Lecture 1 Introduction to Derivatives Nicholas Chen

Nicholas Chen, ICMA Centre 1

Introduction
A little bit about myself
What I am sharing with you Knowledge in finance Applying financial valuation principles to your personal life

Introduction (Cont)
Why is it so hard to make decisions Uncertain consequences Can I wait to make decisions later on? Yes, there is a fee for you to delay your decision-making. In finance, everything, including the right of making

decision, will be priced.

Nicholas Chen, ICMA Centre

Rent a Flat in Town Centre The first decision I need to make is to rent
To Rent: 800 300 = 500 Deposit : 300 Not to Rent: Lose 300

The deposit 300 is the price to have ________ to make

decision later on.

Nicholas Chen, ICMA Centre 4

Objectives
Describe and characterize derivatives

and markets Evaluate and apply pricing and trading methods Perform analysis of financial derivatives data Construct simple spreadsheets for derivatives pricing and trading

Materials
Required textbook Options, Futures and Other Derivatives (Hull, 8th ed) The 7th Edition is ok. Recommended Financial Times and WSJ

Course Operation
Attendance
Work on Assignments on your own Five seminars (where Assignments will not be collected) Casey Chen, [email protected] Four option pricing and trading sessions Tom Markham, [email protected] Office hours Monday 3 pm 5pm

Assessment
One multiple-choice in-class test (20%)
Four trading sessions (10%) One 1.5 hour final examination (70%)

Helpful hints
Spend one hour each day
Practice is the key Speak up in the class

Todays Outline
1. 2.

3.
4. 5.

What are derivatives? Forward contracts Futures contracts Options Contracts Trading types

Arbitrage and futures pricing

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1. What are derivatives?

an instrument whose value depends on the values of other, more basic, underlying variables The underlying variables are generally traded assets, e.g. stocks, indices, commodities, exchange rates or fixed income securities. But they can be any variable, e.g. the weather.

The dependence can be of many types. Nicholas Chen, ICMA Centre

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Underlying Assets: Commodities

Categories of commodities with exchange-traded derivatives:

Grains and Oil seeds

Livestock and Meat

Food and Fiber

GOLD

SILVER

COPPER

Energy

Metals
1.12

Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour

Underlying Assets: Common Stocks and Indexes

Popular US common stock indexes with associated

exchange-traded derivatives:

S&P 500 Index Dow Jones Industrial Average

FTSE Eurofirst 300

The S&P 500 Index, widely diversified across US

industries, comprises 500 stocks, for the most part traded on the NYSE. Typically, it includes the most important stocks in their respective industries. The Index is value-weighted, and a continuous daily price series exists since 1928.
Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour 1.13

Fixed Income Securities

Popular fixed income securities:
US Treasury bills

Eurodollars US Treasury notes/bonds Mortgages

Real world candidates for cash

Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour 1.14

Types of derivatives
Forwards: agreements to buy/sell an underlying in the future at a certain price agreed today over the counter Futures: same as forwards, except that they are standardized and settled daily in exchanges Options (call/put): contracts offered at a fee (or premium) that give the right to buy/sell an underlying in the future (same as futures but no obligation)

Structured products: contracts with non-standard payoff (e.g. convertible bonds, asset-backed securities)
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2. Forward contracts
Forward = agreement to buy/sell an asset at a certain future time for a certain price agreed today they require no fee!
Spot contract = agreement to buy or sell an asset today

Specifications:
Underlying

Type of agreement: buy/sell

Time of delivery Delivery price Size
Nicholas Chen, ICMA Centre 16

Forward contracts
traded over-the-counter personalized settled at the end of the contract

they involve some credit risk have zero value at the time of agreement, so no fee is exchanged Forward price = the price that makes the value of forward contract exactly zero. Terminology:
Long position: the buyer Short position: the seller
Nicholas Chen, ICMA Centre 17

Forward (and Futures) Contracts

October , 2011 December, 2011

Ill buy your house in July for $350,000.

Youve got a deal.

Thanks for the house.

Thanks for the $350,000.

Nothing is exchanged now.

Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour

Trade occurs in the future.

Specification of the above example

Specifications of a long forward contract:
Underlying: _____________ Type of agreement: _____________ Time of delivery: ______________ Price: ______________ Size: ______________
Nicholas Chen, ICMA Centre 19

Position in forward contracts

The price of a 6-month forward contract of gold is $400.

What does Long such a forward contract mean?

You commit to __ gold at the price of $__ in __ months.

Suppose the spot price is $450 in 6 months, will you make any profit?
Profit = ______________ The profit at maturity is ST K, where is the spot price ST is the spot price and K is the delivery price or the forward price when you enter into the contract.
Nicholas Chen, ICMA Centre 20

Profit from a Long Forward Position (K= delivery price=forward price at

time contract is entered into)
Profit

Price of Underlying at Maturity, ST

Options, Futures, and Other Derivatives, 8th Edition, Copyright John C. Hull 2012

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

Profit

Price of underlying at Maturity, ST

Options, Futures, and Other Derivatives, 8th Edition, Copyright John C. Hull 2012

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3. Futures contracts
Same as forward contracts, except:
traded on exchanges

standardized
settled daily

almost no credit risk involved they require margins

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Exchanges
Chicago Board of Trade Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) TIFFE (Tokyo)

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Delivery
Most futures contracts are closed out before maturity

by entering into an offsetting position

Otherwise they are settled by delivering the

underlying assets (when there are alternatives then the counterparty with the short position is making the choice about delivery conditions)
Some contracts (e.g. those written on indices or FX

rates) are settled in cash

Nicholas Chen, ICMA Centre 25

Terminology
Settlement price: the price used in the last trade of

the day (________________)

Open interest: the number of contracts outstanding

a new trade can increase/decrease open interest

Trading volume: the total number of trades during

the day a new trade always increases volume

Nicholas Chen, ICMA Centre 26

Margins
Cash or security deposited by an investor with his broker that helps avoid contract defaults
Settled daily (marked to market)
Minimize the possibility of a loss due to the default of

a counterparty

Types: initial and maintenance

Clearinghouse: holds the margin accounts
Nicholas Chen, ICMA Centre 27

Margins - example
An institution takes a long position in a 6-month

futures contract on stock A with the futures price being 100. Now the stock trades at 110. Contracts are written on 100 stocks.
The initial margin requirement is 2,000 per

contract.
The maintenance margin is 1,000 per contract. If an investor cannot pay the required margin then

his contract will be closed no credit risk

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Margins - example
Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600

Nicholas Chen, ICMA Centre

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Margins - example
Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600

Nicholas Chen, ICMA Centre

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Margins - example
Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600

Nicholas Chen, ICMA Centre

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Margins - example
Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600

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Forward vs. futures contracts Forwards Futures

Private contracts between 2 parties Non-standardized contracts 1 specified delivery date Delivery / cash settlement usually occurs Credit risk involved Settled at the end of the contract Profit / loss made on final day Requires no margins
Nicholas Chen, ICMA Centre

Exchange traded Standardized Range of delivery dates Closed out before maturity No credit risk Settled daily Profit/loss made over the entire period Requires margin payments
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Forward vs. futures contracts

Forward contract is similar to the rental from a private

party. Futures contract is similar to the rental from a letting agent, which can regarded as an exchange.

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4. Options
contract offered at a fee (price) that gives the right to buy/sell an asset in the future at a pre-defined price

Nicholas Chen, ICMA Centre, 2011

Terminology
Call option gives the right to buy Put option gives the right to sell Long the option Short the option the one who has the right he pays the fee the one who has the obligation he receives the fee

European option can be exercised on a specific date American option can be exercised until a specific date
Nicholas Chen, ICMA Centre, 2011

A bad decision maker

I like the house. However, I have not decided I

might change my mind in December.

Can you hold it for me?

Nicholas Chen, ICMA Centre

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(European) Call Options

The right (not obligation) to buy an asset a certain time
October Ill buy your house in If you pay me December for $350,000, $50,000 extra if I want to then. now, its a deal. December Housing Prices Rise

Thanks for the house.

Thanks for the $350,000.

Housing Prices Fall

Ive decided not to buy. Derivative Securities - INVEST II, Spring 2005,
Dr. Alfonso Dufour

Thats OK. But I get to keep the $50,000.

A even worse decision maker

I like the house. However, I have not decided I

might Change my mind in the future. But I do not even know when I will change my mind? Can you still hold it for me?

Nicholas Chen, ICMA Centre

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American Call Options

The right (not obligation) to buy an asset whenever you change your mind before the expiration day.
October Ill buy your house before If you pay me December for $350,000, $60,000 extra if I want to then. now, its a deal. November Housing Prices Rise

Thanks for the house.

Thanks for the $350,000.

Housing Prices Fall

Ive decided not to buy. Derivative Securities - INVEST II, Spring 2005,
Dr. Alfonso Dufour

Thats OK. But I get to keep the $60,000.

5. Traders
Types of traders:
Hedgers Require investment Reduce risk by ocking in the prices.

Speculators very risky! Require investment Increase risk by taking directional positions
Arbitrageours Require no initial investments Take zero risk What rate of return do arbitrageours expect to receive?
Nicholas Chen, ICMA Centre 41

Hedging example
A British company A will need to pay 10 mil in 6 months.

Company A will hedge this obligation with a long position in a forward contract, agreeing to buy 10 mil in 6 months at a specified forward rate 0.91 /.
No matter how much the exchange rate will be, company A

will have to buy the euro at the pre-specified rate.

If the exchange rate will be 0.93 /, then company A made

a good deal, If the exchange rate will be less than 0.91 /, then company A made a loss.
Nicholas Chen, ICMA Centre 42

Hedging Exercise
A US company will pay 10 million for imports from

Britain in 3 months and decides to hedge using a ___ position in a forward contract.

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Speculation Example (pages 10-11)

An investor with $4,000 to invest feels that Amazon.coms stock price will increase over the

next 2 months. The current stock price is $40 and the price of a 2-month call option with a strike of 45 is $2
What are the alternative strategies? Strategy 1: buy $4000 worth of stock Strategy 2: buy $4000 worth of options

Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour 1.44

Strategy 1: Buy Stock

Strategy 1: buy $4000 worth of stock 4000/40 = 100

shares
Possible outcomes in Dec: If AMZN share price = $70
Gain ________________

If AMZN share price = $30 lose _______________

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Strategy 2: Buy options

Strategy 2: buy $4000 worth of options

4000/2 = 2000 options (20 Dec contracts)

If AMZN share price = $70

Gain __________________

If AMZN share price = $30 lose _________________

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Arbitrage Example
Gold: An Arbitrage Opportunity? Suppose that:
The spot price of gold is US$390 The quoted 1-year futures price of gold is

US$425 The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?

Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour 1.47

Arbitrage Example (cont)

Futures price too __________ , yes there is an Arbitrage opportunity

Today Borrow money, buy gold and carry it to maturity of the futures contract
$390---> 390* e0.05x1 = 410

short 1 futures contract receive $425 in 1 year

One year later Close the futures contract by selling the gold at 425 cost to pay back loan =390e0.05*T=410
risk free profit of 425- 410 = 15

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Arbitrage Exercise
Suppose that:
The spot price of gold is US$390

The quoted 1-year futures price of gold is US$390

The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?

Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour 1.49

Arbitrage Exercise (Cont)

Futures price is ____

Today take a long position in futures contract Short sell gold to receive $390 (borrow the gold and sell it to the market) deposit $390 in bank at 5% interest at maturity Receive $410 (390* e0.05x1 = 410) from the deposit buy gold at $390 to close out the futures position return the gold to the lender to close the short sell position risk free profit = _____________ = $20 per contract
Nicholas Chen, ICMA Centre 50

The Futures Price of Gold

If the spot price of gold is S & the futures price for a contract deliverable in T years is F, then F = S e rT or F = S (1+r )T where r is the 1-year (domestic currency) risk-free rate of interest. In our examples, S=390, T=1, and r=0.05 so that F = ___________________

Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour 1.51

Key Q: Why Use Risk-free Rate?

Because forward and futures price is fixed in the

contract, ________ risk.

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Exercise Problem of Futures Pricing

Suppose that:
The spot price of oil is US$19 The 1-year US$ interest rate is 5% per annum

What is the price of oil futures contract?

Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour 1.53

The Futures Price of Oil

In our examples, S=19, T=1 and r=0.05 so that F = 19(1+0.05) = 19.95

Derivative Securities - INVEST II, Spring 2005, Dr. Alfonso Dufour 1.54

Convergence of futures to spot price (when T 0)

Futures price Spot price Spot price Futures price

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