Introduction

Chapter 1 and 2
What is a Derivative?
A derivative is an instrument whose value depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options, exotics…

Assets:
1. Equity ( stocks) Also called Variable income security. Build derivative on options.
2. Commodity (Gold) - Build derivates forwards & futures
3. Bonds/ Debts (Fixed Income Securities)
4. Exchange rate
5. Interest rate
6. Real estate
Early Evolution of Derivatives
1972 Foreign currency futures Options on currency futures
1973 Equity options and futures Options on equity-index futures
1975 T-Bill futures Interest rate caps and floors
1977 T-Bond futures 1985 Eurodollar options
1979 OTC currency options Swaptions
1980 Currency swaps 1987 Average options
1981 Equity index futures Commodity swaps
Options on T-Bond futures 1991 Banker's Trust creates the first
T-Note futures credit-default swap
Eurodollar futures
Interest rate swaps
1983 Options on T-Note futures
 Derivatives Trading Before and After 1970
Before 1970
◦ Derivatives markets were small.
◦ Only futures contracts had a well-functioning market.
◦ Financial derivatives were unknown.
◦ No satisfactory option pricing model existed.

Starting early 1970s

◦ These rapid changes reshaped derivatives trading:
◦ Introduction of new derivative contracts
◦ Opening of new exchanges
◦ Consolidation and linking of exchanges
◦ Introduction of computer technology

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Exchange Rate Risk: Bretton Woods
Bretton Woods system of fixed exchange rates (1944)
◦ Currencies were convertible to US dollar.
◦ Dollar was convertible to gold.
We will peg all the currencies to US Dollar. The exchange rate to US Dollar is Fixed. US dollar pegged to Gold. 1 ounce of Gold =$ 35. what's the
issue with this system??? Arbitrage opportunity. Firm wanted to secure their exchange rate which gave birth to the concept foreign currency
futures.

Rising gold prices helped other nations.

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Exchange Rate Risk (Cont’d)
In 1971: President Richard Nixon ended Bretton Woods. Need arose for
hedging currency risk.

In 1972: Chicago Mercantile Exchange (CME or Merc) introduced foreign

currency futures. We can trade it here. Two kinds of markets Over the counter and exchange traded

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 FIGURE 1.1: Global Derivatives Market. Derivatives
Notional Amounts (Dec 2016, in Billions of USD)
Equity-Linked Contracts
Commodity Contracts
(Global OTC), 6140, 1%
(Global OTC), 1350, 0%

Credit Derivatives (Global

OTC), 10015, 2%

Interest Rate Contracts Other Derivatives

(Global OTC), 386356, (Global OTC), 96, 0%
68%
Unallocated (Global
OTC), 27864, 5%

Futures (Exchange-
Traded), 26172, 5%

Options (Exchange-
Traded), 41073, 7%

Foreign Exchange Contracts

(Global OTC), 68598, 12%
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How Derivatives Are Traded
On exchanges such as the Chicago Board Options Exchange (CBOE)
In the over-the-counter (OTC) market where traders working for banks, fund managers
and corporate treasurers contact each other directly

OTC was unregulated before 2007 crises.

Exchange trading are very regulated. eTD Exchange
trading derivate. standardized size, quantity, price
etc. No counter party risk as there is middle man of
clearing house.

Source: Bank for International

Settlements. Chart shows total
principal amounts for OTC market
and value of underlying assets for
exchange market
How Derivatives are Used
o Risk Management
o Speculation
o Arbitrage
 0

Forward Contracts
(6 months)

F0 = Forward price = $ 100/bushel

oAn agreement to buy or sell an asset at a certain price at a certain

time in future.
oThe forward price for a contract is the delivery price that would be
applicable to the contract if were negotiated today.
oThe forward price may be different for contracts of different maturities.
oThe party that has agreed to buy has what is termed a long position.
oThe party that has agreed to sell has what is termed a short position.

Forward contract = Over the counter not exchange traded, however if i want i can get a clearing house. Usually, OTFs are between trusted
parties.
 Foreign Exchange Quotes for GBP, May 3,
2016 $/Sterling

These are the prices of the market maker = Banks

Bid Offer
Bid = Buy
Spot 1.4542 1.4546 Offer = sell
$/GPB They will sell me GPB =$1.456. Therefore our
buying of Dollar is 1.456
In a month I can sell a 1-month forward 1.4544 1.4548
GPB at 1.4544 and I can
buy GPB at 1.4548.
Difference between Bid 3-month forward 1.4547 1.4551
and offer = spread

6-month forward 1.4556 1.4561

Profit from a Long Forward Position (K=
delivery price=forward price at time contract is entered into)
This is the long position. Short position is the mirror image of the long position

Profit

20
60 80 100
Price of Underlying at Axis = Market price at Delivery . this
K Maturity, ST is not the forward price
-20

-40
Profit from a Short Forward Position (K=
delivery price=forward price at time contract is entered into)
Profit

Price of Underlying
at Maturity, ST
K
Forward Contract Example
oCurrent price of soybeans is $160/ton Spot price

oTofu manufacturer needs 1,000 tons in 3 months

oWants to make sure that 1,000 tons will be available
o3-month forward contract for 1,000 tons of soybeans at $165/ton Forward Price

oLong side will buy 1,000 tons from short side at $165/ton in 3 months

When the underlying assets is crop, weather is conducive, If weather is good supply is more hence market
price on future date is going to below the forward price. If weather is bad demand of crop is more hence market
price > forward price.
Read about weather derivates. ====Assignment
 Futures are ETFs not OTC. Quantity is fixed, Maturity is fixed, delivery is fixed.

Futures Contracts
oA futures contract is an exchange-traded, standardized, forward-like contract that is
marked to market daily. This contract can be used to establish a long (or short) position
in the underlying asset.
oFeatures of Futures Contracts
o Standardized contracts:
o Underlying commodity or asset
o Quantity
o Maturity
o Delivery Arrangements (place)
o Delivery Months

oExchange traded
oGuaranteed by the clearinghouse—no counter-party risk I my not know the party on the other side of the trade.

oGains/losses settled daily (marked to market) Long and short position have to put up Margins. Value of security is
decided by clearing house.
oMargin required as collateral to cover losses
Examples of Future Trade
An investor takes a long position in 2 December gold futures
contracts on June 5
◦ contract size is 100 oz Total Ounces = 200
◦ futures price is US$1,250/ounce
◦ initial margin requirement is US$6,000/contract
(US$12,000 in total)
July 5 December
◦ maintenance margin is US$4,500/contract
(US$9,000 in total)
Pay $ 1250 per
ounce on december
 Big difference between forward and future = Futures have MTM and Forwards dont have

Variation Margin

A Possible Outcome

Loss of 1800 ( from buy position)

Now I buy the will go to the short position
same contract account. Here we settle
same maturity
= $ 1241

you are below

maintenance
margin. Once
you are below
maintainence
margin you have
to top up upto
the INITIAL
MARGIN =$
12000
Margin Cash Flows When Futures Price
Increases
Margin Cash Flows When Futures Price
Decreases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Short Trader
Long Trader
Margins
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
settlement
Margins minimize the possibility of a loss through a default on a
contract
Margins Cash Flow
 A trader has to bring the balance in the margin account up to the
initial margin when it falls below the maintenance margin level
 These daily margin cash flows are referred to as variation margin
 A member is also required to contribute to a default fund
 Options are exchange traded. That means they are standardize. Underlying asset is a stock.
Call Options
Call option = BUY a stock at a certain date at certain price.
eg: Share trading at 60 per share. I think that stock price will go up at $ 70/share
Spot price = S0 = $60
I get into a contract with you to buy the stock from you at $ 65 per share. This called as strike price. This is denoted by K. Cannot negotiate this price. The
market price is denoted as S Market price at maturity
Long position I have an option to walk away from the option contract or not exercise the option. Say after 3 motnhs the asset is selling at $ 62. The short
position cannot not exercise the option or walk away. Long position has the right to exercise the option not the obligation. The short position has only the
obligation not the right. The long position will pay some amount at the start of the option. The price paid at the beginning is the option price or call premium.
If I walk away or exercise the option the short position fellow gets to keep the call premium.

Options
Put options written in the notebook.

A call option is an option to buy a certain asset by a certain date for a

certain price (the strike price)
A put option is an option to sell a certain asset by a certain date for a
certain price (the strike price)
American vs European Options
An American option can be exercised at any time during its life
A European option can be exercised only at maturity
 K= $65 ST = $65 C=$2 K=$65 ST =$70 C =$2
Pay off = 0 Pay off = $ 5
Profit/Loss = -$2 Profit= $ 3

Payoff is the money you make at MATURITY.

Profit / Loss =
Here we are violating the principle of compounding and discounting. But here we will ignore.

Google Call Option Prices from CBOE (May 8, 2013; Stock Price
is bid 871.23, offer 871.37)

Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer

820 56.00 57.50 76.00 77.80 88.00 90.30

840 39.50 40.70 62.90 63.90 75.70 78.00

860 25.70 26.50 51.20 52.30 65.10 66.40

880 15.00 15.60 41.00 41.60 55.00 56.30

900 7.90 8.40 32.10 32.80 45.90 47.20

920 n.a. n.a. 24.80 25.60 37.90 39.40

Google Put Option Prices from CBOE (May 8, 2013; Stock Price
is bid 871.23, offer 871.37)

Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer

820 5.00 5.50 24.20 24.90 36.20 37.50

840 8.40 8.90 31.00 31.80 43.90 45.10

860 14.30 14.80 39.20 40.10 52.60 53.90

880 23.40 24.40 48.80 49.80 62.40 63.70

900 36.20 37.30 59.20 60.90 73.40 75.00

920 n.a. n.a. 71.60 73.50 85.50 87.40

Types of Traders
Hedgers Risk Management. It is referred as hedging your risk.

Speculators speculation

Arbitrageurs Arbitrage
Hedging Examples
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 $28 per
share. A two-month put with a strike price of $27.50 costs $1. The
investor decides to hedge by buying 10 contracts
I anticipate that in 2 months the price is $ 25. So I will Long Put at 2 months strike price $ 27.5 Premium
Pay off = 2.5 per share
Profit = 1.5 per share
 Speculation Example
An investor with $2,000 to invest feels that a 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 22.50 is $1
What are the alternative strategies?
Alternative 2: Buy call option at strike price $ 22.5
Alternative 1: Buy share now at $ 20 and sell after 2 months.
S0 = $20
S0 (spot price) = $20 K = $22.5
Buy 100 Shares = $2000/20 No. of shares = 2000 shares. ($2000/$1)
Period =2months Call premium = $2000 (2000 shares * $1)
Lets say ST (Market price) = $25 then profit = $500
Lets say ST (Market price) = $15 then profit = - $500 Lets say ST = $ 25 then payoff = $5000 and profit $3000
Lets say ST = $15 then payoff = 0 Loss $ 2000

IN THIS STATERGY GIVES RISE TO GREATER GAINS AND

GREATER LOSSES
Arbitrage Example
A stock price is quoted as £100 in London Stock Exchange
and $140 in New York Stock Exchange
The current exchange rate is 1.4300
What is the arbitrage opportunity?

Buy Dollars in Newyork = $140 Sell Dollars in London = $ 143. Profit $3