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Chapter 11: Derivatives: Required Material Are As Following: Book's 11 Edition Futures, Forwards & Options

1. A derivative is a financial security with a price dependent on an underlying asset. Common derivatives include options, forwards, futures, and swaps. 2. An option gives the holder the right but not the obligation to buy or sell an underlying asset at a strike price on or before expiration. Option buyers pay a premium. 3. A future or forward is an agreement to buy or sell an asset at a set price on a future date. For futures, the terms are standardized and traded on an exchange. Forwards are customized over-the-counter contracts.

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50 views

Chapter 11: Derivatives: Required Material Are As Following: Book's 11 Edition Futures, Forwards & Options

1. A derivative is a financial security with a price dependent on an underlying asset. Common derivatives include options, forwards, futures, and swaps. 2. An option gives the holder the right but not the obligation to buy or sell an underlying asset at a strike price on or before expiration. Option buyers pay a premium. 3. A future or forward is an agreement to buy or sell an asset at a set price on a future date. For futures, the terms are standardized and traded on an exchange. Forwards are customized over-the-counter contracts.

Uploaded by

Marwa Hassan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Chapter 11 : Derivatives

Required material are as following: book’s 11th edition


Futures, Forwards & Options.

Mr. Al Mannaei
Derivative
• A derivative is a security with a price that is
dependent upon or derived from one or
more underlying assets.
• Traded over-the-counter (OTC) or on
an exchange (listed).
• Options, Forward, Futures and Swaps are
most common type of derivatives.
1.Options
• A financial security.
• A contract sold by one party (option writer)
• To another party (option holder).
• Offers the buyer the right, but not the
obligation, to buy (call) or sell (put) a security
or at an agreed-upon price (the strike price)
• During a certain period of time or on a specific
date (exercise date).
Option trading
Listed on exchange :
•Prices on screen
•Standardized terms & conditions (cant change
it)
OTC (over the counter):
•Outside the stock exchange.
•Customized terms & conditions (shaped –
tailored)
Call Option
• When you buy a Call option (option holder)

>> you are buying the right to buy. (not


obligation)
for certain price, in certain date.

>> you will pay a premium (price of call


option)
Call Option
• When somebody sell a call option. (option
writer)

>> he MUST sell (obligated) if the buyer ask


him
for certain price, in certain date.

He will receive a premium (price of call


option)
Call option example
Sara found a very nice house close to her job. The
problem is sara cant afford the money until 3 months.
So she pay $3000 to the owner. He agreed to sell the
house after 3 months for sara for $350,000 if she ask.
According to finance, the following represent :
Sara :
Owner :
House :
$3000 :
$350,000 :
3 Months :
Agreement :
Call option example
Sara found a very nice house close to her job. The problem
is sara cant afford the money until 3 months. So she pay
$3000 to the owner. He agreed to sell the house after 3
months for sara for $350,000 if she ask.
According to finance, the following represent :
Sara : option holder (buyer of call option)
Owner : option writer (seller of call option)
House : Underlying asset.
$3000 : Premium.
$350,000 : Strike price (exercise price)
3 Months : Exercise date.
Agreement : Sara has the option (right) to buy the house for $350,000.
On the other hand, the owner is obligated to sell the house for
$350,000.
Call option example
After 3 months.
Scenario 1 : The value of the house skyrockets to $1
million.

Shall sara exercise the option ?! (Shall sara buy the house)

Which party will gain/Loss ?! How much ?!

Can the owner say “ I am NOT going to sell for


$350,000” ?!
No, seller of call option is obligated to sell if sara (buyer) would like to
exercise the option (want to buy the house)
Scenario 2 :
Due to some issues related to public security The value of
the house dropped to $200,000.

Shall sara exercise the option ?! (Shall sara buy the house)

Which party will gain/Loss ?! How much ?!

Can the owner say “ you must buy the house for
$350,000” ?!
No, buyer of call option (Sara) has the option (right) to buy, she is NOT
obligated to buy.
Continue..
What is the maximum profit can be made by Sara?
>> Unlimited
What is the maximum loss can be made by Sara?
>> Premium ($3000)
What is the maximum profit can be made by the
owner ?
>> Premium ($3000)
What is the maximum loss can be made by the owner ?
>> Unlimited

Sara ( Buyer of call option – holder of call option)


The owner (Seller of call option - writer of call option)
Example 2
You bought a call option to buy Google stock after a year for $650.
you paid $20 as a premium.

Scenario 1 : Google price $600.


Is it in the money* ?!
How much you will make profit/loss ?!

*In the money mean the option (call or put) make profit, so holder should exercise it.
You bought a call option to buy Google stock after a
year for $650. you paid $20 as a premium.

Scenario 2 : Google price is $750


Is it in the money ?!
How much you will make profit/loss ?!
You bought a call option to buy Google stock
after a year for $650. you paid $20 as a
premium.

Scenario 3 : Google price is $670


Is it in the money ?!
How much you will make profit/loss ?!
Put Option
• When you buy a put option.(Option holder)

>> you are buying the right to sell. (not


obligation)

>> you will pay a premium (price of put


option)
Put Option
• When somebody sell a put option. (Option
writer)

>> he must buy (obligated) if the buyer ask


him
He will receive a premium (price of put
option)
Put Option Example 1
An trader purchases a put option contract for
Company XYZ for $0.5 with a strike price of $10 per
share, the trader can sell the shares at $10 before or
at the end of  option period.  

If Company XYZ's share price drops to $8 per share.


How much the trader will make profit or loss?!
Put Option Example 2
An trader purchases a put option contract for
Company XYZ for $0.5 with a strike price of $10 per
share, the trader can sell the shares at $10 at the end
of the option period.  If Company XYZ's share price
increases to $12 per share.

How much the trader will make profit or loss?!

Is it American or European option ?! How about


example 1 ?!
Option trading
• American option : allow you to exercise the option
any time during the agreement.

• European option : exercise the option only in expire


date.
Summary : Call vs. Put
• The call option will be
in the money if Strike* < market price
out the money if Strike > market price

• The put option will be


in the money if Strike > market price
Out the money if Strike < market price
Summary : Call vs. Put
Summary : Call vs. Put
• Call options give the right to buy at certain
price, so the buyer would want the stock to
go up.

• Put options give the right to sell at a certain


price, so the buyer would want the stock to
go down.
Summary : Call vs. Put
• Options are type of derivatives.
• Options are used for speculation, income
generation, or hedging a position.
• Options buyers pay a premium for the
right to, but not the obligation, to act.
• Options sellers (writers) have an obligation
(if assigned.
2.Future and Forward
• Agreement between two parties to trade a specific
asset at specific price to be paid in the future.
• At expiration, the buyer takes delivery of the
underlying from the seller or (most likely) the
parties can agree to make a cash settlement.
• Forward and Futures contracts have the same
function.

Video : http://www.investopedia.com/terms/f/futures.asp?header_alt=a
Futures and Forward

“I will sell you 1 ton of


orange for $1000 after 3
Months”

Tom is an orange farmer, sell 1 ton of orange for $1000 to a juice factory, the
settlement will happen after 3 months.

After 3 months, Tom will deliver the orange & the factory will pay the $1000.
2.Future and Forward
• The long position, or buyer, agrees to purchase the
underlying at a later date or at the expiration date
at a price that is agreed to at the beginning of the
transaction. Buyers benefit from price increases.
• The short position, or seller, agrees to sell the
underlying at a later date or at the expiration date
at a price that is agreed to at the beginning of the
transaction.
Sellers benefit from price decreases.
• After 3 months the price increase to $1200,
– How will make profit and loss ?!
– Can the farmer refuse to deliver the orange ?!
• After 3 months the price dropped to $800,
– How will make profit and loss ?!
– Can the factory refuse to pay the $1000?!

• Is it possible to end the contract by cash


settlement.
Yes, if both parties agree.
Futures and Forward
Futures Forward
Listed on exchange ( Centralized ) OTC (Decentralized)
Term & conditions are Terms & conditions are
Standardized Customized
(future contracts are standardized in (Forward contracts can be shaped
quantities, delivery periods, deliverable according to seller & buyer preferences)
goods)
Identity is irrelevant Identity is relevant
(like buying stocks from a financial (buyer & seller will contact directly)
markets)

Less costly More costly


Almost there is NO counterparty Higher counterparty risk
risk

* Counter party risk : chance that one party will not pay or deliver as agreed. In
future contacts, this risk – almost – doesn’t exist because settlement
guaranteed by clearing house.
In expiry date, Clearing house assurance that seller will deliver the assets,
and buyer will pay the money.

It is important to mention that most future contracts end by cash settlement.


Recap..
• Spot market : is commodity or securities
market in which goods are sold for cash
and delivered immediately.
• Pay now >> receive now !
• The spot market is also called the "cash
market" or "physical market”.
Forward price example
Hardy is a portfolio manager who plans to buy 1 month
treasury bills in 2 months. The current price for 3
month treasury bills is $992,537 per 1 million face
amount. If the annual risk free rate over the 2 months
is 3%.
Calculate the fair forward price?
Answer :
.03 2
$992,537(1  ( ))  $997,506
12

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