CFA Tutorial

Derivatives
Anand K. Bhattacharya
April 25, 2012
Background
 2009-Date: Professor of Finance Practice, ASU
 1998-2008: Bank of America/Countrywide
Managing Director
 1993-1998: Prudential Securities Inc
Managing Director
 Various positions in research, product management, sales and
trading (Merrill Lynch; Security Pacific Merchant Bank;
Imperial Credit and Franklin Savings)
 ASU Graduate (Ph.D. and MBA)
 3 Books and 70 academic and professional publications

2
Derivatives and Markets
 Derivative securities
 Financial instrument that offers a return based
on the return of some underlying asset
 Markets
 Exchange traded: standardization, traded on
organized exchanges (CBOE, CBOT)
 OTC: non-standardized, negotiated, traded
anywhere else
 Uses
 Hedging, speculation, or arbitrage
3
Forward Commitments

 Agreement between two parties in which

one party, the buyer, agrees to buy from the
other party, the seller, an underlying asset at
a future date at a price established at the
contract initiation.
 Main characterization: obligation by parties
 Types: forward contracts, futures contracts,
swaps

4
Forward Contracts

 Purchase and sale of underlying asset

(stocks, fixed income instruments and rates,
currencies, commodities, etc.) at a later date
at a price agreed upon today
 Non-standardized, customizable, OTC
transactions between large financial
institutions and/or corporations
 Private and largely unregulated market

5
Futures Markets
 Variation on a forward contract
 Public, standardized transaction that occurs on a
futures exchange
 Exchange determines expiration dates, underlying assets,
size of the contracts, etc.
 Default risk and the clearinghouse
 Exchange is the counterparty in futures transactions
 Marking-to-market
 Daily settlement where profits and losses are charged and
credited to the short and long position each day
 Offsetting transactions
 Ability to unwind positions prior to expiration
 Take an opposite position to the original contract 6
Swaps
 Variation on a forward contract
 Agreement between two parties to
exchange a series of future cash flows
 Equivalent to a package of forwards
 At least one of the two cash flows are
determined at a later date (plain vanilla
interest rate swap)
 Fixed and floating payments
 Make known payments in exchange for something
unknown
 Conversion of one payment (say a fixed rate) to
another (say a floating rate)
 Private, OTC transactions 7
Contingent Claims and the
Option Market
 Contingent claims are derivatives where
payoffs occur if a specific event happens.
 Options are financial instruments that give
the option buyer the right, but not the
obligation, to buy (CALL) [or sell (PUT)] an
asset from [or to] the option seller at a fixed
price on or before expiration.
 Asymmetric payoffs
 Buyer has the right, seller (or writer) has an obligation
if the option is exercised
 Strike or exercise price
 Premium or option price
 OTC and exchange traded options 8
The Good, The Bad,
and The Ugly
 Purposes of Derivatives Markets
 Risk management
 Hedging: reduction or elimination of identifiable risks
 Insurance
 Price discovery and market efficiency:
information about the prices of underlying assets
 Commodity prices, volatility
 Reduced transaction costs and leverage
 Criticisms
 Complexity for un-sophisticated investors
 Gambling critique
9
Arbitrage and
Derivatives Pricing

 Arbitrage: equivalent assets or

combination of assets sell for two
different prices
 LOOP (law of one price)
 Arbitrage will drive prices of equivalent
assets to a single price so that no riskless
profits can be earned.

10
CFA Tutorial

Forward Markets and

Contracts
Basics
 Long position: buyer in a forward contract
 Short position: seller in a forward contract
 Settlement
 Delivery
 Long pays forward price to short
 Short delivers underlying asset
 Cash settlement
 Pay net cash value on delivery date
 Default risk
 Termination prior to delivery
 Offsetting position in a new forward (not necessarily zero
price transaction; credit risk)
 Cancellation 12
Dealers and End-Users
 Dealer: entity that makes a market in a
financial instrument
 Provides quotes (bid-ask spread) on the cost of
and stands by as the counterparty to the
transaction
 Wholesaler of risk
 Engage in transactions with other dealers
and end-users
 End-users, such a corporations, generally has a
risk-management problem

13
Equity Forwards
 Contract for the purchase/sale of an
individual stock, portfolio, or index at a later
date
 Lock in a price today for a transaction in the
future
 Hedging
 Need to sell stock/portfolio in several months
 Concern that prices decline
 Enter into a forward today to sell the assets to a dealer
at expiration
 Regardless of price moves, the selling price is locked
in today
14
Fixed Income Forwards
 Forward contracts on bonds, bond portfolios and
bond indices are similar in nature to equity forwards
 Expiration vs. maturity
 Coupons
 Callability/convertibility
 Default risk
 Zero-coupon bonds (T-bills)
 Discount from par
 Quoted in rates (discount), not price
 Price conversion: $1 – [discount rate*(n/360)]
 Coupon bonds (T-notes and T-bonds)
 Interest-bearing
 Premium or discount
 Price + Accrued Interest
15
FRAs

 Forward Rate Agreement: interest rate

forward contract
 Eurodollar time deposits: deposits in dollars
outside the US
 Short-term unsecured loans
 LIBOR: rate at which London banks lend dollars
to other banks
 360-day add-on interest rate
 Euribor: rate at which banks borrow euros
16
 FRAs (con’t)
 Buyer of FRA (long): long the rate, benefits
if rates increase
 Seller of FRA (short): short the rate, benefits
if rates decrease
 Payoff (long):
Rate at Expiration - Forward rate n 360
Notional Principal
1 [Rate at Expiration n 360 ]
 n = days in maturity of underlying
 Two-rate notation
 1x3, 3x9, 6X12
17
Currency Forwards

 Impetus: move from pegged to floating

exchange rates in late 1970s
 Widely used by corporations and banks to
manage foreign exchange risk
 Currency forwards allow corporations to hedge
 Lock in exchange rates today
 Ex: receive euros, convert to dollars
 Long euro, short dollars
 Hedge: take a short forward (short euro, long dollars)

18
 Pricing of Forward Contracts
 Notation:
 0 = today, T = expiration, underlying asset = S0(or t or T),
forward = F(0,T)
 Long value at maturity: VT = ST – F(0,T)
 Short value at maturity: VT = F(0,T) – ST
 What is the value of a forward today?
 V0 = S0 – F(0,T)/(1+r)T, but
 A forward contract has a value of F(0,T) = S0(1+r)T
 We can make adjustments to this basic formula for income
paying assets, currencies and commodities
 Futures contracts are priced similarly

19
CFA Tutorial

Futures Markets and

Contracts
Review of Futures
 Public, standardized transactions on
organized exchanges
 Underlying asset, quality of asset, expiration
dates (months and maturities), size of contract,
price and position limits
 Homogenization and liquidity = active secondary
market
 Ability to take offsetting positions
 Clearinghouse
 Marking to market: daily settlement of gains and
losses between long and short positions
 Long profits from price increases, short profits from
price decreases
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Margin and Marking to Market
 To open a position in the futures market, a party
must deposit monies into a margin account with the
clearinghouse
 Stock market margin = leverage (borrow up to 50%)
 Futures margin = good faith or collateral (not borrowed)
 Required by long and short positions
 Set by clearinghouse and varies per futures contract
 Gains and losses are charged or credited daily to the margin
accounts by marking to market
 Initial margin: amount deposited at beginning of the
contract (usually less than 10% of contract value)
 Maintenance margin: minimum margin balance that
traders can hold before margin call
 (1) deposit additional funds (variation margin) or (2) close out
position 22
 Settlement price: price at which marking to market occurs
 Marking to Market Example
Long Position
Day Beg. Funds Settlement Price Gain Ending
Bal. Deposited Price Chg Balance
0 0 50 100 50
1 50 0 99.20 -0.80 -8 42
2 42 0 96.00 -3.20 -32 10
3 10 40 101.00 5.00 50 100
4 100 0 103.50 2.50 25 125
5 125 0 103.00 -0.50 -5 120
A note on margin calls: a price change exceeding the difference between
the initial and maintenance margin will trigger a margin call.
Marking to market occurs to collect losses and distribute gains in such a
manner that losses are paid before becoming large enough to run the risk
23
of default.
Price Limits

 Some contracts impose limits on price

changes that can occur from day to
day: SP price limit
 Limit move: if transaction exceeds a price
limit, price freezes at the limit
 Limit up: price stuck at upper limit
 Limit down: price stuck at lower limit
 Locked limit: transaction cannot occur
because price is beyond the limits

24
Closing Out the Position
 Three options:
 Offsetting position: take identical, but opposite contract to
existing position (>90% of all contracts)
 Delivery: holder of oldest long contract to accept delivery
 Accepts delivery and pays the previous day’s settlement
price to the short
 Cash settlement: Let position expire and margin accounts
are settled for final marking to market
 Complications: high transactions cost for physical
delivery, short can often determine when, what and
where to deliver
 Exchange for physicals: arrangement of alternative
delivery procedure acceptable to the exchange
25
The Players
 Locals: floor traders, liquidity providers,
market makers
 Scalper: buys and sells contracts, profit from
changes in the spread
 Day trader: holds a position longer than
scalpers, but ends the day with zero inventory
 Position trader: holds positions overnight
 Day and position traders: attempt to profit from
anticipated market movements
 Brokers: futures commission merchants

26
T-Bill Futures
 Based on a 90-day, $1 million T-bill
 Recall: price = 1 – (disct rate*(n/360))
 Example: rate = 6.25%; quoted futures price =
93.75, actual price = $1M*(1-(0.0625(90/360))) =
$984,375
 In T-bills, computing price changes is easy
 1 bp move = $25 price change
 Trades on a M/J/S/D calendar
 Cash settlement
 Usurped by Eurodollar as the important short-
term rate contract
27
Eurodollar Contracts
 CME contracts on 90-day, $1M notional
principal of Eurodollars
 Prices are quoted in the same manner as T-
bills
 Cash settled
 One of the most widely traded contracts
because of use of LIBOR in swaps, FRAs and
interest rate options
 Unlike Eurodollar deposits, which have “add-on”
interest, Eurodollar futures are quoted on a
discount basis, like T-bills
28
T-Bond Contracts
 Very actively traded long term interest rate
contracts on CBOT
 Contract based on delivery of a T-bond with any
coupon and at least 15 years to maturity.
 Implies many bonds available for delivery
 Short gets to determine which bond to deliver
 Conversion factor puts all bonds on equal footing
 Cheapest to deliver bond: Quoted price – (QFP * CF)
 Contract = $100,000 par value of T-bonds
 Physical delivery
 Quoted in 32nds

29
Stock Index Futures Contracts
 S&P 500 Index contract (most highly traded)
 Quoted in terms of price on the same order as
the underlying index
 Multiplier = $250 times futures price
 M/J/S/D expirations (up to 2 yrs), but active
trading limited to near term
 Cash settled
 Other contracts
 Mini S&P 500 ($50 multiplier)
 S&P Midcap 400, Dow Index, Nasdaq 100,
FTSE 100, Nikkei 225, etc.
30
CFA Tutorial

Swap Markets and Contracts

Swaps
 Agreement to exchange a series of cash
flows
 One payment generally determined by random
outcome (rates, currencies, etc.)
 One payment generally fixed
 Long: party that receives floating
 Short: party that receives fixed
 Generally involve a series of payments
 Like a package of forward contracts
 Initial value of the swap is zero
32
Basics

 Settlement date: date on which parties make

payments
 Settlement period: time between settlement dates
 Netting: generally parties agree to exchange only
the net amount owed from one party to the other
 Termination date: date of the final payment
 OTC market, customized
 Termination: cash settlement of market value,
offsetting swap (default risk), sell swap, swaption

33
Currency Swaps
 Each party makes interest payments to the
other in different currencies
 Four types of currency swaps
 Fixed for fixed
 Fixed for floating
 Floating for fixed
 Floating for floating
 These can also be reversed in terms of currencies paid
 We can also combine currency swaps to eliminate
currency flows and obtain transactions in only one
currency
34
Example
 US firm WEN want to open Wendy’s in London. Needs 8M
British pounds to fund construction. Would like to issue fixed-
rate pound-denominated bond, but not well known in United
Kingdom. Issue in dollars and convert to pounds.
 Issues $10M bond at 5.25%, swaps with NatWest in which
NatWest will make payments to WEN in $/US at a fixed rate of
5.15%, and WEN will make payments to NatWest in pounds at
a fixed rate of 5.00%. Payments on April 18 and October 18
of each year.
 Swap: NatWest pays WEN 8M pounds; WEN pays NatWest
$10M
 Periodic payments: NW pays WEN (0.0515)(180/360)($10M)
= $257,500; WEN pays NW (0.0500)(180/360)(8M) = 200,000
pounds
 Maturity: NW pays WEN $10M; WEN pays NW 8M pounds
 Advantage: save on interest expense
 Disadvantage: assume some credit risk 35
Interest Rate Swaps
 Plain vanilla swap: interest rate swap in
which one party pays a fixed rate and the
other pays a floating rate
 Notional amounts must be equal for each party
 For each payment (usually every 6 months) rates are
multiplied by the fraction (N/360 or N/365), where N is
the number of days in the settlement period
 No need to exchange notional principals since
the swap is done in the same currency
 Netted transactions: if one party owes $250K
and the other owes $245K, the party owing
$250K will pay the net difference ($5K)
 Never do both sides pay fixed in an IRS
36
Example
 Suppose on 4/18 that MSFT wants to borrow $50M for two
years at a fixed rate of 5.75% (semiannual). Concern that
rates will fall and wants to enter into a swap that will exchange
fixed rate payments for floating rate payments. Approaches
Citigroup and requests a quote to pay LIBOR + 25bps and
receive a fixed rate of 5.45%.
 Fixed rates are based on 180/365 window while floating rates
are quoted on 180/360 window. Currently LIBOR is a 5.25%.
 First floating payment from MSFT to C is
$50M*(0.055)*(180/360) = $1.375M; this will change as LIBOR
changes
 First fixed payment from C to MSFT is:
$50M*(0.0545)*(180/365) = $1.344M, this is the amount of all
fixed payments
 Net effect: MSFT pays 5.75%, pays LIBOR + 25bps, and
receives 5.45% = LIBOR + 55bps
37
Equity Swaps
 In an equity swap, the underlying rate is the
return on a stock or index
 Means that party making fixed rate payment
could also have to make an floating rate
payment based on the equity return
 If return on the index is positive, the end-user typically
compensates the dealer for that return
 Dealer pays only fixed rate
 If return on the index is negative, the dealer
compensates the end-user for the fixed rate plus the
shortfall in the index return
 Payments not known until the end of the
settlement period and can include div and cap
gains
38
Equity Swaps (con’t)
 The fixed rate is set at the beginning of the
swap and is based off of T/365 days, where
T is the actual number of days in the
settlement period
 Payment = notional principal*fixed rate*(T/365)
 For the floating rate, it is determined by the
HPR for the settlement period
 Payment = notional principal*equity return
 Generally, equity swap payments are netted

39
CFA Tutorial

Option Markets and Contracts

Basics
 Buyer of an option has the right, but not the
obligation to buy or sell an asset from the option
writer at some future date for a price agreed upon
today.
 Call: right to buy a stock
 Put: right to sell a stock
 Option price or premium
 Exercise (or strike) price: fixed price to buy or sell
the underlying asset
 Expiration date and time to expiration
 Exercise: depends upon call or put
 Call: long gives cash to short, who delivers the asset
 Put: long sells asset to short, who delivers cash
41
More Basics
 European: exercise only on expiration
 American: exercise up to and including
expiration
 Generally, for each option, there are calls and
puts, a variety of strike prices (X) and expiration
dates that trade
 Moneyness:
 ITM: Calls (S-X>0), Puts (X-S>0)
 ATM: Calls (S-X=0), Puts (X-S=0)
 OTM: Calls (S-X<0), Puts (X-S<0)
 Option types
 Stocks, indices, bonds, currencies, interest 42
rates, etc.
Interest Rate Options
 Option on which the underlying is an interest rate
 Exercise rate
 At exercise, the payoff is based on the difference between
the underlying rate and the exercise rate
 Differs from an FRA, since FRAs are commitments to make
one interest payment and receive another at a future date
 IRC: option holder has the right to make a known interest
payment and receive an unknown interest payment
 Underlying rate > exercise rate = ITM
 IRP: option holder has the right to make an unknown
interest payment and receive a known payment
 Underlying rate < exercise rate = ITM
 Payoff = notional principal*Max(0,UR-ER)(N/360): call
 Payoff = notional principal*Max(0,ER-UR)(N/360): put

43
Caps, Floors and Collars
 Interest Rate Cap = combination of interest
rate calls
 Same ER, different exercise dates
 Each component is a caplet
 Interest Rate Floor = combination of interest
rate puts
 See above
 Interest Rate Collar = combination of caps
and floors
 Long cap, short floor or long floor, short cap
 Way to reduce upfront premium charges
44
Pricing Basics
 Payoff (call): Max (ST – X, 0)
 Payoff (put): Max (X – ST, 0)
 Holds for European and American options at expiration
 No arbitrage pricing requires that the option value holds to
these payoffs
 The above are also called intrinsic value
 Value of the option if exercised based upon current
coniditons
 Prior to expiration, options will usually sell for more
than their intrinsic value (i.e., even if option is out of
the money, the option has a non-zero premium).
 The difference between the option price and the intrinsic
value is the time value of the option.

45
Option payoffs and profits
Long Call 20
Short Call
70

Profit (Assuming a $10 premium)

60 10

Payoff of Option
50 0

0 10 20 30 40 50 60 70 80 90 100 110 120

-10
40
Call Payoff

Call Payoff
Call Payoff

30 Call Payoff -20

-30
20

-40
10

Profit (assuming $10 premium)

-50
0
0 10 20 30 40 50 60 70 80 90 100 110 120
-60
-10
Cost of Option
-70
-20
Stock Price ($)
Stock Price (S)

70 20

Profit (Assuming $10 premium)

60 10

Payoff of Option
50 0

0 10 20 30 40 50 60 70 80 90 100 110 120

40 -10

Call Payoff
Call Payoff
Call Payoff

30 -20

Put Payoff
20 -30

10 -40

Profit (assuming $10 premium)

0 -50

0 10 20 30 40 50 60 70 80 90 100 110 120

-10 -60
Cost of Option

-20 -70

Stock Price (S) Stock Price ($)

Long Put Short Put 46

 Pricing Boundaries
 Minimum and Maximum values
 C 0, P 0 (American and European)
 C S, P X/(1+r)T or P X
 Lower bounds
 American:
 C Max(ST-X,0); P Max(X-ST,0)
 European:
 C Max(ST-X/(1+r)T,0)
 P Max(X /(1+r)T-ST,0)
 Issue: early exercise (non-dividend paying stocks)
 Never exercise American calls early, so lower bound on an
American is the same as a European 47
What Effects Option Prices

Variable C P

S0 + -
X - +
T-t + +
+ +
r + -
Dividend - +
48
Put-Call Parity

 Because values of puts and calls are

determined from the same underlying
asset, there must be a relationship in
the pricing of puts and calls
 No arbitrage…again
 Fiduciary call = c+X/(1+r)T
 Protective put = S+p

49
Put-Call Parity
@t @T @T
ST X ST<X

Buy call -c ST-X 0

Buy bonds -Xe-rT X X

Payoff ST X
Buy stock -S ST ST
Buy put -p 0 X-ST
Payoff ST X 50
If No Arbitrage Holds…

 We have two assets with identical

payoffs, regardless of what happens to
prices
 P-C Parity = p+S = c+X/(1+r)T
 Can use the relationship to construct
synthetic puts and calls
 Effect of dividend payments
 p+S = c+X/(1+r)T+PV(CF)
51
CFA Tutorial

Risk Management
Applications of Options
Strategies
Option payoffs and profits
Long Call 20
Short Call
70

Profit (Assuming a $10 premium)

60 10

Payoff of Option
50 0

0 10 20 30 40 50 60 70 80 90 100 110 120

-10
40
Call Payoff

Call Payoff
Call Payoff

30 Call Payoff -20

-30
20

-40
10

Profit (assuming $10 premium)

-50
0
0 10 20 30 40 50 60 70 80 90 100 110 120
-60
-10
Cost of Option
-70
-20
Stock Price ($)
Stock Price (S)

70 20

Profit (Assuming $10 premium)

60 10

Payoff of Option
50 0

0 10 20 30 40 50 60 70 80 90 100 110 120

40 -10

Call Payoff
Call Payoff
Call Payoff

30 -20

Put Payoff
20 -30

10 -40

Profit (assuming $10 premium)

0 -50

0 10 20 30 40 50 60 70 80 90 100 110 120

-10 -60
Cost of Option

-20 -70

Stock Price (S) Stock Price ($)

Long Put Short Put 53

Covered Call

 Combination of a long stock and short call

position
 V = ST - max(0,ST – X)
 If S X, V = S; if X S, V = X
 Profit = VT – So + c
 Used for risk reduction, but also limits
upside returns
 Bullish strategy: losses on underlying are
cushioned by option premium in a down market
54
 Payoff Diagram: Covered Call
Looks like a short put
Covered Call Payoff

40

30

20

10
Payoff

0
40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89

-10

-20

-30
Stock Price

profit on stock profit on call total profit

55
Protective Put
 Long position in put and stock
 Similar to a covered call, a protective put
provides some downside risk protection
 Maintains upside potential
 Like an insurance contract, but costly
 V = ST + max(0, X–ST)
 If S > X, V = S; if X S, V = X
 Profit = VT - So – p
 Profits technically could be unlimited
 Losses limited to put premium
56
 Protective Put Payoff:
Looks like a long call
Protective Put Payoff

40

30

20

10
Payoff

0
40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89

-10

-20

-30
Stock Price

profit on stock profit on put total profit

57