1.

Introduction

Chapter 1

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.2

The Nature of Derivatives

A derivative is an instrument whose

value depends on the values of other
more basic underlying variables

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.3

Examples of Derivatives
• Forward Contracts
• Futures Contracts
• Swaps
• Options

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.4

Derivatives Markets
• Exchange traded
– Traditionally exchanges have used the open-
outcry system, but increasingly they are switching
to electronic trading
– Contracts are standard there is virtually no credit
risk
• Over-the-counter (OTC)
– A computer- and telephone-linked network of
dealers at financial institutions, corporations, and
fund managers
– Contracts can be non-standard and there is some
small amount of credit risk
Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.5

Ways Derivatives are Used

• To hedge risks
• To speculate (take a view on the
future direction of the market)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment
without incurring the costs of selling
one portfolio and buying another

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.6

Forward Contracts
• A forward contract is an agreement to buy
or sell an asset at a certain time in the future
for a certain price (the delivery price)
• It can be contrasted with a spot contract
which is an agreement to buy or sell
immediately
• It is traded in the OTC market

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.7
Foreign Exchange Quotes for
GBP on Aug 16, 2001 (See page 3)
Bid Offer
Spot 1.4452 1.4456
1-month forward 1.4435 1.4440
3-month forward 1.4402 1.4407
6-month forward 1.4353 1.4359
12-month forward 1.4262 1.4268

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.8
Forward Price
• The forward price for a contract is the
delivery price that would be applicable
to the contract if were negotiated
today (i.e., it is the delivery price that
would make the contract worth exactly
zero)
• The forward price may be different for
contracts of different maturities

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.9

Terminology
• The party that has agreed to buy
has what is termed a long position
• The party that has agreed to sell
has what is termed a short
position

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.10

Example (page 3)
• On August 16, 2001 the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months
at an exchange rate of 1.4359
• This obligates the corporation to pay
$1,435,900 for £1 million on February
16, 2002
• What are the possible outcomes?

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.11
Profit from a
Long Forward Position
Profit

Price of Underlying
K at Maturity, ST

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.12
Profit from a
Short Forward Position
Profit

Price of Underlying
K at Maturity, ST

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.13

Futures Contracts
• Agreement to buy or sell an asset for a
certain price at a certain time
• Similar to forward contract
• Whereas a forward contract is traded
OTC, a futures contract is traded on an
exchange

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.14

Examples of Futures Contracts

• Agreement to:
– buy 100 oz. of gold @ US$300/oz.
in December (COMEX)
– sell £62,500 @ 1.5000 US$/£ in
March (CME)
– sell 1,000 bbl. of oil @ US$20/bbl.
in April (NYMEX)

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.15
1. Gold: An Arbitrage
Opportunity?
• Suppose that:
- The spot price of gold is US$300
- The 1-year forward price of gold is
US$340
- The 1-year US$ interest rate is 5%
per annum
• Is there an arbitrage opportunity?
(We ignore storage costs and gold lease rate)?

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.16
2. Gold: Another Arbitrage
Opportunity?
• Suppose that:
- The spot price of gold is US$300
- The 1-year forward price of gold
is US$300
- The 1-year US$ interest rate is
5% per annum
• Is there an arbitrage opportunity?
Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.17

The Forward Price of Gold

If the spot price of gold is S and the forward
price for a contract deliverable in T years is F,
then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
In our examples, S = 300, T = 1, and r =0.05 so
that
F = 300(1+0.05) = 315

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.18
1. Oil: An Arbitrage
Opportunity?
Suppose that:
- The spot price of oil is US$19
- The quoted 1-year futures price of
oil is US$25
- The 1-year US$ interest rate is
5% per annum
- The storage costs of oil are 2%
per annum
• Is there an arbitrage opportunity?
Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.19
2. Oil: Another Arbitrage
Opportunity?
• Suppose that:
- The spot price of oil is US$19
- The quoted 1-year futures price of
oil is US$16
- The 1-year US$ interest rate is
5% per annum
- The storage costs of oil are 2%
per annum
• Is there an arbitrage opportunity?

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.20

Exchanges Trading Options

• Chicago Board Options Exchange
• American Stock Exchange
• Philadelphia Stock Exchange
• Pacific Stock Exchange
• European Options Exchange
• Australian Options Market
• and many more (see list at end of book)
Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.21

Options
• A call option is • A put is an
an option to buy option to sell a
a certain asset certain asset by
by a certain a certain date
date for a for a certain
certain price price (the strike
(the strike price)
price)
Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.22

Long Call on Microsoft (Figure 1.2, Page 7)

Profit from buying a European call option on Microsoft:
option price = $5, strike price = $60

30 Profit ($)

20

10 Terminal
30 40 50 60 stock price ($)
0
-5 70 80 90

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.23

Short Call on Microsoft (Figure 1.4, page 9)

Profit from writing a European call option on Microsoft:
option price = $5, strike price = $60
Profit ($)
5 70 80 90
0
30 40 50 60 Terminal
-10 stock price ($)

-20

-30
Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.24

Long Put on IBM (Figure 1.3, page 8)

Profit from buying a European put option on IBM:
option price = $7, strike price = $90

30 Profit ($)

20

10 Terminal
stock price ($)
0
60 70 80 90 100 110 120
-7

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.25

Short Put on IBM (Figure 1.5, page 9)

Profit from writing a European put option on IBM:
option price = $7, strike price = $90
Profit ($)
Terminal
7
60 70 80 stock price ($)
0
90 100 110 120
-10

-20

-30
Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 Payoffs from Options 1.26

What is the Option Position in Each Case?

K = Strike price, ST = Price of asset at maturity
Payoff Payoff
K
K ST ST

Payoff Payoff
K
K ST ST

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.27

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
Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.28
Hedging Examples (page 11)
• A US company will pay £10 million for
imports from Britain in 3 months and
decides to hedge using a long position
in a forward contract
• An investor owns 1,000 Microsoft
shares currently worth $73 per share. A
two-month put with a strike price of $65
costs $2.50. The investor decides to
hedge by buying 10 contracts

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.29
Speculation Example
• An investor with $4,000 to invest feels
that Cisco’s stock price will increase
over the next 2 months. The current
stock price is $20 and the price of a 2-
month call option with a strike of 25 is
$1
• What are the alternative strategies?

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull
 1.30

Arbitrage Example (pages 12-13)

• A stock price is quoted as £100 in

London and $172 in New York
• The current exchange rate is 1.7500
• What is the arbitrage opportunity?

Options, Futures, and Other Derivatives, 5th edition © 2002 by John C. Hull