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Introduction
Alexei Zhdanov
Derivatives
Derivative is a financial instrument whose value is derived entirely from the value of another asset (or a group of assets), known as the underlying asset Most commonly used types of derivatives Forwards Futures Swaps Options
Spot contract
A spot contract is an agreement between a buyer and a seller at time 0 The seller agrees to deliver the asset immediately The buyer agrees to pay for that asset immediately Thus, in these contracts there is an immediate and simultaneous exchange of cash for securities
Forward contract
A forward contract is a firm commitment to buy or sell an asset at a specified price, on a specified future date (the delivery date) -Just like a spot contract but with delayed delivery and payment time
Forward contract
Almost all forward contracts are traded over the counter - No exchange listing - Price have to be collected from dealers Forward contracts are part of many commercial transactions - Built to order Planes, houses, bridges, shoes, suits
Forward payoffs
Buy forward
Sell forward
F,t
St+
P (oil)
Core Business
Hedging FX receivables
Suppose that a U.S. firm sells computers to a French firm for 1,000,000 The payment of the computers is due in 90 days The exchange rates are as follows - Spot: St ($/ ) = 1.25 - Forward: F90,t ($/ ) = 1.30
Hedging FX receivables
If the receivables are not hedged, the firm will receive in 90 days from now St+90 1,000,000 This cash flow depends on the spot rate in 90 days from now and as of now is uncertain
Hedging FX receivables
Suppose the firm sells euros forward at F90,t ($/ ). The firm will receive in 90 days from now F90,t ($/ ) 1,000,000 = $ 1,300,000 This cash flow does not depend on the spot rate in 90 days from now and is certain Spot 1,300 Forward 0 1.3 2 St+90 Hedged position
Futures contracts
A futures contract is normally arranged through an exchange Contrary to forward contracts, futures contracts are marked to market daily - The contracts price is adjusted each day as the futures price for the contract changes Futures contracts are agreements to - Purchase (sell) a specified quantity of a specified asset at a specified date for the then current futures price
Margin calls
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 settlements Margins minimize the possibility of a loss through a default on a contract Futures contracts are settled daily leading to margin calls Initial margin the amount that must be deposited at the time the contract is entered Maintenance margin the minimum balance allowed on the margin account
Example
An investor takes a long position in 2 December gold futures contracts on June 5 - Contract size: 100oz. - Futures price: US$400 - Margin requirement per contract is USD $2,000 (so that the total requirement is US$4,000) - Maintenance margin per contract is USD $1,500 (so that the maintenance margin on the position is US$3,000 in total) The mechanics are as follows
Example
Daily Cumulative Margin Futures Gain Gain AccountMargin Price (Loss) (Loss) Balance Call Day (US$) (US$) (US$) (US$) (US$) 400.00 5-Jun 397.00 . . . . . . 6-Jun . . . 7-Jun . . . 8-Jun 393.30 . . . (600) . . . (740) . . . 4,000 (600) 3,400 . . . . . . 0 . . .
(1,340) 2,660 + 1,340 = 4,000 . . . . . . . . < 3,000 (2,600) 2,740 + 1,260 = 4,000 . . . . . . . . . (1,540) 5,060 0
Clearinghouse
Long Position
Money Commodity
Clearinghouse
Money Commodity
Short Position
Futures contracts
Futures contracts Resettled daily (margin calls) Exchange traded Clearinghouse Tick size, price limit Pros and cons - Futures contracts have lower default risk - Forward contracts can be customized Forward contracts Payments at maturity OTC Counterparty risk No regulation
Futures prices
Terminology
Open interest: the total number of contracts outstanding - equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day - used for the daily settlement process Volume of trading: the number of trades in 1 day
Questions
When a new trade is completed what are the possible effects on the open interest? Can the volume of trading in a day be greater than the open interest? What must be the net inflow or outlay from marking to market for the clearinghouse?
Pricing
Arbitrage: An arbitrage strategy is a strategy which requires no initial investment, never yields a negative terminal value and has a strictly positive expected terminal value The absence of arbitrage opportunities implies that two equivalent goods or cash flows must have the same value Otherwise - Buy the cheap one - Convert it to the expensive one at no cost - (Short) Sell the expensive one - Do this at a large scale to make very large profits at no cost
Short selling
Short selling involves selling securities you do not own Your broker borrows the securities from another client and sells them in the market in the usual way At some stage you must buy the securities back so they can be replaced in the account of the client You must pay dividends and other benefits the owner of the securities receives
Pricing - no dividends
What should be the forward price of a non-dividend paying stock 1 year from now? Strategy 1: Buy stock now - CF today: -St - CF in 1 year: S1 year Strategy 2: Buy stock forward, invest F1 year,t/(1+r) in the risk-free asset - CF today: - F1 year,t/(1+r) -CF in 1 year: S1 year F1 year,t + F1 year,t= S1 year
Pricing
What should be the forward price of a non-dividend paying stock 1 year from now? Both strategies result in identical payoffs one year from now Therefore, their costs at date 0 must be the same:
FT, t = St (1+r)T
If interest is compounded continuously, then
FT, t = St erT
Example
What should be the price of a forward contract to purchase a non dividend paying stock in 3 months? The current stock price is $40 and the 3-month interest rate is 5% per annum
Pricing - dividends
Strategy 1: Buy stock now, reinvest all dividends in the risk-free asset - CF today: -St - CF in 1 year: S1 year +FV(Div) Strategy 2: Buy stock forward, invest F1 year,t/(1+r)+ PV(Div) in the risk-free asset - CF today: - F1 year,t/(1+r)- PV(Div) - CF in 1 year: S1 year F1 year,t + F1 year,t + FV(Div)
= S1 year + FV(Div)
Pricing
Time 0 costs must be the same:
Example
What should be the price of a forward contract to purchase a dividend paying stock in 1 year? The current stock price is $40 and the risk-free interest rate is 5% per annum. The stock is expected to pay a dividend of $2 per share in 6 months.
Pricing
It is usually assumed that the dividends provide a known yield rather than a known cash income. If q is the dividend yield rate then
FT, t = St e(r-q)T
Consider a 3 month futures contract on S&P 500. Suppose that the stocks underlying the index provide a dividend yield of 1% per annum, the current price of the index is 800, and the risk-free rate is 6% per annum. What is the futures price?
Futures on commodities
Storage cost can be treated as negative income. Let U be the present value of all storage costs during the life of a forward contract. Then
FT, t = St e(r+u)T
Futures on commodities
Suppose F T, t > [St +U] erT 1. borrow St +U at the risk-free rate and use it to purchase one unit of commodity and pay storage costs. 2. Short a forward contract on one unit of the commodity Suppose F T, t < [St +U] erT 1. Sell the commodity, save storage costs, and invest the proceeds in the risk-free asset. 2. Take a long position in a forward contract
Futures on commodities
The second strategy cannot be applied to commodities that are not to any significant extent held for investment. For such commodities
Pricing
Some assets, like commodities, may have both carrying/storage costs u and/or a convenience yield y The convenience yield is positive and reflects the benefits from ownership of the physical commodity that are not obtained by the holder of the forward contract - May include the ability to profit from temporary local shortages or the ability to keep the production process running The pricing formula in that case becomes
F,t = St e (r+u-y)
f = (F0 K)e -r
where - F0 is the forward price today
Forwards on currencies
A foreign currency is analogous to a security providing a dividend yield The continuous dividend yield is the foreign risk-free interest rate It follows that if rf is the foreign risk-free interest rate
F ,t = St e
( r r f )
Forwards on currencies
1000 units of foreign currency at time zero
1000 e
rf T
1000 F0e
rf T
dollars at time T
1000S0 e rT
dollars at time T
Example
Suppose that the two year interest rates in Switzerland and the US are 1.5% and 5%, respectively and the spot exchange rate between CHF and USD is 0.85 USD per CHF. Suppose that the 2 year forward exchange rate is 0.881. Are there any arbitrage opportunities?
Pricing
The absence of arbitrage opportunities implies a convergence of futures prices to spot prices at maturity
Time
Time
(a)
(b)
Options
An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset on (or perhaps before) a given date, at prices agreed upon today. Calls versus Puts - Call option gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. When exercising a call option, you call in the asset. - Put option gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at prices agreed upon today. When exercising a put, you put the asset to someone.
Options - preliminaries
Exercising the option - The act of buying or selling the underlying asset through the option contract
Options - preliminaries
Expiry - The maturity date of the option is referred to as the expiration date, or the expiry
European versus American options - European options can be exercised only at expiry - American options can be exercised at any time up to expiry
Options - preliminaries
In-the-Money (ITM) option is an option that if exercised immediately would result in a positive payoff. - For calls, ITM options have exercise < underlying - For puts, ITM options have exercise > underlying At-the-Money option (ATM) - The exercise price is equal to the spot price of the underlying asset
Options - preliminaries
Out-of-the-Money (OTM) option is an option that if exercised immediately would result in a negative payoff. The price of the option is sometimes called the option premium Writing and selling an option are synonymous
Options - preliminaries
Open interest in a particular option contract (for
example, the March 2006 call on IBM with strike $105) measures the total number of contracts currently outstanding. Buying the underlying, buying a call option, or selling a put option represents a bullish position in the underlying security Short selling the underlying, writing a call option, or buying a put option represents a bearish position in the underlying security
Options - preliminaries
At expiry, an American call option is worth the same as a European option with the same characteristics.
If the call is in-the-money, it is worth ST E If the call is out-of-the-money, it is worthless C = Max(ST E, 0)
Where
ST is the value of the stock at expiry (time T) E is the exercise price. C is the value of the call option at expiry .
40
20
20 20
40
50
60
80
100
40
40
Buy a call
40
Sell a call
Options - preliminaries
At expiry, an American put option is worth the same as a European option with the same characteristics If the put is in-the-money, it is worth E ST. If the put is out-of-the-money, it is worthless. P = Max(E ST, 0)
40
20
20 20
40
50
60
80
100
40
40
20 10 20 10 20 40 50 60 80
Sell a put
Stock price ($) 100
Buy a put
Types of options
Individual stock options
Maturities usually several months or less, but occasionally up to several years May be traded on exchanges (CBOE) or overthe-counter (OTC) Almost always American options Settled in cash
Types of options
Stock index options
Maturities up to several years, but most volume is in 1-3 months contracts Usually exchange traded (CBOE) Large markets for American and European options Settled in cash Underlying asset is an index (possibly foreign, as in Nikkei 225 options)
Types of options
Bond/interest rate options
Payoffs depend on movements in the yield curve Traded on the Amex and CBOE Usually American options
Cost of hedge
Suppose that a speculator considers that Cisco is likely to increase in value over the next two months. The stock price is currently $20/share and a 2 month call option with a $25 exercise price is currently selling for $1. Suppose that the investor is willing to bet $4000 on his information. He has two alternatives: Buy shares or buy call options. How many shares can he buy for $4000?
Suppose now that the price actually drops to $15 instead. What is the loss on the two different positions? What do you notice?
Profit
St
Ee-r(T-t) loss
St
Put
Ee-r(T-t) loss
St
Put-Call Parity: pt + St = ct +
Portfolio value today: ct + Ee-r(T-t)
Option payoffs ($)
-r(T-t) Ee
Portfolio payoff
25
25
Consider the payoffs from holding a portfolio consisting of a call with a strike price of $25 and a bond with a future value of $25.
Put-Call Parity: pt + St = ct +
Portfolio value today: pt +St
Option payoffs ($)
-r(T-t) Ee
Portfolio payoff
25
25
Consider the payoffs from holding a portfolio consisting of a share of stock and a put with a $25 strike.
Put-Call Parity: pt + St = ct +
Portfolio value today: ct + Ee-r(T-t)
-r(T-t) Ee
25
25
25
25
Since these portfolios have identical payoffs, they must have the same value today: hence
Put-Call parity
Suppose that c=3 T = 0.25 E =30 S = 31 r = 10% D=0 What are the arbitrage opportunities when p = 2.25? p = 1? Put call parity with dividends
pt + St = ct + Ee-r(T-t) +Dt
r D
Trading strategies
Types of strategies - Take a position in the option and in the underlying asset - Take a position in 2 or more options of the same types (a spread) - Combination: Take a position in a mixture of calls and puts
ct - St = pt - Ee-r(T-t)
Graphical representation
ct - St = pt - Ee-r(T-t)
Graphical representation
Spreads
A spread is a trading strategy involving several option contracts on the same written underlying asset, with the same maturity and with different exercise prices We are going to study the following strategies - Bull spread - Bear spread - Butterfly spread
Bull Spread
A bull spread involves a long position on a call option with exercise price E1 and a short call option with exercise price E2 with E1 E2. The two options have the same maturity date This strategy requires an initial investment. It reduces potential losses and gains One can also construct a Bull Spread with put options
Graphical representation
Bear spread
A bear spread involves a long position on a put option with exercise price E2 and a short put option with exercise price E1 with E1 E2. The two options have the same maturity date This strategy produces an initial cash flow. One can also construct a Bear Spread with call options
Graphical representation
Butterfly spread
A butterfly spread can be obtained by buying a long position on a call option with exercise price E1 and a call option with exercise price E3 E1 and by selling two call options with exercise price E2[E1,E3]. The butterfly spread produces a positive cash flow at maturity if the underlying asset value belongs to [E1,E3]. One can also construct a Butterfly spread using a combination of put options
Graphical representation
Combinations
A combination is a trading strategy involving positions on call and put options written on the same underlying asset and with the same maturity Examples - Straddle - Strip / Strap - Strangle
Straddle
A straddle involves a long position in a call option and a long position in a put option with the same exercise price At-the-money straddles are bets that price movements will be large Useful when your volatility forecast differs form the markets - Market forecasts low volatility, so market views large movements over the life of the option unlikely - Price of the straddle is low, reflecting the low probabilities of large payouts - You believe these payouts are more probable, so straddle appears cheap
Graphical representation
Graphical representation
Straddle Strangle
Strip
Strap
Graphical representation
Condor Collar
p 0 e r ( T t ) E
A $1 increase in the strike price causes the put price to increase by no more than the PV of $1
cE1 (t , T ) cE2 (t , T ) ( E2 E1 )e r (T t ) 0 e e
r ( T t )
cE2 (t , T ) cE1 (t , T ) E2 E1
r ( T t )
c 0 E
A $1 increase in the strike price causes the call price to decrease by no more than the PV of $1
( E2 E1 ) CE2 (t , T ) CE1 (t , T ) 0 C 1 0 E
The slope restriction for American puts:
0 PE2 (t , T ) PE1 (t , T ) ( E2 E1 ) P 0 1 E
Convexity Restrictions
A butterfly spread combines three options of the same type
but with different strike prices Let us construct a butterfly spread with calls: Long a call with strike E1 Long a call with strike E3 Short two calls with strike E2=(E1+E3)/2 The payoff of this butterfly spread is always positive, therefore
Convexity Restrictions
For calls options, we have:
c( E1 ) 2c( E2 ) + c( E3 ) = 0 c( E3 ) c( E2 ) c( E2 ) c( E1 ) 0 E3 E 2 E2 E1 2c 0 2 E
What about puts? Question: do convexity restrictions apply to options on dividend paying stocks?
Arbitrage Example
WMT is trading at $48. A 4 month European put options are priced At $11 for E=55 At $15.75 for E=60 At $20 for E=65 The risk-free rate over the next 4 months is 3.25% Is there an arbitrage opportunity?
C P 0; 2 0 2 E E
2 2
Example
Exotic options
Derivatives with more complicated payoffs than the standard European or American calls are sometimes referred to as exotic options Most of these securities trade in the over-the-counter market and are designed by financial institutions to meet the requirements of their clients
Compound Options
Option to buy/sell an option - Call on call - Put on call - Call on put - Put on call Price is quite low compared with a regular option When the firm has issued coupon-bearing debt, equity can be viewed as a compound option written on the firms assets
Asian Options
Payoff related to the average stock price Useful if the counterparty is large enough to affect the underlying price Average price options pay - max(Save - E; 0) (call) or - max(E - Save; 0) (put) Average strike options pay - max(ST - Save ; 0) (call) or - max(Save - ST; 0) (put)
Pricing options
See next handout