Unit 7

DERIVATIVES
 Derivative Instruments
• Value is determined by, or derived from, the
value of another investmentvehicle, called
the underlying asset or security
• Forward contracts are agreements between
two parties - the buyer agrees to purchase an
asset, the seller agrees to sell the asset, at a
specific date at a price agreed upon now
• Futures contracts are similar, but are
standardized and traded on an organized
exchange
 Derivative Instruments
• Options offer the buyer the right, but not the
obligation, to buy or sell and underlying asset
at a fixed price up to or on a specific date
• Buyer is long in the contract
• Seller or “writer” is short the contract
• The price at which the transaction would we
made is the exercise or strike price
• The profit or loss on an option position
depends on the market price
 Why Do Derivatives Exist?
• Assets are traded in the cash or spot
market
• Sometimes have one’s fortunes
dependent on spot price movements
leads to considerable risk
– Various derivatives markets have evolved
that allow some investors to manage these
risks, while also creating opportunities for
speculators to invest in the same contracts
 Potential Benefits of
Derivatives
• Risk shifting
– Especially shifting the risk of asset price changes
or interest rate changes to another party willing to
bear that risk
• Price formation
– Speculation opportunities when some investors
may feel assets are mis-priced
• Investment cost reduction
– To hedge portfolio risks more efficiently and less
costly than would otherwise be possible
 Forward Contracts
• An agreement between two parties to
exchange an asset at a specified price on a
specified date
• Buyer is long, seller is short; symmetric gains
and losses as price changes, zero sum game
• Contracts trade OTC, have negotiable terms,
and are not liquid
• Subject to credit risk or default risk
• Value realized only at expiration
• Popular in currency exchange markets
 Futures Contracts
• Like forward contracts…
– Buyer is long and is obligated to buy
– Seller is short and is obligated to sell
• Unlike forward contracts…
– Standardized – traded on exchange
– More liquidity - can “reverse” a position and offset
the future obligation, other party is the exchange
– Less credit risk - initial margin required
– Additional margin needs are determined through a
daily “marking to market” based on price changes
 Futures Contracts
• Chicago Board of Trade (CBOT)
– Grains, Treasury bond futures
• Chicago Mercantile Exchange (CME)
– Foreign currencies, Stock Index futures, livestock
futures, Eurodollar futures
• New York Mercantile Exchange (NYMEX)
– Crude oil, gasoline, heating oil futures
• Development of new contracts
– Futures exchanges look to develop new contracts
that will generate significant trading volume
 Futures Contracts
• Futures Quotations
– One contract is for a fixed amount of the
underlying asset
• 5,000 bushels of corn (of a certain grade)
• $250 x Index for S&P 500 Index Futures (of a certain
maturity)
– Prices are given in terms of the underlying asset
• Cents per bushel (grains)
• Value of the index
– Value of one contract is price x contract amount
– Settle is the closing price from the previous day
 Options
Option Terminology
• Option to buy is a call option
• Option to sell is a put option
• Option premium – price paid for the
option
• Exercise price or strike price – the price
at which the asset can be bought or
sold under the contract
 Options
• Intrinsic Value of Options
– Call Option Intrinsic Value = Max [0, V-X]
– Put Option Intrinsic Value = Max [0, X-V]
• V = Stock Value
• X = Strike Price
– Option values cannot be negative since
they need not be exercised if it is not in the
owner’s interest to do so
 Options
Option Terminology
• Expiration date
– European: can be exercised only at expiration
– American: exercised any time before expiration
• In-the-money: option has positive intrinsic
value, would be exercised if it were expiring
• Out-of-the-money: option has zero intrinsic
value, would not be exercised if expiring
– If not expiring, could still have value since it could
later become in-the-money
 Options
• Chicago Board Options Exchange (CBOE)
– Centralized facility for trading standardized option
contracts
– Clearing Corporation is the opposite party to all
trades, allowing buyers and sellers to terminate
positions prior to expiration with offsetting trades
– Standardized expiration dates, exercise prices,
and contract sizes
– Secondary market with standardized contracts
– Offer options on almost 1,400 stocks and also
index options
 Options
• Stock Option Quotations
– One contract is for 100 shares of stock
– Quotations give:
• Underlying stock and its current price
• Strike price
• Month of expiration
• Premiums per share for puts and calls
• Volume of contracts
• Premiums are often small
– A small investment can be “leveraged” into high
profits (or losses)
 Options
• Payoff diagrams
– Show payoffs at expiration for different stock
prices (V) for a particular option contract with a
strike price of X
– For calls:
• if the V<X, the payoff is zero
• If V>X, the payoff is V-X
• Payoff = Max [0, V-X]
– For puts:
• if the V>X, the payoff is zero
• If V<X, the payoff is X-V
• Payoff = Max [0, X-V]
 Option Trading Strategies
There are a number of different option
strategies:
• Buying call options
• Selling call options
• Buying put options
• Selling put options
• Option spreads
 Buying Call Options
• Position taken in the expectation that the
price will increase (long position)
• Profit for a purchasing a Call Option:
Per Share Profit =Max [0, V-X] – Call Premium
• Note that profits on an option strategy include
option payoffs and the premium paid for the
option
• The following diagram shows different total
dollar profits for buying a call option with a
strike price of $70 and a premium of $6.13
 Buying Call Options
Profit from Strategy
3,000
2,500 Exercise Price = $70
Option Price = $6.13
2,000
1,500
1,000
500
0
(500) Stock Price at
Expiration
(1,000)
40 50 60 70 80 90 100
 Selling Call Options
• Bet that the price will not increase greatly –
collect premium income with no payoff
• Can be a far riskier strategy than buying the
same options
• The payoff for the buyer is the amount owed
by the writer (no upper bound on V-X)
• Uncovered calls: writer does not own the
stock (riskier position)
• Covered calls: writer owns the stock
 Selling Call Options
Profit from Uncovered Call
1,000 Strategy
Exercise Price = $70
500
Option Price = $6.13
0
(500)
(1,000)
(1,500)
(2,000)
(2,500) Stock Price at
Expiration
(3,000)
40 50 60 70 80 90 100
 Buying Put Options
• Position taken in the expectation that the
price will decrease (short position)
• Profit for purchasing a Put Option:
Per Share Profit = Max [0, X-V] – Put Premium
• Protective put: Buying a put while owning the
stock (if the price declines, option gains offset
portfolio losses)
• The following diagram shows different total
dollar profits for buying a put option with a
strike price of $70 and a premium of $2.25
 Buying Put Options
Profit from Strategy
3,000
2,500
2,000
Exercise Price = $70
1,500 Option Price = $2.25
1,000
500
0
(500) Stock Price at
Expiration
(1,000)
40 50 60 70 80 90 100
 Selling Put Options
• Bet that the price will not decline greatly
– collect premium income with no
payoff
• The payoff for the buyer is the amount
owed by the writer (payoff loss limited
to the strike price since the stock’s
value cannot fall below zero)
 Selling Put Options
Profit from Strategy
1,000
500
0
(500) Exercise Price = $70
Option Price = $2.25
(1,000)
(1,500)
(2,000)
(2,500) Stock Price at
Expiration
(3,000)
40 50 60 70 80 90 100
 Option Spreads
Many other option strategies can be crafted
using combinations of option positions
• Price spread (vertical spread)
– Buying and selling options on the same stock with
the same expiration, but with different strike prices
• Time spread (horizontal or calendar spread)
– Buying and selling options on the same stock with
the same strike price, but with different expirations
 Option Spreads
• Bullish spreads
– Buy a higher priced option and sell a lower priced
option on the same stock
• Bearish spreads
– Sell a higher priced option and buy a lower priced
option on the same stock
• Straddle
– Combination of a purchasing (long) or selling
(short) a put and a call on the same expiration
– Betting on a large price movement (long straddle)
or little price movement (short straddle)
 Option Spreads
• Strangle
– Combination of a call and put with the same
expiration but different exercise prices (long or
short)
– Similar to straddle strategies
• Butterfly spread
– Combination strategy with 4 options, similar to
straddles and strangles, but with less risk of large
losses
• The number of different strategies is
potentially limitless
 Put/Call Parity
• Premiums for puts and calls are not
completely independent otherwise arbitrage
opportunities would exist
• Two investments with equally risky payoffs
should have similar costs
• Parity relationships exist between options,
also between options and futures, options
and spot prices, and futures and spot prices
 Futures Valuation Issues
Cost of Carry Model
• Suppose that you needed some commodity
in three months. You have at least the
following two options:
– Purchase the commodity now at the current spot
market price (S0) and “carry” the commodity for 3
months
– Buy a futures contract for delivery of the
commodity in 3 months for the current futures
price (F0,3)
 Futures Valuation Issues
Cost of Carry Model
• The futures prices and spot prices must be
related to one another in order for there to be
no arbitrage opportunities for investors.
• If the carrying cost only amounts to forgone
interest at a risk-free rate (rf) for T time
periods, then the following relationship must
hold:
F0,T = S0 (1+rf)T
 Futures Valuation Issues
Cost of Carry Model Example: Suppose that
you can buy gold in the spot market for $300.
The monthly risk-free is .25%. You need the
gold in three months.
• What should be the current futures price?
F0,T = 300 (1+.0025)3 = 302.26
• What if the futures price is $305?
– You have a risk-less profit opportunity. Buy gold
at $300, sell futures at $305. In three months,
delivery the gold, pay the known interest, pocket
the difference.
 Futures Valuations Issues
• Similar futures-spot price relationships can
be derived when there are “market
imperfections” involved with carrying the
commodity or financial asset
• Incorporating storage and insurance costs as
a percentage of contract value (SI):
F0,T = S0 (1+rf +SI)T
• Incorporating ownership benefits lost with a
futures position, especially dividends(d):
F0,T = S0 (1+rf +SI -d)T
 Futures Valuation Issues
• Basis
– Basis is the difference between the spot and
futures prices.
– For a contract expiring at time T, the basis at time
t is:
Bt,T = St – Ft,T
– Over time, the spot and futures prices converge,
and basis becomes zero at expiration
– Between time t and expiration, basis can change
as the difference between spot and futures prices
vary (known as basis risk)
 Advanced Applications of
Financial Futures
• Stock Index Arbitrage
– An example of a program trading strategy
designed to take advantage of temporarily
“mis-pricing” of securities
– Monitor the parity condition (one period):
F0,T = S0 + S0 (rf - d)
– If it does not hold, construct a risk-free
position to take advantage of the situation.
 Advanced Applications of
Financial Futures
• T-Bond/T-Note Futures Spread
– “Note over bond” (NOB) spread
– Strategies based on speculating the
changing slope of the yield curve
 Options on Futures
• Also known as Futures Options
• Options on Stock Index Futures
– Gives the owner the right to buy (call) or
sell (put) a stock futures contract
• Options on Treasury Bond Futures
– Gives the owner the right to buy (call) or
sell (put) a Treasury bond futures contract
 Options on Futures
• Why would they be attractive?
– If exercised, it would seem to have been better to
simply buy a futures contract instead (no option
premium to pay)
– One primary advantage can be found when
looking at all the potential price movements
• Futures contracts used for hedging offset portfolio value
changes; thus, advantageous price movements for a
portfolio are offset by the futures position
• Options give the right (but not the obligation) to
purchase the futures contract; thus, favorable price
movements will be offset only by the option premium
rather than by a corresponding loss on the futures
position
 Valuation of Options
• Factors influencing the value of a call option:
– Stock price (+)
• For a given exercise price, the higher the stock price, the
greater the intrinsic value of the option (or at least the
closer to being in-the-money)
– Exercise price (-)
• The lower the price at which you can buy, the more
value
– Time to expiration (+)
• The longer the time to expiration, the more likely the
option will be valuable
 Valuation of Options
• Factors influencing the value of a call
option:
– Interest rate (+)
• Options involve less money to invest, lower
opportunity costs
– Volatility of underlying stock price (+)
• The greater the volatility of the underlying
stock, the more likely that the option position
will be valuable
 Valuation of Options
• Factors influencing the value of a put option:
– The same listed, but different directions for
several items.
– Stock price (-)
– Exercise price (+)
– Time to expiration (+)
– Interest rate (-)
– Volatility of underlying stock price (+)
 The Binomial Option-Pricing
Model
• Derives an option price using the
principle of no riskless profit
• Find a portfolio of stock and call options
that gives the same payoff in the future
regardless of whether the stock goes up
or down
– Called a hedge portfolio
 The Binomial Option-Pricing
Model
• If the hedged portfolio offers a risk-free
return, we can determine the portfolio’s
current value by discounting this return
at the risk-free rate
• Once we know the value of the
portfolio, we can separate this value
into two components
– The value of the stock
– The value of the option
 Binomial Option Pricing
Model: Example 1
Stock price Price in one year
now
$65

$50

$40
Assume: rf = 8%

Want the price of a call option (C0) with X =

$52.50
 Calculating Binomial Option
Prices
• We will look at a three step procedure:
Step 1: Estimate the number of call
options needed
Step 2: Determine the present value of
the hedge portfolio
Step 3: Compute the price of a call option
 Calculating Binomial Option
Prices: Step 1
• Calculate the option’s payoffs for each
possible future stock price
– If stock goes to $65, option pays off $12.50
– If stock goes to $40, option pays off $0
 Calculating Binomial Option
Prices: Step 1
• Determine the composition of the hedge
portfolio
– It contains one share of stock and “n” call
options
• Portfolio value = 1 share + n options
– If stock goes up, portfolio will pay:
$65 + [n x $12.50]
– If stock goes down, portfolio will pay:
$40 + [n x $0]
 Calculating Binomial Option
Prices: Step 1
• To determine the composition of the
hedge portfolio, find the number of
options that equates the payoffs
• $65 + $12.50n = $40 + $0n
– Implies n = -2
– Hedge portfolio is long one share of stock
and short two call options
 Calculating Binomial Option
Prices: Step 1
• Value of hedge portfolio today:
$50 - 2.00(C0)
 Calculating Binomial Option
Prices: Step 2
• Next, we must determine the today’s
value of the hedge portfolio
• We know the portfolio will pay $40 in
one year with certainty
• Thus the value of that portfolio right
now is
40/1.08 = $37.04
 Calculating Binomial Option
Prices: Step 3
• Finally, separate the current value of
the portfolio into its component parts
• The portfolio is worth $37.04 right now
– $50 of this value is the current price of the
stock
– The difference between $37.04 and $50 is
the revenue you would have received if
you sold the two call options
 Calculating Binomial Option
Prices: Step 3
• Value of the Call Option:
$50 – 2 C0 x = $37.04
Call price = $6.48
 Black-Scholes Option Pricing
Model
• Model for determining the value of
American call options
• This work warranted the awarding of
the 1997 Nobel Prize in Economics!
 Black-Scholes Option Pricing
Formula
P0 = PS[N(d1)] - X[e-rt][N(d2)]
where:
P0 = market value of call option
PS = current market price of underlying stock
N(d1) = cumulative density function of d1 as defined later
X = exercise price of call option
r = current annualized market interest rate for prime
commercial paper
t = time remaining before expiration (in years)
N(d2) = cumulative density function of d2 as defined later
 Black-Scholes Option Pricing
Formula
P0 = PS[N(d1)] - X[e-rt][N(d2)]
The cumulative density functions are defined as:
 ln( P / X  (r  0.5 2 )t 
d1   S
1

  (t ) 2 
Where:
ln(PS/X) = natural logarithm of (Ps/X)
d 2  d1   (t ) 2 
 1

  S = standard deviation of annual rate of

return on underlying stock
 Using the Black-Scholes
Formula
• Besides mathematical values, there are five
inputs needed to use this model:
– Current stock price (Ps)
– Exercise price (X)
– Market interest rate (r)
– Time to expiration (t)
– Standard deviation of annual returns (s)
• Of these, only the last in not observable
• Also, using the put/call parity, we can value
put options as well after calculating call value
 Option-like Securities
• Several types of securities contain
embedded options:
– Callable and Putable Bonds
– Warrants
– Convertible Securities
 Callable and Putable Bonds
• Callable Bonds contain a “call provision”
– The issuer has the option of buying the bonds
back at the call (exercise) price rather than having
to wait until maturity
– Attractive option for issuers if interest rates fall,
since they can purchase back old bonds and
refinance (refunding) with new, lower interest
bonds
– Typically will trade at no more than the call price,
since call becomes likely at that point
 Callable and Putable Bonds
• Putable Bonds contain a “put provision”
– Investors may resell the bonds back to the
issuer prior to maturity at the put (exercise)
price, often par value
– Puts can generally be exercised only when
designated events take place
 Warrants
• Warrant is an option to buy a stated
number of shares of common stock at a
specified price at any time during the
life of the warrant
• Similar to a call option, but usually with
a much longer life
• Issued by the company whose stock
the warrant is for
 Warrants
• Intrinsic value is the difference between the
market price of the common stock and the
warrant exercise price
Intrinsic Value = (Stock Price – Exercise Price)
x Number of Share
• Speculative value is the value of the warrant
above its intrinsic value
– Like other options, the value is higher than
intrinsic value, except at maturity
 Convertible Securities
• Allows the holder to convert one type of
security into a stipulated amount of another
type (usually common stock) at the investor’s
discretion
• With convertible securities, value depends
both on the value of the original asset and
the value if conversion takes place
– Value cannot fall below the greater of the two
values
 Convertible Securities
Convertible Bonds
• Advantages to issuing firms
– Lower interest rate on debt
– Debt represents potential common stock
• Advantages to investors
– Upside potential of common stock
– Downside protection of a bond
 Convertible Securities
Convertible bonds
– Conversion ratio = number of shares
obtained if converted
– Conversion price = Face Value/Number of
shares
• Valuation of convertible bonds
– Combination value of stock and bond
– Two step process to determine minimum
value
 Convertible Securities
Convertible Bonds
• Value of a convertible as a bond
– Determine the bond’s value as if it had no
conversion feature
– This is the convertible’s investment value or floor
value
• Value of a convertible as stock
– Compute the value of the common stock received
on conversion
– This is the conversion value
 Convertible Securities
Convertible Bonds
• Minimum Value = Max (Bond Value,
Conversion Value)
• Like other options, including embedded
options, they typically only sell at their
minimum, intrinsic value only at maturity.
– Conversion Premium = (Market Price – Minimum
Value)/Minimum Value
 Convertible Securities
Convertible Bonds
• Conversion Parity Price = Market
Price/Conversion Ratio
– An risk-free profit opportunity would exist if the
price of the convertible below this price, since
immediate conversion of the bond and then selling
the stock would yield a profit
• Conversion Arbitrage
– An attempt to take advantage of mis-priced
convertible bonds relative to the conversion ratio