Topic X Derivatives

Market

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the nature and characteristics of forward contract, futures
contract and options;
2. Analyse the factors that influence the price of options;
3. Differentiate between options and futures contract;
4. Justify the importance of hedging in managing risk; and
5. Evaluate how derivatives are priced using the basic Binomial Pricing
theorem and the Black-Scholes pricing model.

X INTRODUCTION
Among the most innovative and most rapidly growing markets to be developed
in recent years are the markets for financial futures and options. Futures and
options trading are designed to protect the investor against interest rate risks,
exchange rate risks and price risks. In the financial futures and options markets,
the risk of future changes in the market prices or yields of securities are
transferred to someone (an individual or an institution) who is willing to bear
that risk. Financial futures and options are used in both short-term money
markets and long-term capital markets to protect both borrowers and lenders
against the risks involved.
Although financial futures and options are relatively new in the field of finance,
risk protection through futures and options trading is an old concept in
marketing commodities. As far back as the Middle Ages, traders in farm
commodities developed contracts calling for futures delivery of farm products at

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DERIVATIVES MARKET W 127

a guaranteed price. Trading in rice futures began in Japan in 1697. In the United
States, the Chicago Board of Trade established a futures market in grain in 1848.
More recently, the Chicago Board developed futures and options markets for
financial instruments. The Malaysian first derivatives exchange was established
in July 1993 under the name Kuala Lumpur Options and Financial Futures
Exchange (KLOFFE). In October 1995, the Malaysian Derivatives Clearing House
(MDCH) was established for both KLOFFE and the Commodity and Monetary
Exchange of Malaysia (COMMEX), and the Malaysian Derivative Exchange
(MDEX) is the only derivative exchange in Malaysia. MDEX in now known as
Bursa Malaysia Derivatives Berhad (BMD) and it operates under the supervision
of Securities Commission.

8.1

GENERAL DESCRIPTION OF DERIVATIVES

A derivative security is a financial contract written on an underlying asset.

The underlying asset may be a share, Treasury Bill, foreign currency or even
another derivative security. For example:
(a)

The value of a share option depends upon the value of the share on which it
is written.

(b)

The value of a Treasury Bill futures contract depends upon the price of the
underlying Treasury Bill.

(c)

The value of a foreign currency forward contract depends upon the foreign
currency forward rates.

(d)

The value of a swap depends upon the value of the underlying swap
contract.

Two types of derivative security, futures and options, are actively traded on
organised exchanges. These contracts are standardised with regard to a
description of the underlying asset, the right of the owner, and the maturity date.
Forward contracts, on the other hand, are not standardised; each contract is
customised to its owner, and they are traded in what is called over-the-counter.
Options can be found embedded in other securities, convertible bonds and
extendible bonds being two such examples. A convertible bond contains a
provision that gives an option to convert the security into common share. As
extendible bond contains a provision that gives an option to extend the maturity
of the bond.

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Once we understand simple derivative securities, then it will be easy to

understand the complicated examples of derivative securities such as these
embedded options. This topic explains derivative securities: forward contracts,
futures, and both call and put options.

8.2

FORWARD CONTRACT

A forward contract is an agreement to buy or sell a specified quantity of asset at

a specified price, with delivery at a specified time and place.
The specified price will be referred to as the delivery price. At the time the
contract is written, the delivery price is set such that the value f of the forward
contract is zero. The party that agrees to sell the underlying asset is said to have a
short position. The party that agrees to buy the underlying asset is said to have a
long position.
A forward contract is settled at the delivery date, sometimes called the maturity
date. The holder of the short position delivers the specified quantity of the assets
at the specified place and in return receives from the holder of the long position a
cash payment equal to the delivery price. No cash exchange occurs prior to the
delivery date.
For example, suppose that a company enters into a forward contract today, at
date t. The forward contract matures at date T. Let f(t, T) denote the forward
price. There are two arguments in this price. The first argument, t, denotes the
date that forward price is quoted, and the second argument, T, denotes the
delivery date of the contract.
When the contract is initiated, by definition the forward price equals the delivery
price, denoted by K(t). The delivery price is determined so that no cash is
exchanged at this time; the delivery price is fixed over the life of the contract.
f(t, T)
t
Initial date

K(t)
T
Delivery date

Let S(t) denote the spot exchange rate (RM/USD) at date t. When the contract
matures at date T, the spot exchange rate is denoted by S(T). This spot exchange
rate is unknown when the forward contract is initiated. It is called a random

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variable. The value of the forward contract at the delivery date, date T, to the
long position initiated at date t for one currency is:
S(T)  K(t)
Note that the argument t in the delivery price refers to the date the contract was
initiated. The value of the forward contract at delivery equals the value of the
foreign currency, S(T), less the delivery price paid, K(t). As illustrated in the
above example, the value of the forward contract at delivery can be either
positive or negative. A graph of the possible values is shown below.

Figure 8.1: Possible value of a forward contract

The delivery price K(t) equals the forward price f(t, T) when the contract is
initiated.
If the spot exchange rate at the delivery date is less than the delivery price S(T) <
K(t), then the value of the forward contract is negative; otherwise, it is zero or
positive. The delivery price equals the prevailing forward price, K(t) = f(t, T),
when the contract is initiated. Once the contract is written, the delivery price is
fixed over the life of the contract. The forward price, which represents the
delivery price of newly written contracts, of course can change. If you contracted
with a financial institution tomorrow, date t + 1, about buying USD for delivery
date T, in general there would be a new delivery price or forward price, K(t + 1)
= f(t + 1, T).
This completes the institutional description of a forward contract. We will return
to these contracts when we analyse pricing and hedging.

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ACTIVITY 8.1
List at least three examples of forward contracts available in the
Malaysian market. You can refer to the Malaysian Investor website at
http://www.min.com.my under products, and other resource
materials such as business newspapers and magazines. Also list the
advantages and disadvantages of a forward contract.

8.3

FUTURES CONTRACT

A futures contract is an agreement to buy or sell a specified quantity of an asset

at a specified price, and at a specified time and place.
This part of the definition of a futures contract is identical to that of a forward
contract. But futures contracts differ from forward contracts in four important
ways. The differences are:
(a)

Futures contracts allow participants to realise gains or losses on a daily

basis, while forward contracts are cash settled only at delivery.

(b)

Futures contracts are standardised with respect to the quality and the
quantity of the asset underlying the contract, the delivery date or period,
and the delivery place if there is physical delivery. In contrast, forward
contracts are customised on all these dimensions to meet the needs of the
two counterparties.

(c)

Futures contracts are settled through a clearing house. The clearing house
acts as a middleman. This minimises credit risk as the second party to a
futures contract is always the clearing house.

(d)

Futures markets are regulated, while forward contracts are unregulated.

Now let us look at an example of a futures contract.

Consider that A wants to sell futures (that means he wants to sell the underlying
asset) that matures in three months. The price of the underlying asset now is
RM2.30 and the risk-free interest rate is 4% per year. What A could do is: (1)
borrow RM2.30 from a bank for three months, and (2) use the borrowed money
to buy the asset at RM2.30. After three months, A will sell the asset at the agreed
price f and the proceeds will be used to pay the loan and he can keep the balance.
This strategy is called the ccash-and-carry strategy.

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The payoff from this strategy is:

Stock investment
Futures contract
Repay borrowing
Net payoff

8.3.1

2.30
 [2.30  f ]
 2.30 (1 + 0.04 u 0.25)
f  2.30(1 + 0.04 u0.25)

Clearing House

This intervention of the clearing house means that the futures market has no
counterparty risk. If A plans to buy futures and B plans to sell futures, both
parties will refer to the clearing house to fulfil their intentions. The clearing
house is thus the counter party to every contract. In this case, B is not the counter
party to A.
The clearing house must have reserves to guarantee that its contracts are
executed and are considered risk-free. It actually accepts that the counterparty
may default on the contract and for this it charges a small fee for each contract
executed. Further, the clearing house only accepts contracts from recognised
traders and sets a margin account. In margin accounts, investors are required to
maintain or keep some amount of money. In Malaysia, the clearing house
derivatives is the Malaysian Derivative Exchange (MDEX). Please note that if the
net payoff is not equal to zero, then arbitrage profit is possible.
The functions of the Clearing House can be summarised as shown in Figure 8.2.

Figure 8.2: Clearing House functions

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8.3.2

Settlement Price

A futures contract is marked-to-market each day. When each trading is closed,

the exchange will establish the closing price, which is the settlement price.
This settlement price is used to compute the investors position, whether at a loss
or a gain compared with the initial settlement price agreed upon at the inception
of the contract. This means that the change in the futures price over the day is
credited (debited) to the account of the long (short) if the change is positive. If the
change is negative, the account of the long (short) is debited (credited).

8.3.3

Daily Margin

When a person enters into a futures contract, the individual is required to deposit
funds in an account with the broker. This account is called the margin account.
The exchange sets the minimum amount of margin required, but brokers can
increase the margin if they feel that the risk of the investors default is increased.
This margin account may or may not earn interest. The economic role of the
margin account is to act as collateral to minimise the risk of default by either
party in the futures contract.
Since the price of futures is marked-to-market, the gain or loss on the futures
contract will also change on a daily basis. Thus the margin needs to be adjusted
to reflect these changes. These changes are reflected in what is known as the
maintenance margin. This will ensure that a minimum amount is kept in the
margin account with respect to the changes in gain or loss.
Lets look at an example of the initial margin and the maintenance margin.
Consider A, who on 3 March enters into a futures contract to buy 100 troy ounces
of gold at the futures price of RM365 per troy ounce. The initial margin for the
contract is set at RM2,000 and the maintenance margin is set at 75% of the initial
margin, or RM1,500.
Table 8.1 below shows the calculation that reflects the changes in the margin
when the daily price changes. We observe that on 5 March, the price drops to
RM359 and a cash flow of RM300. This reduces the initial margin to RM1,400
which is below the maintenance margin of RM1,500. At this point, A has to topup the margin account back to the original RM2,000. Thus, A has to withdraw or
put in RM600 into the margin account. We assume that A will withdraw any
excess margin (in excess of RM2,000).

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Table 8.1: Margin and Marking to Market

Date

Futures Price

Cash Flow

3/3
4/3
5/3
6/3
7/3
8/3

365
362
359
364
365
367

0
300
300
+500
+100
+200

8.3.4

Cash Deposit/
Withdrawal
2000
0
600
500
100
200

Ending Margin
2000
1700
2000
2000
2000
2000

Basis

Let F(t, T) denote the futures price at date t, for delivery at time T. Let the
contract be written on an underlying asset, with spot price S(t). In a wellfunctioning and efficient market, the futures price equals the price of the
underlying asset at the delivery date. Figure 8.3 shows that F(t, T) = S(T).
s(t)

S(T)

t
F(t, T)

T
Figure 8.3: F(t, T) = S(T)

In fact, the futures price at T for immediate delivery should be equal to S(T). That
is F(T, T) = S(T). The difference between the futures price and the spot price is
known as the basis. Thus, the basis at time t is;
Basist = F(t, T)  S(t).
In the forward or futures contracts investment, the risk involved is represented
by the change in the value of the basis. Thus, when the change in the basis is
relatively large, the risk involved in that investment is also large. This is
important when we consider the use of forward or futures contracts to hedge, for
instance, our investment in the cash market. We will consider this idea later in
the topic.
A typical graph of the basis with respect to maturity is shown in Figure 8.4.

134 X TOPIC 8 DERIVATIVES MARKET

Figure 8.4: Basis with respect to maturity

In the graph above, we see that the basis is positive. However, this is not always true.
Basis can also be negative. What is important is that the graphs should converge.

8.3.5

Using Futures for Hedging

Futures are usually used to hedge our investment or lock the price of the
underlying asset. Thus with hedging, we can construct a portfolio consisting of
assets on both the spot and the derivatives markets. It is important to understand
that in the spot market, we are dealing with the price risk whereas in the futures
market, we are faced with the basis risk. If basis0 = basisT, then we should be able
to use perfect hedging, which means the value of the underlying asset at time 0
and time T are equal.
Hedging is easier to understand by using examples. Lets look at examples where
futures are used for hedging. Be sure to follow the example and understand what
happens to the value of our portfolio when basis0  basisT.

We will assume that as the price in the spot market increases, the price in the
futures market will also increase. This is to say that the two prices are closely

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DERIVATIVES MARKET W 135

correlated, which is what we usually observe. Suppose you sell one unit of
futures and buy one unit of the underlying asset. Thus, your portfolio is (S  F).
At time t, your portfolio is worth (S(t)  F(t)), and at time T, it is worth (S(T) 
F(T)).
Thus, the change in spot price is (S(T)  S(t)) and the change in the futures price is
(F(T)  F(t)). To see how the value of our portfolio changes, refer to the following
formula.
(S(t)  F(t))

= S(t)  F(t) = (S(T)  S(t))  (F(T)  F(t))

= (S(T)  F(T))  (S(t)  F(t))
= BasisT  Basist
= (Basis)

If there is no change in the basis, then the value of our portfolio remains the
same, thus we have locked in the value of the portfolio. The result would be
different if the values of the basis are not constant.
Now, lets look at the mechanism in using futures for hedging using two companies,
Gold Mining Company and Jewellery Company. The Gold Mining Company
expects to sell 1,000 ounces of gold next month and the Jewellery Company expects
to buy 1,000 ounces of gold next month. However, to hedge against the risk of
changes in the price of gold in a months time, both companies want to lock in
todays price. Assume that todays price for gold is $352.40 per ounce and the
current futures price is $397.80. Each futures contract is for 100 ounces.
You are advised to carefully study Tables 8.2  8.5 on the next page to understand
the mechanism of using futures in hedging. Attention should be given to what
happens to hedging when the basis at the time the contract is initiated is not equal
to the basis when the futures mature. This will explain the basis risk which will
ultimately influence the gain or loss when futures are used. We also note that since
the Gold Mining Company wishes to sell gold in the future, then it will short or
sell futures when the contract is initiated. Similarly, the Jewellery Company will
long or buy futures since it wishes to buy gold in the future.

136 X TOPIC 8 DERIVATIVES MARKET

Table 8.2: Hedging Price That Locks Gold Spot Price: Spot Price Decrease
Assumption
Spot price when hedging is made
Futures price when hedging is made
Spot price when hedging expires
Futures price when hedging expires
Number of ounces hedged
Number of ounces in one futures contract
Number of futures contract used

$352.40
397.80
304.20
349.60
1000
100
10

per oz.
per oz.
per oz.
per oz.

Short (sell) hedging by Gold Mining Company

Cash market

Futures market

Basis

When hedging is made

Value of 1,000 ounces:
1,000 x $352.40 = $352,400

Sell 10 contracts:
10 x 100 x $397.80 = $397,800

$45.40 per oz.

When hedging expires

Value of 1,000 ounces:
1,000 x $304.20 = $304,200

Buy 10 contracts:
10 x 100 x $349.60 = $349,600

Loss in cash market

= $48,200

Gain in futures market

= $48,200

$45.40 per oz.

Overall loss or gain

= $0
Long (buy) hedging by Jewellery Company
Cash market

Futures market

Basis

When hedging is made

Value of 1,000 ounces:
1,000 x $352.40 = $352,400

Buy 10 contracts:
10 x 100 x $397.80 = $397,800

$45.40 per oz.

When hedging expires

Value of 1,000 ounces:
1,000 x $304.20 = $304,200

Sell 10 contracts:
10 x 100 x $349.60 =$349,600

Gain in cash market

= $48,200

Loss in futures market

= $48,200
Overall loss or gain
= $0

$45.40 per oz.

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Table 8.3: Hedging Price That Locks Gold Spot Price: Spot Price Increase
Assumption
Spot price when hedging is made
Futures price when hedging is made
Spot price when hedging expires
Futures price when hedging expires
Number of ounces hedged
Number of ounces in one futures contract
Number of futures contract used

$352.40
397.80
392.50
437.90
1000
100
10

per oz.
per oz.
per oz.
per oz.

Short (sell) hedging by Gold Mining Company

Cash market

Futures market

Basis

When hedging is made

Value of 1,000 ounces:
1,000 x $352.40 = $352,400

Sell 10 contracts:
10 x 100 x $397.80 = $397,800

-$45.40 per oz.

When hedging expires

Value of 1,000 ounces:
1,000 x $392.50 = $392,500

Buy 10 contracts:
10 x 100 x $437.90 = $437,900

Gain in cash market

= $40,100

Loss in futures market

= $40,100

-$45.40 per oz.

Overall loss or gain

= $0
Long (buy) hedging by Jewellery Company
Cash market

Futures market

Basis

When hedging is made

Value of 1,000 ounces:
1,000 x $352.40 = $352,400

Buy 10 contracts:
10 x 100 x $397.80 = $397,800

-$45.40 per oz.

When hedging expires

Value of 1,000 ounces:
1,000 x $392.50 = $392,500

Sell 10 contracts:
10 x 100 x $437.90 = $437,900

Loss in cash market

= $40,100

Gain in futures market

= $40,100
Overall loss or gain
= $0

-$45.40 per oz.

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Table 8.4: Hedging Price That Locks Gold Spot Price:

Spot Price Decrease and Basis Increase
Assumption
Spot price when hedging is made
Futures price when hedging is made
Spot price when hedging expires
Futures price when hedging expires
Number of ounces hedged
Number of ounces in one futures contract
Number of futures contract used

$352.40
397.80
304.20
385.80
1000
100
10

per oz.
per oz.
per oz.
per oz.

Short (sell) hedging by Gold Mining Company

Cash market

Futures market

Basis

When hedging is made

Value of 1,000 ounces:
1,000 x $352.40 = $352,400

Sell 10 contracts:
10 x 100 x $397.80 = $397,800

-$45.40 per oz.

When hedging expires

Value of 1,000 ounces:
1,000 x $304.20 = $304,200

Buy 10 contracts:
10 x 100 x $385.50 = $385,800

Gain in cash market

= $48,200

Loss in futures market

= $12,000

-$81.60 per oz.

Overall loss or gain

= $36,200
Long (buy) hedging by Jewellery Company
Cash market

Futures market

Basis

When hedging is made

Value of 1,000 ounces:
1,000 x $352.40 = $352,400

Buy 10 contracts:
10 x 100 x $397.80 = $397,800

-$45.40 per oz.

When hedging expires

Value of 1,000 ounces:
1,000 x $304.20 = $304,200

Sell 10 contracts:
10 x 100 x $437.90 = $385,800

Loss in cash market

= $48,200

Gain in futures market

= $12,000
Overall loss or gain
= $36,200

-$81.60 per oz.

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Table 8.5: Hedging Price That Locks Gold Spot Price: Spot Price Increase Basis Increase
Assumption
Spot price when hedging is made
Futures price when hedging is made
Spot price when hedging expires
Futures price when hedging expires
Number of ounces hedged
Number of ounces in one futures contract
Number of futures contract used

$352.40
397.80
392.50
474.10
1000
100
10

per oz.
per oz.
per oz.
per oz.

Sh
hort (sell) hedging by Gold Mining Company
Cash market

Futures market

Basis

When hedging is made

Value of 1,000 ounces:
1,000 x $352.40 = $352,400

Sell 10 contracts:
10 x 100 x $397.80 = $397,800

-$45.40 per oz.

When hedging expires

Value of 1,000 ounces:
1,000 x $392.50 = $392,500

Buy 10 contracts:
10 x 100 x $474.10 = $474,100

Gain in cash market

= $40,100

Loss in futures market

= $76,300

-$81.60 per oz.

Overall loss or gain

= $36,200
Long (buy) hedging by Jewellery Company
Cash market

Futures market

Basis

When hedging is made

Value of 1,000 ounces:
1,000 x $352.40 = $352,400

Buy 10 contracts:
10 x 100 x $397.80 = $397,800

-$45.40 per oz.

When hedging expires

Value of 1,000 ounces:
1,000 x $392.50 = $392,500

Sell 10 contracts:
10 x 100 x $474.10 = $474,100

Loss in cash market

= $40,100

Gain in futures market

= $76,300
Overall loss or gain
= $36,200

-$81.60 per oz.

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EXERCISE 8.1
1. Suppose you bought a share at time t at RM4.70, and the price of
the futures on the share is RM4.60. At time T, the price of the
share drops to RM3.90 and the price of the futures drop to
RM4.00. If you short (sell) the futures at time t, what is the value
of your share at time T?
2. Consider a forward contract written on a non-dividend paying
asset. The current spot price is RM65. The maturity of the
contract is 90 days and the simple interest rate for this period is
4.50% per annum.
(a)

Determine the forward price. What is the value of the

contract?

(b)

A corporate client wants a 90-day forward contract with the

delivery price set at RM60. What is the value of the
contract?

(Assume a 365-day year).

8.4

OPTIONS

Before we proceed further with options, an important concept that needs to be

stressed is the difference between options and futures contracts, how the pricing
of options are determined, and how investors can reduce their investment
risk or reach their investment objectives by using options contracts.
An options contract is a contract where the writer (or seller) of the options
gives to the buyer of the options the right, but not an obligation, to buy
(call options) or sell (put options) to the writer something (or the
underlying) at a specified price, during a specified period (or specific time).

By giving the right, the writer will receive a fee called the price of the options or
the options premium.

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Elements in an options contract consist of the following:

(a)

Either the buyer of the call options has the right to buy something or the
buyer of put options has the right to sell something.

(b)

The underlying is usually a financial instrument, index or commodity that

could be traded.

(c)

The strike price or the exercise price.

(d)

Expiration date.

(e)

Either the buyer of the options can exercise anytime during a specified
duration (for American options) or at a specific time (European options).

Now lets look at an example of European call options.

Price = c
Exercise price = K
Expiration date = three months
Initial price of share (the underlying) = S0
This means that the buyer of the call options can buy the share in three months
time at the price X, no matter what the price of the share will be.

Options can be traded in an organised market or over-the-counter. There

are three advantages when options are traded in an organised market:
(i)

The exercise price and the expiration date can be standardised.

(ii)

Clearing house can function in the options market similar to that in the
futures market.

(iii) The transaction cost is much lower compared with the options traded overthe-counter.
Usually institutional options buyers need a specific or a tailor-made option that
matches their needs. This usually happens in portfolio management of fixed
income securities. In fact, in portfolio management of fixed income securities like
bonds, over-the counter trading is more popular because the risk in the cash
market can be hedged by using the options.

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8.4.1

Options Moneyness

Options moneyness describes the relationship between the options stated price
and the price of the underlying asset and determines if it is a profitable
transaction.

The transaction can be immediately profitable or not. Moneyness is always

viewed from the buyers or the long position viewpoint and not from the sellers
viewpoint. Furthermore, moneyness is obtained by comparing the exercise price
with the spot value of the underlying asset. There are three types of moneyness
in options. They are shown in Table 8.6:
Table 8.6: Types of Moneyness
Types of
Moneyness

Remarks

However, the remarks are true only when:

For call options

For put options

In-the-money
(ITM)

An option is said to be
in-the-money if it is
profitable
to
immediately exercise.

Exercise price (K) <

Spot price of
underlying asset

Exercise price (K)

> Spot price of
underlying asset

At-the-money
(ATM)

An option is said to be
at-the-money if it does
not
matter
if
immediately exercised.

Exercise price (K)

= Spot price of
underlying asset

Exercise price (K)

= Spot price of
underlying asset

Out-of-the
-money (OTM)

An option is said to be
out-of-the-money if it is
not
profitable
to
immediately exercise.

Exercise price (K)

> Spot price of
underlying asset

Exercise price (K)

< Spot price of
underlying asset

8.4.2

Difference between Options and Futures

Contracts

There are some fundamental differences between futures and options. They are:
(a)

Only the sellers (not the buyers) are obliged to buy or sell. The buyers of
options need not buy or sell the underlying. In the futures contract, the
buyers and sellers are obliged to buy or sell. Thus, the main advantage of
options is where the holder or the buyer of options will benefit from an
upside benefit while limiting a downside loss.

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(b)

The buyer of options must pay a fee or the price of the options to the seller
to get the right. In the futures contract, there is no exchange of money when
the contract is initiated.

(c)

The buyer of the options will decide on the price of the options to buy (for
call options) or to sell (for put options) but can take the opportunity if the
price of the options is low. In the futures contract, the price is already fixed
and the parties to the contract cannot obtain profit or suffer losses from any
price movement.

SELF-CHECK 8.1
In the earlier section, we discussed the definition of options and futures
contracts. We also discussed the characteristics of each security. Based
on your understanding, what is the main difference between options
and futures contracts?

8.4.3

Characteristics of Returns and Risk in Options

There are four basis positions in options contracts. Most other options contracts
are some combinations of the four basis positions. The four basic options
contracts are:
(a)

Buy call options

(b)

Sell call options

(c)

Buy put options

(d)

Sell put options

The buyer of an option can seize opportunities to make a profit from the
movement of the price of the underlying asset. However, they must pay a fee for
this. The maximum profit for the seller of options is the price of the options itself.
At the same time, the seller of options is also exposed to the risk of loss from the
movement of the price of the underlying asset. Figures 8.6  8.9 show the gain or
loss incurred by the seller (writer) or the buyer of the respective options with the
following assumptions:

144 X TOPIC 8 DERIVATIVES MARKET

Price of options
Exercise price (x)

C
+ C

P
+ P

S
+ S

=
=
=
=
=
=
=
=

$3
$100
sell call options
buy call options
sell put options
buy put options
sell share
buy share

The following graphs show what happens to the profit or value of options
when the price of the underlying asset changes. A full understanding of the
graphs is very important as they are used in more exotic options portfolios, since
the concept is similar. For instance, in understanding put-call parity, all we need
to do is add the relevant linear graphs to look at the profit or the value of our
options portfolio.

Figure 8.5: Profit/loss

for seller (writer)
of call options

Figure 8.6: Profit/loss for

buyer of call options

TOPIC 8

DERIVATIVES MARKET W 145

Figure 8.7: Profit/loss for

Seller (writer) of put
options

Figure 8.8: Profit/loss for

buyer of put options

Figure 8.9: Value of asset

(S)

146 X TOPIC 8 DERIVATIVES MARKET

To understand the options transactions (buy and sell) better, let us look at the
following example.
Suppose that todays price of a MAS share is RM5.00. A European three-month
call option on the MAS share is quoted as RM4.90 MAS @ 0.30. (i.e. the price of
this call option is RM0.30). This means that in three months time the buyer of the
call option can exercise or buy a MAS share at RM4.90, at whatever the price
MAS shares will be. Based on this information:
Price of MAS in 3 months time

Exercise

Profit/Loss

Price of MAS share goes up to RM5.30

Exercise (buy)

5.30  4.90  0.30 = 0.10

Price of MAS share goes up to RM5.70

Exercise (buy)

5.70  4.90  0.30 = 0.50

Price of MAS share drops to RM4.30

Dont exercise

 0.30

Using the same information given above, except that instead of a call option, the
option is a put option. Then we will have:
Price of MAS in 3 months time

Exercise

Price of MAS share goes up to RM5.30

Dont exercise

 0.30

Price of MAS share goes up to RM5.70

Dont exercise

 0.30

Price of MAS share drops to RM4.30

Exercise (sell)

4.90  4.30 0.30 = 0.30

8.4.4

Profit/Loss

Put-Call-Parity

Graphs can also be used to look at the profit/loss of some combinations of

call, put options and the underlying asset. One of the most important
S + P  C). This means when we buy
portfolios of options is the portfolio (S
one share, we buy one put on the share and sell one call on the share. This
portfolio is an interesting portfolio as it gives what is known as put-call parity.
The graph for the portfolio is shown in Figure 8.10:

TOPIC 8

DERIVATIVES MARKET W 147

Figure 8.10: Graph for portfolio S + P  C

S + P  C), lets look at the following

To calculate the profit for portfolio (S
example.
Assume the exercise price for the options is X. We consider what happens to
the portfolio when the price of the underlying asset is less than X and when it is
greater than X. Further assume that the price of the underlying asset is S when
the option is exercised.
Price < X

Price > X

Put

(X S)

Call

(S X)

Profit for S + P  C

Share

We observe that whatever the value of the underlying asset is, it always equals to
X, the exercise price. It should be clear that the graph in Figure 8.10 gives the
same result. Thus, we can plot the profit of a portfolio of options by using
S + P  C) is a
either graphs or calculations similar to the above. The portfolio (S
riskless portfolio and should earn a riskless rate of return (Rf ).

148 X TOPIC 8 DERIVATIVES MARKET

We can value the portfolio (S

S + P  C) by using the formula below:

S+P-C=

X
1+R f

This formula is known as the put-call parity and it explains the relationship
between the price of call and put options.

8.4.5

Factors Affecting the Price of an Option

The diagram below shows the time diagram between time 0 and T, where we
include the relevant variables that affect the price of options. Then we will
tabulate to see how they affect the price of options.

where:
c
C
p
P
S0
ST
K
D
T
r

:
:
:
:
:
:
:
:
:
:
:

European call option price

American call option price
European put option price
American put option price
Share price today
Share price at option maturity
Strike price
Present value of dividends during options life
Life of option
Risk-free rate for maturity T with continous compounding
Volatility of stock price

We summarise how the variables affect the price of options below:

Variable
S0
K
T

c
+

?


+
?

r
D

+


C
+


+


+
+


+


+

TOPIC 8

DERIVATIVES MARKET W 149

Where:
+ means the variable and the option move in the same direction (for example
+
if r increases then c will also increase);
 means the variable and the option move in opposite directions (for example
if D increases then c will decrease); and
?? means it depends on our expectations regarding the price of the
underlying asset.

8.5

THEORIES IN PRICING OF OPTIONS

We will look at how options are priced by considering the Binomial Pricing
Model and the Black-Scholes model. First, we will explain the Binomial Pricing
Model, followed by the Black-Scholes model, for which we will only state the
formula. The derivations of Black-Scholes model is beyond the scope of this
module.

8.5.1

The Binomial Pricing Model

In this model, we use a riskless portfolio (S

S  C) where we buy a unit of
the underlying asset and sell a call option on the asset. We further assume that
there are only two possible states  market goes up or market goes down.
The assumptions used in this model are as follows:
(a)

There are no market frictions.

(b)

Market participants entail no counterparty risk.

(c)

Markets are competitive.

(d)

Market participants prefer more wealth to less.

(e)

There are no arbitrage opportunities.

We will now consider both the cash and the options markets. Assume that if the
market goes up, the price will increase by 20% and if the market goes down, it
will decrease by 20%. Thus, if the initial price of the share is S0, it will be
S0(1 + 0.20) if the market goes up and S0(1  0.20) if the market goes down. Here,
we assume that we only need one call option (in reality, we need to first calculate
the number of options needed).

150 X TOPIC 8 DERIVATIVES MARKET

Figure 8.11: Stock market

Figure 8.12: Option market

If we combine the two markets, we will have:

Figure 8.13: Combination of stock market and option market

Since the portfolio is a riskless portfolio, 1.20S0  fu = 0.80S0 fd. Thus we can
find the value of C by considering the formula below (assuming the maturity of
the portfolio is T);

TOPIC 8

S0  C =

1.20S 0  fu

1+R f 

or

DERIVATIVES MARKET W 151

S 0 C

0.8S 0  fu

1  R f T

From the formula above, we obtain:

S0 

1.20S 0  fu

1  R f T

It should be noted that S0, Rf and T are known when the contract is initiated.
Thus, we are left with the prices of call and put. If we know the price of the call,
we can find the price of the put, and vice-versa.

8.5.2

The Black-Scholes Model

The Black-Scholes model for pricing put (p

p) and call (cc) options is as follows:
c
S 0 N d 1   K e  rT N d 2 

p
where:

d1
d2

K e  rT N  d 2   S 0 N  d 1 
In  S 0 IK    r  V 2 I 2 T

V T
In  S 0 IK    r  V 2 I 2 T
V T

d1  V T

152 X TOPIC 8 DERIVATIVES MARKET

N(d1), N(d2), = the cumulative probability density. The value for N(.) is obtained
from a normal distribution that is tabulated in most statistics textbooks.
c
P
S0
ST
K
T
R

=
=
=
=
=
=
=
=

European call option price p

European put option price
Share price today
Share price at option maturity
Strike price
Life of option
Risk-free rate for maturity T with continous compounding
Volatility of stock price

EXERCISE 8.2
1. Consider a European call option on an asset with price S(t), strike
price K, and maturity T.
(a)

What is the payoff to this call option at date T? Consider a

European put option on the same asset S(t) with strike price
K and maturity T.

(b)

What is the payoff to this put option at date T?

(c)

Is the payoff to the call option exactly opposite to the payoff

to the put option? Explain.

2. The current share price is RM50. The value of a European call

option with a strike price of RM47 and maturity 100 days is RM4.
The 100-day default-free discount rate is 5%, assuming a 360-day
year.
(a)

For a put option with a strike price of RM47 and maturity

100 days, you are quoted a price of RM2. Is this consistent
with the absence of arbitrage? Please justify your answer.

(b)

If your answer to (a) is that arbitrage is possible, how

would you construct an arbitrage portfolio to take
advantage of the situation?

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DERIVATIVES MARKET W 153

3. Suppose you construct the following portfolio:

(a)

Long 1 call, strike price 40

(b)

Short 1 call, strike price 50

(c)

Short 1 call, strike price 70

(d)

Long 1 call, strike price 80

All options are written on the same share and mature at the same
time. Without the aid of diagrams, describe the total value of the
portfolio when the options mature.

Derivatives are usually used to hedge the risk that exists in the cash markets.
It should be understood that when we discuss hedging, we are concerned
with reducing or transferring risk in the cash market.

The common derivatives used are the forward, the futures and the options.

The two types of options include call and put options.

Factors influencing the options are the price of the underlying asset, the
maturity, the exercise price, interest rate, dividend and the variance of the
price of the underlying.

The prices of call and put options are related through the put-call parity. This
means that once we know the price of call options, we can theoretically find
the price of put options.

Pricing of options can be complicated compared with pricing of futures. The

basic idea of options pricing can be seen from the binomial options pricing.
This method discusses the pricing in the two-state model and can be
extended into a multi-period model.