Introduction to Options and Futures

Options
(& others)
Hedging
Financial with…
markets and
Swaps
corporate
applications
Pricing…
Forwards
and Futures
 Determine the prices of forwards and futures

 Introduce “no arbitrage” arguments

 General formulas for forward prices

 Forwards, futures, and expected spot prices

 Forward contract
The buyer and seller agree today upon the
delivery of a specified quantity and quality of an
asset at a future date for a given price
Today (𝒕 = 𝟎) Future date (𝒕 = 𝑻)
Terms and conditions: On settlement:
. Price (𝐹0 ) . Delivery of the asset
. Quantity & quality . Payment of 𝐹0
. Settlement date (𝑇)
. Location for delivery
 How is 𝐹0 determined?

▪ How much to pay for asset (stock, oil, gold, …) today?

▪ How much to pay for asset (stock, oil, gold, …) in 6m?

 How is 𝐹0 determined?
▪ What would it cost to buy the asset today, hold it until the
future date, and then deliver it?

𝐹0 = 𝐹𝑉 𝑆𝑂
𝑆0 : spot price of the underlying asset (today)
𝐹0 : future price for transaction (set today)
𝐹𝑉: “Compute the future value” (just as PV is a present value)
 Hedging portfolio
Value of a security = cost of hedging its risk

 Replicating portfolio
Value of a security = cost of a portfolio of securities
that generates the same payoff

 Underlying both approaches: No arbitrage

 A $100 bill is lying on the ground. Two
economists pass by. One tells the other:
«Didn’t you see the money there?»
 «I thought I did, but I must have imagined it.
If there really had been $100, someone would
have picked it up already»
 ‘No free lunches’
 Approach #1: Suppose you sell a forward

 What risk do you face, at maturity?

 What payoffs for buyer and seller at 𝑡 = 𝑇?

𝑡=0 𝑡=𝑇

Forward Buyer Seller Buyer Seller

contract … … … …
 Approach #1: Suppose you sell a forward

 What risk do you face, at maturity?

 How would you hedge that risk?

  How can the seller deliver the asset at 𝑡 = 𝑇?

𝑡=0 𝑡=𝑇

Forward Buyer Seller Buyer Seller

contract … … … …

Buyer Seller Buyer Seller

How can the
seller “hedge”? … …
… …
 Approach #1: Suppose you sell a forward

 What risk do you face, at maturity?

 How would you hedge that risk?

 Finance the purchase of the underlying by

borrowing cash
 How do we make our portfolio (short fwd +
hedge)
▪ Risk-free?
▪ A “fair” deal, such that we want to hold it?
 Therefore: 𝐹0 = 𝑆0 1 + 𝑟 𝑇
 Key idea to price assets: Replication
Law of one price (“LOOP”): two assets with
the same future payoff must have the same
price
 Approach #2: Put together a combination of
assets, whose price you know, that replicates
the same payoff as the forward
 Same future payoff ⇒ Same price today
 Borrowing to buy the asset today replicates a
short position in the forward
𝒕=𝟎 𝒕=𝑻
Short forward $0 Settle forward 𝐹0 − 𝑆𝑇
Buy asset −𝑆0 Asset value +𝑆𝑇
𝑇
Borrow +𝑆0 Repay loan −𝑆0 1 + 𝑟
Profit = Profit =

No arbitrage: No risk-free profits. How do we make 0

profits at 𝑡 = 0 and 𝑡 = 𝑇? 𝐹0 = …
 Suppose 𝑘 is the expected return on the
underlying, such that:
𝑇
𝐸 𝑆𝑇 = 𝑆0 1 + 𝑘
 Since 𝑆𝑇 is risky, 𝑘 will incorporate a risk
adjustment (just think of the CAPM!)
 Our expression for 𝐹0 is similar to 𝐸 𝑆𝑇 , but
has no risk adjustment
𝐹0 = 𝑆0 1 + 𝑟 𝑇
 Intuitively: 𝐹0 is an expectation of 𝑆𝑇 , in a
market where investors are indifferent to risk
 Thus: “risk-neutral” pricing
 We will see (a lot) more about this when we
discuss option pricing!
 Suppose:
▪ 1-year maturity

▪ Spot price of gold 𝑆0 = $390/oz

▪ 1-year interest rate 𝑟 = 5% per annum

▪ No income; no storage cost

 Plugging in our expression, 𝐹0 = …

 What if the quoted 𝐹0 is $425. What is the arbitrage
opportunity?

 Arbitrage strategy: “Buy low, sell high”

▪ “Buy low”: What is cheap? …

▪ “Sell high”: What is expensive? …

▪ Thus our strategy must go long , and

short .
  If 𝐹0 = $425, then arbitrage by going long underlying
and short the futures contract

𝒕=𝟎 𝒕=𝑻
Settle futures:
Short futures $0 deliver gold at $425 − 𝑆𝑇
𝐹0
Buy gold −$390 Gold value 𝑆𝑇
Borrow +$390 Repay loan −$390 1 + 5%
Profit = Profit =
  If 𝑭𝟎 > 𝑺𝟎 𝟏 + 𝒓 𝑻 , then arbitrage by going long
underlying and short the futures contract

𝒕=𝟎 𝒕=𝑻
Settle futures:
Short futures 0 deliver gold at 𝐹0 − 𝑆𝑇
𝐹0
Buy gold −𝑆0 Gold value 𝑆𝑇
Borrow +𝑆0 Repay loan −𝑆0 1 + 𝑟 𝑇

Profit = 0 Profit = 𝐹0 − 𝑆0 1 + 𝑟 𝑇
 What if the quoted 𝐹0 is $390. What is the arbitrage
opportunity?

 Arbitrage strategy: “Buy low, sell high”

▪ “Buy low”: What is cheap? …

▪ “Sell high”: What is expensive? …

▪ Thus our strategy must go long , and

short .
  If 𝐹0 = $390, then arbitrage by going short underlying
and long the futures contract

𝒕=𝟎 𝒕=𝑻
Settle futures:
Long futures $0 𝑆𝑇 − $390
pay 𝐹0 for gold
Shortsell gold +$390 Gold value −𝑆𝑇
Invest in 1-yr −$390 Get bond +$390
bond payoff × 1 + 5%
Profit = Profit =
  If 𝑭𝟎 < 𝑺𝟎 𝟏 + 𝒓 𝑻 , then arbitrage by going short
underlying and long the futures contract

𝒕=𝟎 𝒕=𝑻
Settle futures:
Long futures 0 𝑆𝑇 − 𝐹0
pay 𝐹0 for gold
Shortsell gold +𝑆0 Gold value −𝑆𝑇
Invest in 1-yr Get bond 𝑇
−𝑆0 +𝑆0 1 + 𝑟
bond payoff
Profit = 0 Profit = 𝑆0 1 + 𝑟 𝑇 − 𝐹0
The spot price of an investment asset that
provides no income is $30; the 3-year forward
price is $40. What is the 3-year risk-free rate of
return?
 𝑇
 Start from 𝐹0 = 𝑆0 1 + 𝑟

𝐹0 𝑇
𝐹0
= 1+𝑟 ⇒ ln = 𝑇 ln 1 + 𝑟
𝑆0 𝑆0

1 𝐹0
⇒ ln = ln 1 + 𝑟
𝑇 𝑆0
1 𝐹0
⇒ exp ln − 1 = 𝑟 = 10.1%
𝑇 𝑆0
 𝑇
 What about 𝑟 = 𝐹0 /𝑆0 − 1?

 Also correct…

 …but it can be impractical (what if 𝑇 = 10?)

 …and manipulating logarithms comes in

handy in our later classes
 Sell something you don’t own
 Broker borrows the assets from another client and sells
them in the market
 Later: the short seller buys assets back, to replace them
in the client’s account
 Short sale proceeds remain with the broker, and
investor must post collateral (“margin”)
 Short seller must pay dividends and other benefits to
the asset owner
 Why sell something short?
 No arbitrage assumption is extremely useful,
but is it always true?

 What do you think we need for no arbitrage?

 What happens if arbitrage is limited?

 2 March 2000: 3Com IPOs
5% of Palm shares to public
 1 March 2000: 3Com trades
at $104.30
 2 March 2000, close:
▪ Palm trades at $95.06
▪ 3Com should trade at $145 3Com shareholders to
▪ 3Com price: $81.81 receive 1.5 Palm shares
for each 3Com share
 50%

3Com Palm
Cumulative Excess Return

0%

Mar May Jul Sep Nov

-50%

-100%

-150% Mar – Oct 2000: 7 months

 “The market
can stay
irrational
longer than
you can stay
solvent”
J. M. Keynes
 Why does the mispricing
persist?
 Further reading:
Lamont, O. A., and R. H.
Thaler, 2001, Can the market
add and subtract?, NBER
Working paper 8302
 Price of forwards in the simplest case:
𝑇
𝐹0 = 𝑆0 1 + 𝑟

 Next: Let’s adapt it to a number of realistic

cases
 Suppose:
▪ 1-year maturity, spot price of gold 𝑆0 = $390/oz, 1-
year interest rate 𝑟 = 5% per annum, no income

▪ Present value of storage cost: 𝐶 = $10

𝑇
 Arbitrage pricing: 𝐹0 = 𝑆0 + 𝐶 1 + 𝑟
 In our example:
  If 𝐹0 = $425, then arbitrage by going long underlying
and short the futures contract

𝒕=𝟎 𝒕=𝑻
Settle futures:
Short futures $0 deliver gold at 𝐹0 − 𝑆𝑇
𝐹0
Buy gold −𝑆0 Gold value 𝑆𝑇
Borrow +𝑆0 Repay loan −𝑆0 1 + 𝑟 𝑇
Storage? $0 Pay storage −𝐶 1 + 𝑟 𝑇
Profit = Profit =
 Quoted interest rates usually annualized, with
an implicit compounding convention
 5% compounded semi-annually: a 2.5%
payment every 6 months
 $1 invested at (annualized) 𝑟 with a
compounding frequency 𝑛 yields, after 1 year:
𝑟 𝑛
$ 1+
𝑛

 With continuous compounding: $𝑒 𝑟

 Number of Value of 5%
Compounding periods per $1 value after
frequency one year interest, at
year (𝒏)
different
Annually 1 1 + 5.0000% compounding
Semi-annually 2 1 + 5.0625% frequencies
Quarterly 4 1 + 5.0945%
Monthly 12 1 + 5.1162%
Weekly 52 1 + 5.1246%
Daily 365 1 + 5.1267%
Hourly 4,380 1 + 5.1271%
Per minute 262,800 1 + 5.1271%
Continuously ∞ 1 + 5.1271%
 Number of Example: 𝑆0 =
Compounding periods per Loan payback $390, 𝑟 = 5%,
frequency
year (𝒏)
𝑇 = 1 year.
Annually 1 How much to
Semi-annually 2 pay back at
Quarterly 4 different
Monthly 12 compounding
Weekly 52 frequencies?
Daily 365
Hourly 4,380
Per minute 262,800
Continuously ∞
You receive €1,100 in one year, in return for a
€1,000 upfront investment. What is your
percentage return with…
(a) Annual compounding?
(b) Semiannual compounding?
(c) Continuous compounding?
Annual compounding:
1,100
− 1 = 10%
1,000
Semiannual compounding:
𝑟 2
1,000 × 1 + = 1,100
2
Continuous compounding:
1,000𝑒 𝑟 = 1,100
 No income, no storage costs:
𝐹0 = 𝑆0 𝑒 𝑟𝑇
 Income = negative storage cost. For
example?

 Known income, with present value 𝐼:

𝐹0 = 𝑆0 − 𝐼 𝑒 𝑟𝑇
 Suppose:
▪ 1-year maturity

▪ Stock with 𝑆0 = $100, paying $5.2 dividend in 6m

▪ Interest rates: 𝑟6𝑚 = 8.16%, 𝑟12𝑚 = 10%

 (Dividend) income = negative storage cost

𝐹0 = 𝑆0 − 𝐼 𝑒 𝑟𝑇
where 𝐼 = PV of future dividends
 What if the quoted 𝐹0 is $115. What is the arbitrage
opportunity?

 Arbitrage strategy: “Buy low, sell high”

▪ “Buy low”: What is cheap? …

▪ “Sell high”: What is expensive? …

▪ Thus, our strategy must go long , and

short .
  If 𝐹0 = $115, then arbitrage by going long underlying
and short the futures contract
𝒕=𝟎 𝒕 = 𝟔𝒎 𝒕=𝑻
Short 𝐹 $0
Buy 𝑆 −$100
Borrow
$5.2𝑒 −0.5×8.16%
PV(dividend)
Borrow PV(𝐹0∗ ) $105𝑒 −10%
Profit = $0
  If 𝐹0 = $115, then arbitrage by going long underlying
and short the futures contract
𝒕=𝟎 𝒕 = 𝟔𝒎 𝒕=𝑻
Short 𝐹 $0
Buy 𝑆 −$100
Borrow
+$5
PV(dividend)
Borrow PV(𝐹0∗ ) +$95
Profit = $0
  If 𝐹0 = $115, then arbitrage by going long underlying
and short the futures contract
𝒕=𝟎 𝒕 = 𝟔𝒎 𝒕=𝑻
Short 𝐹 $0 $0
Buy 𝑆 −$100 +$5.2
Borrow
+$5 −$5.2
PV(dividend)
Borrow PV(𝐹0∗ ) +$95 $0
Profit = $0 $0
  If 𝐹0 = $115, then arbitrage by going long underlying
and short the futures contract
𝒕=𝟎 𝒕 = 𝟔𝒎 𝒕=𝑻
Short 𝐹 $0 $0 $115 − 𝑆𝑇
Buy 𝑆 −$100 +$5.2 𝑆𝑇
Borrow
+$5 −$5.2 $0
PV(dividend)
Borrow PV(𝐹0∗ ) +$95 $0 −$105
Profit = $0 $0 $10
  If 𝐹0 = $115, then arbitrage by going long underlying
and short the futures contract
𝒕=𝟎 𝒕 = 𝟔𝒎 𝒕=𝑻
Short 𝐹 $0 $0 $115 − 𝑆𝑇
Buy 𝑆 −$100 +$5.2 𝑆𝑇
Borrow
+$5 −$5.2 $0
PV(dividend)
Borrow PV(𝐹0∗ ) +$95 $0 −$105
Profit = $0 $0 $𝟏𝟎
 Stock index
▪ Tracks the return on a hypothetical portfolio of
stocks
▪ Various kinds of weights, prop. to prices, market
cap, trading volume, …
▪ Ex. S&P500, Euro Stoxx 50, MSCI World

 Futures on stock indexes: typically settled in

cash
 With stock indexes, it makes more sense to
assume a known income yield 𝑞 than a given
$ income.

 Why do you think that is?

 Modify our forward price expression as:

𝑟−𝑞 𝑇
𝐹0 = 𝑆0 𝑒
 Forward on foreign currencies
Foreign currency = same as a security
providing a yield equal to the foreign interest
rate 𝑟𝑓
𝑟−𝑟𝑓 𝑇
𝐹0 = 𝑆0 𝑒

 Does this look familiar?

The risk-free interest rate is 9% per annum, and
the dividend yield on a stock index varies
throughout the year: In February, May, August,
and November, dividends are paid at a rate of 5%
per annum. In other months, dividends are paid at
a rate of 2% per annum. Suppose that the value of
the index on July 31 is 1,300. What is the futures
price for a contract deliverable on December 31 of
the same year?
 Time to maturity = ?

 Average dividend yield over the contract’s life?

1
3 × 2% + 2 × 5% = 3.2%
5
 Plug into the futures price:
5
9%−3.2% ×
𝐹0 = 1,300𝑒 12 = 1,331.80
The 2-month interest rates in Switzerland and
the United States are, respectively, 1% and 2%.
The spot price of the Swiss franc is $1.0500. The
futures price for a contract deliverable in two
months is also $1.0500. Are there any arbitrage
opportunities? If yes, please describe your
arbitrage strategy. If not, why not?
 How do we know if there are arbitrage
opportunities?

 Theoretical price:
2
2%−1% ×
𝐹0 = 1.0500𝑒 12 = 1.0518
 The futures contract is undervalued! To make an
arbitrage, we should…
 Futures price = Expected price in the future?

Futures Spot

Spot Futures

Time Time

Futures price should converge to spot price near

maturity (…otherwise?)
 Expectations hypothesis
𝐹0
𝐹0 = 𝐸 𝑆𝑇
 Can this be true in
general? 𝑆𝑇 is risky! Expectations
hyp.

Time
 Backwardation
𝐹0
𝐹0 < 𝐸 𝑆𝑇
 If speculators are long,
they require higher Expectations
hyp.
return
Backwardation

Time
 Contango
𝐹0
𝐹0 > 𝐸 𝑆𝑇
 If hedgers are long, they Contango

willing to pay a higher Expectations

hyp.
futures price to kill risk
Backwardation

Time
 Modern approach: Risk & return
 Suppose you are a speculator, and expect 𝑆𝑇
to be greater than 𝐹0 at time 𝑇
 What happens to 𝐹0 today?
 Consider the following strategy:

1. Enter a long futures position

2. Invest 𝐹0 𝑒 −𝑟𝑇 at risk-free rate 𝑟

 Ideally: At 𝑇 you obtain 𝐹0 and use it to pay

for the futures, obtaining 𝑆𝑇
 Cash flows:
▪ 𝑡 = 0:
−𝐹0 𝑒 −𝑟𝑇 + 0

▪ 𝑡 = 𝑇:
𝑆𝑇 − 𝐹0 + 𝐹0 = 𝑆𝑇
Long futures Risk-free
investment
 Value of the investment?
−𝐹0 𝑒 −𝑟𝑇 + 𝐸 𝑆𝑇 𝑒 −𝑘𝑇
where 𝑘 = risk-adjusted discount rate.
 No arbitrage: −𝐹0 𝑒 −𝑟𝑇 + 𝐸 𝑆𝑇 𝑒 −𝑘𝑇 = 0, or
𝑟−𝑘 𝑇
𝐹0 = 𝐸 𝑆𝑇 𝑒
 Thus: depends on 𝑘 ≷ 𝑟.
 CAPM
𝑘 = 𝑟 + 𝛽 𝐸 𝑟𝑀 − 𝑟

 When is 𝑘 > 𝑟?

 What kind of assets have 𝑘 < 𝑟?