DEPARTMENT OF FINANCE

University Of Dar Es Salaam Business

School

FN 319: Advanced Securities Analysis &

Portfolio Management

Lecture 7: Derivatives
 Coverage
 Derivative security and how it differs from more fundamental
securities
 The important characteristics of derivatives and how they are viewed
as insurance policies
 The organization of markets for derivative securities and how they
differ from other security markets
 Terminologies used to describe transactions that involve derivative
contracts
 Quotation and interpretation of prices for derivative securities

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 Coverage

 Payoff for forward, futures and option contracts

 How forward contracts, put options, and call options are related to
one another
 Using derivatives
 in conjunction with stock and Treasury bills to replicate the payoffs
to other securities and create arbitrage opportunities for an investor
 to restructure cash flow patterns and modify the risk in existing
investment portfolios

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 Derivatives
 A derivative is an instrument whose value depends directly on, or is
derived from, the value of another security or commodity
 These assets also are called contingent claims because their payoffs
are contingent on the prices of other securities
 Options: offer the buyer the right (without obligation) to buy or sell
at a fixed price up to or on a specific date
 Forward and futures contracts: the buyer agrees to purchase an asset
from the seller at a specific date at a price agreed to now
 Swap contracts-powerful tools for both hedging and speculation
 The advantages include risk shifting, price formation and
investment cost reduction

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 Options
 An option contract gives the holder the right, but not the obligation
to do something
 Specifically in relation to finance, an option contract gives the
holder the right, but not the obligation, to conduct a transaction
involving an underlying security or commodity at a predetermined
future date and at a predetermined price
 Two categories exist
 call option
 put option

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 Call Options
 A call option gives its holder the right (but not obligation) to
purchase an asset for a specified price, called the exercise or
strike price, on or before some specified expiration date.
 For example, an April call option on IBM stock with exercise price $95 entitles its owner to purchase
IBM stock for a price of $95 at any time up to and including the expiration date in April. The buyer
pays a purchase price known as premium

 The holder will choose to exercise only if the market value of the asset to be
purchased exceeds the exercise price . When the market price does exceed the
exercise price, the option holder may “call away” the asset for the exercise price.

 What will be the value of option? = Difference btn mtk price & strike price
 Net profit of exercising option = value derived-premium paid

 Why call option? Because You are worried that prices could go up in the
future.

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 Call Options
 Buyer/holder (long Position)

Net profit= Value derived-Premium paid

 Seller/Writer (short position)

Net profit= Premium- Value derived
If the call option is not exercised then net profit to the
seller will be equal to premium received which is also the
maximum loss suffered by the buyer

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 Call Options
• Consider the April 2020 expiration call option on a share of IBM stock with an exercise
price of $95 per share selling on March 2, 2020, for $1.35. Exchange-traded options expire
on April 20.

a) if On March 21, IBM sells for $90.90 what will the buyer do?
b) if IBM sells for $96 on April 20, what will the buyer do?

Suggested solution a) Because the stock price is currently less than $95 a share, it clearly
would not make sense at the moment to exercise the option to buy at $95.
Indeed, if IBM stock remains below $95 by the expiration date, the call will be
left to expire worthless

Profit to the writer= premium= $1.35 which is also the loss to the holder

b) The option will be exercised since it will give its holder the right to pay $95 for a
stock worth $9

Value at expiration =Stock price- Exercise price=$96- $95= $1

Profit/Loss to the holder=value-premium =$1-$1.35=- $0.35 which the net profit to

8 the writer
 Put Options
• A put option gives its holder the right to sell an asset for a specified exercise or
strike price on or before some expiration date.

• An April put on IBM with exercise price $95 entitles its owner to sell IBM stock
to the put writer at a price of $95 at any time before expiration in April, even if
the market price of IBM is less than $95

• A put will be exercised only if the exercise price is greater than the market price
of the underlying asset,

NB: One doesn’t need to own the shares of IBM to exercise the IBM put option
 Profit to Put holder which is also t he loss to the put writer= Value at expiration(Strike price-
market price)-Premium

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 Put Options
 Now consider the April 2020 expiration put option on IBM
with an exercise price of $95, selling on March 2, 2020, for
$4.90. It entitled its owner to sell a share of IBM for $95 at
any time until April 20.

a) If on expiration, market price turns to $90.90, what

will the put holder do?

b) If IBM sells for $88 at expiration, what will the put

holder do?

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 Put Options
• Suggested solutions

a) If the holder of the put buys a share of IBM and immediately

exercises the right to sell at $95, net proceeds will be $95-$90.90
$4.10. Because he pays $4.90 for the put, he won’t of exercise it
immediately.
b) If, IBM sells for $88 at expiration, the put turns out to be a
profitable investment.
Its value at expiration=$95-$88 =$7 and the investor’s profit =$7-
$4.90 =$2.10

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 Key terms

Term Call Option Put Option

Market price> Strike price: Market price < Strike price:
In the Money Call option exercised Put Option exercised

Market price<Strike price Market Price > Strike Price

Out of the Money Call option NOT exercised Put Option NOT exercised

Market price= Strike price: Market price=Strike price:

At the Money Call option may/may not be Put Option may/may not be
exercised exercised

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 Trading of Options

Options can be traded either over the counter or in a

standardized market.
Under OTC Market the terms of the option contract—the
exercise price, maturity date, and number of shares committed
—can be tailored to the needs of the traders.

Its disadvantage: costs of establishing an OTC option contract

are relatively higher and hence less common in the world.

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 Trading of Options

 Standardized Markets: Options are traded with

standardized maturity dates and exercise prices for each
listed option.

 Advantages: all market participants trade in a limited and

uniform set of securities which increases the depth of trading
in any particular option, lowers trading costs and results in a
more competitive market (increases liquidity).

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 Trading of Options

The Option Clearing Corporation (OCC)

the clearinghouse for options trading

jointly owned by the exchanges on which stock options are traded

places itself between options traders, becoming the effective buyer of the
option from the writer and the effective writer of the option to the buyer

effectively guarantees contract performance. How? By collecting

margin to guarantee from the writers as evidence that they can fulfill
their contract obligations

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 Options Embedded Securities

 Many securities have explicit or implicit options attached.

 Callable Bonds
 Convertible Securities
 Warrants
 Collateralized loans

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 Other Listed Options

• Index options -a call or put based on a stock market index such as the S&P
500 or the New York Stock Exchange index.

• Futures options-give their holders the right to buy or sell a specified

futures contract, using as a futures price the exercise price of the option

• Foreign currency options-offers the right to buy or sell a quantity of

foreign currency for a specified amount of domestic currency

• Interest rate options -traded on Treasury notes and bonds, Treasury

bills, certificates of deposit, and yields on Treasury securities of various
maturities.

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 Options
 Terminologies for conventional/tradable options:
 Exercise or strike price (X)
 Expiration date (T)
 Tenure of the Option (from t0 to T)
 Time to expiration (at any time t, the time to expiration is
the gap between T and t)
 The price of the option (commonly known as premium) (c
for call and p for put)
 The price of the underlying asset (St) – changes with time

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 Options

 When can the option (right) holder exercise?

 Only at expiration date – European option
 Anytime during its tenure and including the expiration
day – American option

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 Call Options Payoff Profiles

 Suppose you hold a call option on Fin Corp stock with an exercise price of
$80, and Fin Corp is now selling at $90, you can exercise your option to
purchase the stock at $80 and simultaneously sell the shares at the market
price of $90, generating a value at expiration of $10 per share.
 if the shares sell below $80, you can sit on the option and do nothing,
realizing no further gain or loss
 We can generate a schedule of option values at different stock prices as
shown below

 If we assume the cost of option is $14, the graph of values against stock prices for the
Option HOLDER can be shown below;

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 Call Options Payoff Profiles

$30

Payoff and profit to call

Payoff = Value at
option at expiration
$20 expiration

$10

0 ST
60 70 80 100
90 of option
Cost
Profit
– $10
– $14

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 Call Options Payoff Profiles

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 Put Options Payoff Profiles

• Recall this fact ; the put holder will not exercise the option
unless the asset price is less than the exercise price

• If Fin Corp shares were to fall to $70, a put option with

exercise price $80 could be exercised to give a $10 payoff to
its holder.

• The holder would purchase a share for $70 and

simultaneously deliver it to the put option writer for the
exercise price of $80.

• If the stock price at option expiration is above $80, the put

has no value
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 Put Options Payoff Profiles

If we assume different stock prices and determine value at

expiration, the following schedule be generated for the Put
holder

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 Put Options Payoff Profiles

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 Options vs Stock Investments

• Purchasing call options is a bullish strategy; that is, the calls

provide profits when stock prices increase

• Purchasing puts, in contrast, is a bearish strategy

• Writing calls is bearish, while writing puts is bullish

• Because option values depend on the price of the underlying

stock, the purchase of options may be viewed as a substitute
for direct purchase or sale of a stock.

• Why might an option strategy be preferable to direct stock

transactions?
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 Options vs Stock Investments

Suppose you believe the stock will increase in value from its current level,
which we assume is $90. Suppose also that a six-month maturity call option
with exercise price of $90 sells for $10, and the semiannual interest rate is
2%

Consider the following three strategies for investing $9000

•Strategy A: Invest entirely in stock. Buy 100 shares, each selling for $90.

•Strategy B: Invest entirely in at-the-money call options. Buy 900 calls,

each selling for $10.

•Strategy C: Purchase 100 call options for $1,000. Invest the remaining
$8,000 in six- month T-bills, to earn 2% interest.

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 Options vs Stock Investments
Portfolio Stock price ($)
85 90 95 100 105 110

A: 100 shares 8500 9000 9500 10000 10500 11000

stock

B: 900 call 0 0 4500 9000 13500 18000

options

C: 100 calls 8160 8160 8660 9160 9660 10160

plus $8,000
In T-Bills

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 Options vs Stock Investments

  Stock Price  

Portfolio $85 $90 $95 $100 $105 $110

A: 100 shares stock —5.56% 0.0% 5.56% 11.11% 16.67% 22.22%

B: 900 call options —100.0 —100.0 —50.00 0.0 50.0 100.0

C: 100 calls plus          

$8,000 in T-bills —9.33 —9.33 —3.78 1.78 7.33 12.89

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 Options vs Stock Investments

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 Options vs Stock Investments

Two key issues from the graph

•First, an option offers leverage; This leverage factor is the
reason that investors (illegally) exploiting inside information
commonly choose options as their investment vehicle.
•Second, Options offer potential insurance value as they can be
used by investors who desire to tailor their risk exposures in
creative ways.

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 Option Strategies

1. Protective Put : Under this strategy, an asset is

combined with a put option that guarantees minimum
proceeds equal to the put’s exercise price. This can be
illustrated as follows
ST ≤ X ST › X

Payoff to protective put strategy Stock ST ST

Put X — ST 0

  Total X ST

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 Option Strategies

A protective put will guarantee you a minimum payoff as

illustrated in the graph below

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 Option Strategies

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 Option Strategies
Suppose the strike price of a protective put is X = $90. What
will be the value of protective put

a)If the stock is selling for $87 at option expiration

b)If the stock is selling for $94 at option expiration

Suggested solution:

a)Value of protective put= value of put ($90-$87) + stock price

($87)= $90

b)Value of protective put=Value of put($0)+stock price ($94)=

$94
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 Option Strategies
2. Covered Call;
Under this strategy, purchase of a share of stock is done
with the simultaneous sale of a call on that stock. The
option is “covered” because the potential obligation to
deliver the stock is covered by the stock held in the
portfolio.

The payoff to a covered call equals the stock value minus the
payoff of the call
•Why minus? because it involves issuing a call to another
investor who can choose to exercise it to profit at your expense.
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 Option Strategies

ST ≤X ST › X

Payoff to a covered call Payoff of stock ST ST

–Payoff of call —0
—(ST — X)

Total ST
X

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 Option Strategies

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 Option Strategies

•Writing covered call options boost income by the premiums

collected at the expense of potential capital gains should the
stock price rise above the exercise price.
•But if we assume strike price as the price at which they
plan to sell the stock, then the call may be viewed as
enforcing a kind of “sell discipline.”
•The written call guarantees the stock sale will occur as
planned.

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 Option Strategies

Assume a pension fund holds 1,000 shares of GXX stock, with a

current price of $130 per share. Suppose the portfolio manager
intends to sell all 1,000 shares if the share price hits $140, and a
call expiring in 90 days with an exercise price of $140 currently
sells for $5.
Would you advice the Pension fund to write a covered call?

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 Option Strategies

Suggested solution
By writing 10 GXX call contracts (100 shares each) the fund can
pick up $5,000 in extra income.
The fund would lose its share of profits from any movement of
GXX stock above $140 per share, but given that it would have
sold its shares at $140, it would not have realized those profits
anyway.

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 Option Strategies
3. Straddle:
•A combination of a call and a put, each with the same
exercise price and expiration date.
•useful strategies for investors who believe a stock will
move a lot in price but are uncertain about the direction of
the move. e.g if the company is having a court case that may
severely impact share price.
•An investor who establishes a straddle must view the stock
as more volatile than the market does.
• Investors who write straddles—selling both a call and a put—must
believe the market is less volatile and accept the option premiums now,
hoping the stock price will not change much before option expiration.
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 Option Strategies

ST≤ X ST › X
Payoff to a
straddle

ST — X
Payoff of a call 0

+ Payoff of a Put +(X — ST) +0

Total X — ST ST — X

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 Option Strategies

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 Options

 Straddle
Buy a Call with an
Exercise price of
500 for 100

Long Straddle

100

150 350 450 Buy a Put with an

600
500 Exercise price of
650 500 for 50

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 Options
Levered Equity position & the Put-Call Parity
Consider two investors A and B with similar
investment horizon (from T0 to T)
 Investor A: At time T0 borrows an amount, S0, at interest
rate, rf , to be repaid at time T such that the total repayment
equals X. The borrowed amount, S0, is then used to buy a
stock.
 Investor B: At time T0 buys a call option on a stock (pays C0
) and simultaneously writes (sells) a put option on the same
stock (gets P0). Both options have the same exercise price
(X) and expiration date (T).
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Determine the outcome/payoff of each investor at time T
 Options

 The terminal values (payoff at the end) for the

two investors are identical (ST-X)
 When the payoffs are identical, the cash outlay
needed to set up the positions must also be equal
 Investor A has a levered equity position in the stock
 Borrowed X/(1+ rf)T to buy the stock at S0
 His equity in setting up the position is S0-X/(1+ rf)T
 Investor B sold the put option at P0 and bought
the call option at C0
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 His equity in setting up the position is C0-P0
C 0  Xe  r  P0  S 0

Options

 This is the put call parity: C0-P0 = S0-X/(1+ rf)T

 Full leveraged equity put-call parity:
 With a fully levered position (i.e. when S0 = X/(1+ rf)T),
investor A is able to set up the position with no cash
outlay of his own.
 This means that investor B need no own funds to set
up her position.
 Therefore, the relationship C0-P0 =0 or C0=P0 holds

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 Options

 With continuously compounding interest, the

put-call parity has the form C0-P0 = S0-Xe-rτ
 Where τ is the time to maturity
 This is also written as C0 = P0 + S0-Xe-rτ t or P0 =
C0-S0+Xe-rτ
 At any given time t, the relationship
Ct = Pt + St-Xe-rτ or Pt = Ct-St+Xe-rτ holds

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 Options
 The relationship Ct = Pt + St-Xe-rτ or
Pt = Ct-St+Xe-rτ tells us that, for given strike
price (X), the price of an option depends on:
1. The time value of money as captured by the risk-
free interest rate
2. The time to expiration (τ) and
3. The price of the stock (St).
 Since the price of the stock (St) fluctuates overtime, the
volatility of the price needs to be taken into account

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 Options

 The time value of a call option

 Intrinsic or exercise value is IV= St-X
 Time value is TV=Ct – IV
 We rewrite the time value as TV=Ct – (St-X)
 From the put-call parity Ct = Pt + St-Xe-rτ we
know that Ct >= St-Xe-rτ
 If we deduct St+X from both sides we get
Ct – St+X>= St-Xe-rτ - St+X
Ct – (St-X)>= X – Xe-rτ
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 Options

 Ct – (St-X)>= X – Xe-rτ
 The LHS is TV hence TV>= X – Xe-rτ
 The time value is greater than the difference
between the exercise price and its present value.
 So where does the “extra value”, if any, come from?

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