DERIVATIVES: INTRODUCTION

Week 1

Semester 2
2009-10
Peter Moles

Todays key ideas

Course outline & contents
Arbitrage
Aka Law of One Price

Replicating portfolios
Static replication
Dynamic replication

These are the essential

principles for understanding
derivatives pricing

Role of derivatives
Trading and settlement
Workshop: contract specifications

Derivatives

1. Course Outline & Contents

Course teacher
Dr Peter Moles
Current activity:
Researching in areas of capital budgeting
securities trading and risk management

Have in the past:

Dealt in derivatives
Traded securities

Located in Room 317

William Robertson Building
50 George Square
email: Peter.Moles@ed.ac.uk

Derivatives

Course outline
3 components

Key teaching approach

Forwards/futures
Swaps
Options

Combination of:

Assessment
Examination only
NB you may need a
calculator in class and
Definitely for tutorials

Taught material
Case studies
Workshops
Self-study via weekly exercises;
end of chapter review questions,
etc.

Derivatives

Topics
Terminal instruments
[I] Futures & Forwards
Introduction
Arbitrage & replicating
portfolio

[III] Options
Introduction & option
strategies/
Properties & behaviour of
options

Forward & futures pricing

Option pricing models
Index & interest rate futures
[II] Swaps
Swaps pricing
Swaps applications

Binomial
Black-Scholes-Merton

Options on indices,
currencies, futures/
Embedded options
The Greeks
Exotic options/Review

Derivatives

Required text
John Hull, 2009, Options, Futures, and Other Derivatives, 6e, Prentice Hall
References in the course booklet are made to this textbook
Also recommended is:
Robert Kolb & James Overdahl, 2007, Futures, Options, and Swaps, Blackwells
In addition, there are many textbooks, treatments and expositions of derivatives
pricing, markets, strategies, investment, etc.
Also many, many websites which have material on derivatives
but beware of quality of some of the discussion/analysis

Derivatives

2. Arbitrage or the Law of One Price in financial

markets

Arbitrage
Classic deterministic arbitrage involves buying an asset at a low
price in one market whilst immediately selling it at a higher price in
another market to make a risk-free profit with no net investment as
the cash received from selling is used to finance the purchase
Rule of thumb: buy low, sell high

Derivatives

Some principles
In an efficient market, assets (or combinations of assets [portfolios])
with the same payoffs should trade at the same price
To determine whether assets or combinations of assets are correctly
priced, we need a valuation model
in finance, most models are valuation models since we want to determine
whether our asset, portfolio, security or whatever we want to value is being
priced correctly
that is, we want to measure our model price against market prices
In addition, we may also be seeking to establish the price at which it would
trade in the market

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3. Replicating Portfolios
or
Applying Arbitrage

What is a replicating portfolio?

Law of one price says that two assets or portfolios that are identical
in payoff at a future point in time should have the same price today
A replicating portfolio is a portfolio that has the same payoff of
some other asset.
This is useful for derivatives pricing. We dont price the derivative
instrument directly we price the replicating portfolio that has the
same payoff as the derivative instrument
This is a very important insight and is the underpinning of
derivatives pricing

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Covered interest arbitrage

Interest rate parity:
t
(
1+ rUS$ )
F = S0
(1+ rfc )t

Quadrangle arbitrage:
Exploiting mispricing in different elements in FX market

1.
2.
3.
4.

Spot foreign exchange

Forward foreign exchange
Domestic deposit/loan
Foreign currency deposit/loan

See next slide

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13

Interest rate parity

and covered interest arbitrage
Domestic currency deposit/loan

Spot FX rate

[1]

(3)

(4)

[2]

Foreign currency deposit/loan

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Forward FX rate
14

Dynamic arbitrage
Some Not all arbitrage operations can take place at the onset. Take a
contingent claim [aka option] on a share (stock) which has a payoff (S K)
at T=2 where K = $90.
At T=1, the share price might rise to $120 or fall to $80. If it rises to $120 at
T=2 it might rise again to $140 or fall back to $100;
If it falls to $80 at T=1, at T= 2 it might rise again to $100 or continue to fall
to $60
The payoffs of the contingent claim at T=2 will depend on the share price
and will be:
Share price:
140
100
60
Contingent claim:
50
10
0
The current value of the share is $100 and the market price of the
contingent claim is $25, the one period interest rate = 4%
Is there an arbitrage opportunity?
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Possible price paths for the

security
T=0

Value of
contingent claim
T=2 at maturity (S K)

T=1
[UU]

140

50

100

10

60

120
[U]
[UD]

[a]

100
[DU]

[b]

[D]

80
[DD]

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Payoff of contingent claim

at maturity
What do we get at the maturity of the transaction from holding the
contingent claim?
With a strike price (K) = $90, then we will get the following outcomes:
T=2
Price of stock
Price for stock
Payoff

60
60*
0

100
90
10

140
90
50

Gain = difference between what we buy for and what we can sell for
(market price)
*In this case we dont complete transaction since we dont have to
(and, if needed can buy the share in market)
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Dynamic arbitrage [1]

As with the earlier examples, we want to sell the overvalued asset1
(in this case the contingent claim) and hold the arbitrage or
replicating portfolio:
T=0
Buy 0.6985 of share:

(69.85)

Borrow:

48.32

Proceeds from sale of contingent claim:

25.00

Net position/gain

3.47

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18

Dynamic arbitrage [2]

T=1
Share Price

120

80

Value of fractional holding in share

Required fractional holding1
Adjustment to share position2
[A] Total Asset position
Original borrowing (48.32 + interest)
Additional borrowing (repayment)
[B] Net borrowed funds
[A B] Net equity in position:

83.82
1.00
36.18
120.00
50.29
36.18
86.47
33.53

55.88
0.25
(35.88)
20.00
50.29
(35.88)
14.41
5.59

11
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19

Dynamic arbitrage [3]

Value of Shares
[A] Portfolio from T=1 S=120
[B] Borrowing (86.47 + interest)
[A B] Net equity in position

T=2
140
140
90
50

[A] Portfolio from T=1 S=80

[B] Borrowing (14.41 + interest)
[A B] Net equity in position
Payout on contingent claim
(S K), where K = $90
Net Position of arbitrageur

100
100
90
10(a)

60

25
15
10(b)

15
15
0

50

10

Note either (a) or (b) occurs

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20

10

Violation of the Law of One Price

The same thing can be obtained at two different prices.
It can be purchased at one price and sold for a higher price.
[Note: it might require clever analysis to determine how to
construct the same thing synthetically via a combination of market
instruments.]
Stakes are high enough since arbitrage = prospect of increased
wealth.
However, real financial markets are characterised by:
transaction costs
differences in information
irrationality, etc

Almost the same thing the same thing

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21

An aside: fundamental securities

and contingent claims
Fundamental financial instruments (securities) exist because
they are necessary to raise capital, modify and transfer risks, and/or
address contractual problems
Contingent claims (which derive their value from the price
behaviour fundamental securities and hence are often referred to
as derivatives i.e. their value is contingent on another security,
instrument, etc.) enable market participants to efficiently allocate
resources and modify risks.
Note: all contingent claim payoffs can be replicated using fundamental
financial instruments

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22

11

Implications of replicating
portfolio approach
Financial engineering of new securities (contingent claims)
Uses only (1) borrowing & lending and (2) investment in existing
securities (i.e. fundamental financial instruments)
Seller is indifferent to outcome (position is hedged against loss, if
model is correct)
Model provides a means of determining fair value of contingent claim
It is the cost of replication or the price of hedging

Assumes perfect capital market conditions

Real world might lead to divergence between model and outcome
Efficiency of outcome therefore depends on validity and applicability of the
pricing model

To make the model work, we only need to know, (1) risk-free interest
rate, and (2) values of securities in two states, not the probabilities of
the states occurring
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4. Role of Derivatives in Financial Markets

12

The financial markets

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25

What derivatives do [I]

Risk modification
Allows market participants to modify exposure to a
risk factor
Market risk
Credit risk

Hedging
Special case of risk modification where exposure is
reduced to zero

Speculation
Taking advantage of directional or exposure to
risks

Arbitrage
Exploiting market mispricing
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13

What derivatives do [II]

Decrease financing costs
Reducing borrowers financing costs

Tax and regulatory arbitrage

Exploiting differences in the way financial
instruments are treated by tax authorities and
regulators

Completing the market

Providing payoffs in states of the world that
are not available from existing securities

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5. Markets, Trading, and Settlement

(Institutional setting for markets in derivatives)

14

Derivatives markets
Exchange Traded
standard products
trading floor or computer trading
virtually no credit risk

Over-the-Counter
non-standard products
telephone market
some credit risk

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29

Types of traders
Hedgers
Speculators
Arbitrageurs

Some of the large trading losses in

derivatives occurred because individuals
who had a mandate to hedge risks
switched to being speculators

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30

15

Trading floor of the Chicago

Board of Trade (CBOT)

Derivatives exchanges are now mostly electronic platforms

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31

Securities firm/bank trading

room

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32

16

Margin
A margin is cash or marketable securities
deposited by an investor with his or her broker
The balance in the margin account is adjusted
to reflect daily settlement
Margins minimize the possibility of a loss
through a default on a contract

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Example of a futures trade

An investor takes a long position in 2 December gold

futures contracts on June 3
contract size is 100 oz.
futures price is US$400
margin requirement is US$2,000/contract (US$4,000 in total)
maintenance margin is US$1,500/contract (US$3,000 in total)

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17

A possible outcome

Day

Daily
Futures Gain
Price (Loss)
(US$) (US$)

Cumulative Margin
Gain
Account Margin
(Loss) Balance Call
(US$)
(US$) (US$)

400.00

4,000

3-Jun 397.00
.
.
.
.
.
.

(600)
.
.
.

(600)
.
.
.

3,400
.
.
.

0
.
.
.

11-Jun 393.30
.
.
.
.
.
.

(420)
.
.
.

(1,340)
.
.
.

2,660 + 1,340 = 4,000

.
.
.
.
.
< 3,000

17-Jun 387.00
.
.
.
.
.
.

(1,140)
.
.
.

(2,600)
.
.
.

2,740 + 1,260 = 4,000

.
.
.
.
.
.

24-Jun 392.30

260

(1,540)

5,060

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Other key points about exchange

traded contracts
They are settled daily
Closing out a position
In futures involves entering into an
offsetting trade
More complicated if option:
holder (buyer) can exercise, or
sell;
writer (seller) must repurchase

Note that most contracts are closed

out before maturity

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18

Delivery
If a contract is not closed out before maturity, it is
usually settled by delivering the assets underlying
the contract.
When there are alternatives about what is
delivered, where it is delivered, and when it is
delivered, the party with the short position chooses.
Some contracts, for example, those on stock
indices and Eurodollar deposits are settled in cash

(known as cash-settled)

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Regulation
Regulation is designed to protect the
public interest
Regulators try to prevent questionable
trading practices by either individuals
on the floor of the exchange or outside
groups

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19

Workshop

Contract specifications compared

Symbol
Hours
Contract unit
Price quotation

NYMEX
Light sweet crude oil
CL
09.00 13.30 (EST)
1,000 barrels
$ & per barrel

Minimum fluctuation
Termination of
trading
Listed contracts
Settlement type
Delivery
Grade & quality
Position limits

$0.01 per barrel

3 bus days prior to 25th
of month
9 years forward
Physical
Yes
Yes
Yes

CME
T-bond contract
US
07.20 14.00 (CST)
T-bond $100,000
Points ($1,000) & 1/32nd of
point ($31.25)*
1/32nd of a point (=$31.25)
7th bs day prior to delivery
day
3 contracts (M, J, S, D)
Physical
Yes
Deliverable bonds/notes
Yes
* 134-16 = 134 16/32

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par = 100 points

40

20

Finance & derivatives terminology

Do you understand all the various specialist terms used in finance?

Lets check some out terms that are used in derivatives markets

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21