be the same as for
the outright purchase.

2-11
 Forward vs. Outright Purchase
Forward payoff Bond payoff

Forward + bond = Spot price at expiration – $1,020 + $1,020

= Spot price at expiration

Figure Summing
the value of the long
forward plus the
bond at each S&R
Index price gives the
line labeled “Forward
+ Bond”.

2-12
 Additional Considerations
Type of settlement
• Cash settlement: less costly and more practical
• Physical delivery: often avoided due to
significant costs
Credit risk of the counter party
• 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

2-13
 Call Option and Put Option
A call option gives the owner the right but not the
obligation to buy the underlying asset at a predetermined
price during a predetermined time period
• The seller of a call option is obligated to sell if asked
A put option gives the owner the right but not the
obligation to sell the underlying asset at a predetermined
price during a predetermined time period

2-14
 Terminology
Strike (or exercise) price: predetermined price

Exercise: the act of paying the strike price to buy (for

call) or selling the asset for the strike price (for put)

Expiration: the date by which the option must be

exercised or become worthless

2-15
 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 only on predetermined
dates, typically every month.
Focus: European-style options.

2-16
 Reading Price Quotes
Hang Seng Index Options Daily market report on top-10 traded
options on August 9, 2019. Source: www.hkex.com.hk

Ha ng S e ng Inde x Optio ns HK$ 5 0 pe r po int

TOP 10 TRADED (BY VOLUME) VOLUME O.Q.P. IV% DAILY DAILY OPEN O.Q.P.
CLOSE HIGH LOW INTEREST CHANGE
C 19-Aug 26800 2478 93 15 155 82 3158 -41
P 19-Aug 25400 2366 276 20 294 174 1970 20
P 19-Aug 25000 2261 189 21 202 115 2990 9
C 19-Aug 26000 1979 379 17 530 343 1962 -92
C 19-Aug 26400 1977 203 16 309 177 2100 -63
P 19-Aug 25600 1918 338 19 355 213 2394 27
C 19-Aug 26200 1779 279 17 413 250 1980 -81
C 19-Aug 26600 1760 141 16 220 121 2664 -51
C 19-Aug 27000 1612 59 15 101 53 4261 -29
P 19-Aug 25800 1548 412 18 430 264 2673 38 2-17
 Call Option on S&R Index
A 6-month 1000-strike call on S&R Index
• Underlying asset: S&R Index with current (spot) price of
$1,000
• Strike price: $1,000
• Expiration date: 6 months later
Today:
• call buyer acquires the right to pay $1,000 in six months for
the index, but is not obligated to do so
• call seller is obligated to sell the index for $1,000 in six
months, if asked to do so

2-18
 Payoff for the Buyer
Six months later at contract expiration:
• If the spot price ST is higher than $1,000, the call buyer will
exercise the option: pay $1,000, get ST. Payoff = spot price –
1,000
• If the spot price ST is lower than $1,000, the option buyer
will walk away and do nothing. Payoff = 0.

Payoff = Max [0, spot price – strike price]

2-19
 Call Option on S&R Index
Call option preserves the upside potential ( ), while at
the same time eliminating the unpleasant ( ) downside
(for the buyer)

Why would anyone agree to be on the seller side?

• The option buyer must pay the seller an initial premium of
$93.81 (option pricing)

– 93.81 Max(0, ST – 1000)

2-20
 Payoff and Profit for the Buyer
Payoff = Max [0, spot price at expiration – strike price]
Profit = Payoff – future value of option premium
Suppose effective 6-month risk-free rate is 2%
• If index value in six months = $1,100
• Payoff = max [0, $1,100 – $1,000] = $100
• Profit = $100 – ($93.81 x 1.02) = $4.32
• If index value in six months = $900
• Payoff = max [0, $900 – $1,000] = $0
• Profit = $0 – ($93.81 x 1.02) = – $95.68

2-21
 Profit Table for Long Call Position
Profit after 6 months from a purchased 1000-strike S&R call
option with a future value of premium of $95.68.

S&R Index Call FV of Call

in 6 Months Payoff Premium Profit
850      
900      
950      
1000      
1050      
1100      
1150       2-22
 Diagrams for Purchased Call
Payoff at expiration Profit at expiration
y = max [0, x –
1,000]
– (93.81 x 1.02)

2-23
 Payoff/Profit of a Written Call
Call writer: the option seller
• To receive the premium for option sold
• To have the obligation to sell if requested
Seller’s payoff and profit is opposite to the buyer
• Payoff = - max [0, spot price at expiration – strike price]
• Profit = Payoff + future value of option premium
The payoff and profit diagram of a written call is the mirror
image of a purchased call, symmetric with regard to the X-axis

2-24
 Profit Diagram for a Written Call

Figure Profit
for writer of 6-
month S&R call
with strike of
$1000 versus
profit for short
S&R forward.

y = (93.81 x 1.02)
– max [0, x –
1,000]
2-25
 Put Option
A put option gives the owner the right but not the
obligation to sell the underlying asset at a predetermined
price during a predetermined time period
• The buyer of a put option exercises the right if and only if
the spot price at expiration is lower than the strike price.
Payoff = max [0, strike price – spot price at expiration]
Profit = Payoff – future value of option premium

• The seller of a put option is obligated to buy if asked

2-26
 Put Option on S&R Index
A 6-month 1000-strike put on S&R Index
• Underlying asset: S&R Index with current (spot) price of
$1,000
• Strike price: $1,000
• Expiration date: 6 months later
Today:
• Put buyer pays $74.20 to acquire the right to sell the index
for $1,000 in six months, but is not obligated to do so
• Put seller is obligated to buy the index at $1,000 in six
months, if asked to do so
2-27
 Profit Table for Long Put Position
Profit after 6 months from a purchased 1000-strike S&R put option
with a future value of premium of $75.68.

S&R Index Put FV of Put

in 6 Months Payoff Premium Profit
850      
900      
950      
1000      
1050      
1100      
1150       2-28
 Profit Diagram for a Long Put Position

Figure Profit
on a purchased
S&R index put
with strike price of
$1000 versus a
short S&R index
forward.

y = max [0, 1,000 –

x]
– (74.20 x 1.02)
2-29
 A Few Items to Note
A call option becomes more profitable when the underlying
asset appreciates in value
A put option becomes more profitable when the underlying
asset depreciates in value
Moneyness of option:
• In-the-money: positive payoff if exercised immediately
• At-the-money: zero payoff if exercised immediately
• Out-of-the money: negative payoff if exercised immediately

2-30
 Discussion
For options with the same underlying asset,
An in-the-money call option has strike price higher or
lower than that of an out-of-the-money call? Or it can be
either higher or lower?
How about put options?
Is the following statement true or false?
• In-the-money call option has strike price higher than that
of in-the-money put option.
• Out-of-the-money call option has strike price higher than
that of out-of-the-money put option. 2-31
 Summary on Forward & Option
Table Maximum possible profit and loss at maturity for long
and short forwards and purchased and written calls and puts.

2-32
 Summary on Forward & Option

Figure Profit
diagrams for the
three basic long
positions: long
forward, purchased
call, and written put.
(Long w.r.t. the
underlying asset.)

2-33
 Summary on Forward & Option

Figure Profit
diagrams for the
three basic short
positions: short
forward, written
call, and
purchased put.
(Short w.r.t. the
underlying asset.)

2-34
 Basic Risk Management
In general, to hedge against price increase in the future:
• Take derivatives positions with positive payoff when price
is high
• Long forward, long call, short put

To hedge against price decrease in the future:

• Take derivatives positions with positive payoff when price
is low
• Short forward, short call, long put

2-35
 The Producer and the Buyer
A producer selling a risky commodity has an inherent
long position in this commodity
When the price of the commodity , the firm’s profit 
(assuming other costs are fixed)

A buyer that faces price risk on an input has an inherent

short position in this commodity
When the price of the input , the firm’s profit 
(assuming other costs are fixed)
2-36
 Golddiggers: Producer
Plan to mine and sell 100,000 ounces of gold over the
next year.

Fixed cost: $330 per ounce

Variable cost: $50 per ounce

Unhedged year-1 profit: S1 – $380 per ounce

Current gold price: $405 per ounce (in 2005)

Gold price one year later S1 is unknown.

2-37
 Hedging Instruments
In the market, there exists gold forward/futures and gold
options.
One-year gold forward: $420 per ounce
One-year gold options:

2-38
 Hedging Strategies
As a gold producer, the Golddigger worries about the
gold price one year later being too low. In order to
hedge:
• Short forward: lock in a price for his output
• Long put: secure the minimum selling price of his gold
one year later
• Short call: bring in premium now which is useful to
reduce the loss if the gold price is low one year later
• Combination of the above

2-39
 Hedging Result: Short Forward

The firm enters into a

short forward contract,
agreeing to sell gold at a
price of $420/oz. in 1
year.

Hedged profit: $40 per

ounce

2-40
 Hedging Result: Long Put
Suppose the mining firm
purchases a 420-
strike put
Result: sell at $420 if
gold price is lower than
$420.
Buying a put option
allows a producer to
have higher profits at
high output prices, while
providing a floor on the
price 2-41
 Hedging Result: Short Call
A written call reduces losses through a premium, but limits
possible profits by providing a cap on the price
Example: the
mining firm sells
a 420-strike call
and receives an
$8.77 premium
Result: forced to sell at $420 if gold price
is higher than $420.

2-42
 Producer: Hedging Strategies
$100.00

$80.00

$60.00

unhedged
$40.00
short
forward
long put
$20.00
short call

$0.00
360 380 400 420 440

-$20.00

-$40.00
2-43
 Different Use of Options
Purchasing a put option to hedge against price decline is
costly. The brought-in benefit is a minimum price at which
the producer will be able to sell the product.
Using put option with different strike price will incur
different cost (option price/premium) and have different
benefit.
Selling a call in addition to purchasing a put will result in
lower cost  collar position.

2-44
Figure Comparison of profit for
Golddiggers using three different put strikes.

Hedging using put

with higher strike
price results in
higher minimum
selling price but
benefit less from
price appreciation.

2-45
Figure Comparison of Golddiggers hedged with 420-strike
put versus hedged with 420-strike put and written 440-strike
call (420–440 collar).

Gold Price in 1 Year ($)

2-46
 Hedging Strategies for Buyer
As for gold buyer who needs gold one year later, the
worry is that the gold price may increase. To hedge:
• Long forward: lock in a future purchasing price
• Long call: set the maximum purchasing price of gold one
year later
• Short put: bring in premium now which is useful to
reduce the loss if the gold price is high one year later
• Combination of the above

2-47
 Use of Derivatives
Not all firms choose to hedge for the following reasons
• Transaction costs of dealing in derivatives
• The requirement for costly expertise
• The need to monitor and control the hedging process
• Complications from tax and accounting considerations
• Potential collateral requirements
Historically, there are many cases related to misuse of
derivatives.

2-48
 What can Go Wrong?
One of the risks faced by a company that trades
derivatives: an employee who has a mandate to hedge or
to look for arbitrage opportunities may become a
speculator.
Barings Bank Case:
• One of the most infamous tales of financial demise
• The 200-year-old British bank was wiped out in 1995 by
the activities of one trader, Nick Leeson, in Singapore

2-49
In 1993, Nick Leeson was appointed general manager of the
bank's Barings Futures subsidiary in Singapore.
The mandate is to look for arbitrage opportunities between
the Nikki 225 futures price on the Singapore exchange and
the Osaka exchange.
Over time, Leeson moved from being an arbitrageur to being
a speculator: bets on the future direction of the Nikkei 225
using futures and options.
When incurring losses, he began to take bigger speculative
positions.
By the time Leeson’s activities were uncovered, the total loss
was close to one billion dollars.

2-50
 Barings Bank Case
One trading strategy Leeson used: written straddle –
selling put and call options on the Nikkei 225 Index.
A written straddle is a bet on the volatility being low.
Hence it will produce positive earnings when markets
are stable but can result in large losses if markets are
volatile.
When an earthquake in Japan caused a steep drop in the
Nikkei 225 equity index, Leeson's unauthorized trading
positions suffered huge losses and his operation
unraveled.

2-51
 Barings Bank Case
Leeson managed both the trading and back office
function as the general manager. Thus he was able to
conceal his unauthorized trading activities for over a
year.
The senior managers at Barings came primarily from a
merchant banking background and knew very little
about trading.
In March 1995, Dutch banking group ING bought
Barings for one British pound, assumed its debts, took
over operations and renamed it ING Barings.

2-52
 Leeson Afterwards
Leeson pleaded guilty to fraud and was sentenced to six and
a half years in prison. (He was released from prison in July
1999 for good behavior.)
During his detention, he was diagnosed as suffering from
colon cancer which he survived.
When in prison, Leeson wrote a book “Rogue Trader”, which
was made into a movie.
Nick Leeson was the CEO of Galway United Football Club
(Ireland) for several years
In June of 2005, Leeson released a new book “Back from the
Brink: Coping with Stress”.

2-53
End of the Notes!

2-54