Introduction To Derivatives

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 CONTENTS

• OVERVIEW

• BASICS REVISITED

• FORWARD CONTRACTS

• FUTURE CONTRACTS

• OPTION CONTRACTS

• FINANCIAL ENGINEERING
 LEARNING THE FUNDAMENTALS

Derivatives refer to contract that derive from another – whose value

depends on another contract or asset.

- Used as a hedging device to insulate business risk.

- Also known as devices for transferring risks.

- In Practice they are also yield kickers.

 DEFINITION AS PER ACCTG STANDARD SFAS 133

A Derivative instrument is a financial instrument or other contract with

three characteristics:
● It has one or more underlyings and one or more notional
amounts or payments provisions or both. Those terms determine the
amount of the settlement/settlements and in some cases whether or
not a settlement is required.
● It requires no initial net investment or an initial net investment
that is smaller than would be required for other types of contracts
that would be expected to have a similar response to changes in
market factor.
● Its terms require or permit net settlement, it can readily be
settled net by a means outside the contract or it provides for
delivery of an asset that puts the recipient in a position not
substantially different from net settlement.
 GENERAL BUSINESS RISKS

• INTEREST RATE RISK

- Risk of changing interest rates faced by banks and financial

institutions.

- The risk of an adverse movement i.e. declining interest rates can be

sheltered by swapping the floating rate for fixed rate.

- Interest rate movement on basis risk may be mitigated by entering

into basis swap.
 GENERAL BUSINESS RISKS

● FOREIGN EXCHANGE RISK

The risk of adverse exchange rate is sheltered by foreign currency
futures or forward covers.
● COMMODITY RISK
Business on position of Commodity prices are sheltered by again
futures and forwards in commodities.
● CAPITAL MARKET INSTRUMENT
Equity share price fluctuations can also be mitigated using future
and options available.
 GENERAL BUSINESS RISKS

● CREDIT RISK

Credit derivatives are hedged against credit risk.

● WEATHER RISK

Something like risk of changes in weather is hedged and

transferred. There are variety of weather derivatives, that are
generally instruments that pay off based on weather changes.
 TYPES OF DERIVATIVES

• FORWARDS

• FUTURES

• OPTIONS
 CATEGORIES OF PARTICIPANTS

• HEDGERS
Minimize the risk associated with price of an asset using
Future/option markets
• SPECULATORS
Bet on future movement in the price of an asset. Future/option
contracts give them extra leverage that can increase both
potential gain /losses in a speculative venture.
• ARBITRAGEURS
They are in the business to take advantage of the discrepancy
between prices in two different markets.
 FORWARDS CONTRACTS

• An agreement to buy/sell an asset on a specified date for a specified

price.
• One of the party assumes long position and agrees to buy the
underlying asset on a certain specified future date at a certain
specified price.
• The other party assumes a short position and agrees to sell the
asset on the same date on the same price..
 ESSENTIAL FEATURES OF FORWARD CONTRACT

• Bilateral contracts and hence exposed to counterparty risks.

• More customized to parties unique requirements and not
standardized in nature.
• Contract price not available in public domain i.e. outside stock
exchanges and are popularly OTC (over the counter) market.
• On expiry date, the contract has to be settled by delivery of assets.
• Reversing of contract by any party necessarily has to be with the
same counterparty.
• Risks: Decentralized trading
Liquidity
Counterparty risk
 FUTURES/FUTURE CONTRACT

• These are necessarily designed to solve the problems of forward

markets.
• It is an agreement between the parties to buy/sell an asset at a
certain time in the future at a certain price but unlike forward
contracts they are standardized and stock exchange traded.
• Requires margin payments unlike forwards.
• Follow daily settlement unlike settlement at the end of contract in
forwards.
• Eliminate counterparty risk and offer more liquidity.
 OPTIONS

• An option unlike future/forward contracts gives the holder the right

to do something.
• In Future/forwards apart from margin requirement only commitment
comes into play however, option requires an upfront payment.
• Unlike future/forward, option provides only an option not an
obligation to buy/sell a financial instrument /security at a prefixed
price called strike price. Obviously the option buyer will exercise the
option only when he is in the money i.e. he gains by exercising the
option as no party wishes out of money to loose the deal.
 TYPES OF OPTIONS

• Call Option: Option that gives the holder the right but not the
obligation to buy an asset by a certain date for a certain price.
• Put Option: Option that gives the holder the right but not the
obligation to sell an asset by a certain date for a certain price.
 FUTURE VS OPTIONS

• Both are exchange traded.

• Both define the exchange product.
• In option strike price is fixed and price moves where as in future it
works the other way round.
• In futures price is zero where as it is always positive in options.
• Futures have a linear payoff where as its nonlinear for option.
• Futures have both long and short at risk where as in options only
short is at risk.
 OTHER INSTRUEMENTS

• SWAPS: When both the parties exchange recurring payments with

the idea of exchanging one stream of payments with another e.g.
swap of fixed interest rates with floating rates or rates floating
with reference to one basis to another basis. In credit derivative
market, there are swaps based on the total return from a
particular credit asset against total return on a reference asset.
• CAPS, FLOOR AND COLLARS: Essentially options designed to shift
the risk of an upward and/or downward movement in variables
such as interest rate. These are normally linked to a notional
amount and a reference rate.
 OTHER INSTRUEMENTS

• SWAPTION: An option on a swap. This option provides the holder

with the right to enter into a swap at a specified future date at
specified terms.
BASICS
 Basics
• Finance is the study of risk.
– How to measure it
– How to reduce it
– How to allocate it

• All finance problems ultimately boil down to three main

questions:
– What are the cash flows, and when do they occur?
– Who gets the cash flows?
– What is the appropriate discount rate for those cash flows?

• The difficulty, of course, is that normally none of those

questions have an easy answer

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 Basics
• As you know, we can generally classify risk as being
diversifiable or non-diversifiable:

– Diversifiable – risk that is specific to a specific investment – i.e. the

risk that a single company’s stock may go down (i.e. Enron). This is
frequently called idiosyncratic risk.

– Non-diversifiable – risk that is common to all investing in general

and that cannot be reduced – i.e. the risk that the entire stock
market (or bond market, or real estate market) will crash. This is
frequently called systematic risk.

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 Basics

• The market “pays” you for bearing non-diversifiable risk only

– not for bearing diversifiable risk.
– In general the more non-diversifiable risk that you bear, the greater
the expected return to your investment(s).
– Many investors fail to properly diversify, and as a result bear more risk
than they have to in order to earn a given level of expected return.

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 Basics
• In this sense, we can view the field of finance as being about
two issues:
– The elimination of diversifiable risk in portfolios;
– The allocation of systematic (non-diversifiable) risk to those
members of society that are most willing to bear it.

• Indeed, it is really this second function – the allocation of

systematic risk – that drives rates of return.
– The expected rate of return is the “price” that the market pays
investors for bearing systematic risk.

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 Basics
• A derivative (or derivative security) is a financial instrument
whose value depends upon the value of other, more basic,
underlying variables

• Some common examples include things such as stock

options, futures, and forwards
• It can also extend to something like a reimbursement
program for college credit. Consider that if your firm
reimburses 100% of costs for an “A”, 75% of costs for a “B”,
50% for a “C” and 0% for anything less.

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 Basics
• Your “right” to claim this reimbursement, then is tied to the
grade you earn. The value of that reimbursement plan,
therefore, is derived from the grade you earn

• We also say that the value is contingent upon the grade you
earn. Thus, your claim for reimbursement is a “contingent”
claim

• The terms contingent claims and derivatives are used

interchangeably

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 Basics
• So why do we have derivatives and derivatives markets?
– Because they somehow allow investors to better control the
level of risk that they bear.
– They can help eliminate idiosyncratic risk.
– They can decrease or increase the level of systematic risk.

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 First Example
• There is a neat example from the bond-world of a derivative that is
used to move non-diversifiable risk from one set of investors to
another set that are, presumably, more willing to bear that risk.

• Disney wanted to open a theme park in Tokyo, but did not want to
have the shareholders bear the risk of an earthquake destroying
the park.

– They financed the park through the issuance of earthquake bonds.

– If an earthquake of at least 7.5 hit within 10 km of the park, the bonds did
not have to be repaid, and there was a sliding scale for smaller quakes and
for larger ones that were located further away from the park .

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 First Example
• Normally this could have been handled in the insurance (and
re-insurance) markets, but there would have been transaction
costs involved. By placing the risk directly upon the
bondholders Disney was able to avoid those transactions costs.

– Presumably the bondholders of the Disney bonds are basically the same
investors that would have been holding the stock or bonds of the
insurance/reinsurance companies.
– Although the risk of earthquake is not diversifiable to the park, it could
be to Disney shareholders, so this does beg the question of why buy the
insurance at all.

• This was not a “free” insurance. Disney paid LIBOR+310 on the

bond. If the earthquake provision was not it there, they would
have paid a lower rate.

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 First Example
• This example illustrates an interesting notion – that insurance
contracts (for property insurance) are really derivatives!
• They allow the owner of the asset to “sell” the insured asset
to the insurer in the event of a disaster.
• They are like put options (more on this later)

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 Basics
• Positions – In general if you are buying an asset – be it a physical stock or
bond, or the right to determine whether or not you will acquire the asset
in the future (such as through an option or futures contract) you are said
to be “LONG” the instrument.

• If you are giving up the asset, or giving up the right to determine whether
or not you will own the asset in the future, you are said to be “SHORT” the
instrument.
– In the stock and bond markets, if you “short” an asset, it means that you borrow
it, sell the asset, and then later buy it back.
– In derivatives markets you generally do not have to borrow the instrument – you
can simply take a position (such as writing an option) that will require you to give
up the asset or determination of ownership of the asset.
– Usually in derivatives markets the “short” is just the negative of the “long”
position

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 Basics
• Commissions – Virtually all transactions in the financial
markets requires some form of commission payment.
– The size of the commission depends upon the relative position of the
trader: retail traders pay the most, institutional traders pay less,
market makers pay the least (but still pay to the exchanges.)
– The larger the trade, the smaller the commission is in percentage
terms.
• Bid-Ask spread – Depending upon whether you are buying or selling
an instrument, you will get different prices. If you wish to sell, you
will get a “BID” quote, and if you wish to buy you will get an “ASK”
quote.

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 Basics
• The difference between the bid and the ask can vary
depending upon whether you are a retail, institutional, or
broker trader; it can also vary if you are placing very large
trades.
• In general, however, the bid-ask spread is relatively constant
for a given customer/position.
• The spread is roughly a constant percentage of the
transaction, regardless of the scale – unlike the commission.
• Especially in options trading, the bid-ask spread is a much
bigger transaction cost than the commission.

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 Basics
• Here are some example stock bid-ask spreads from
8/22/2006:
• IBM: Bid – 78.77 Ask – 78.79 0.025%
• ATT: Bid – 30.59 Ask – 30.60 0.033%
• Microsoft: Bid – 25.73 Ask – 25.74 0.039%
• Here are some example option bid-ask spreads (All with good
volume)
– IBM Oct 85 Call: Bid – 2.05 Ask – 2.20 7.3171%
– ATT Oct 15 Call: Bid – 0.50 Ask –0.55 10.000%
– MSFT Oct 27.5 : Bid – 0.70 Ask –0.80. 14.285%

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 Basics
• The point of the preceding slide is to demonstrate that the
bid-ask spread can be a huge factor in determining the
profitability of a trade.
– Many of those option positions require at least a 10% price movement
before the trade is profitable.

• Many “trading strategies” that you see people propose (and that
are frequently demonstrated using “real” data) are based upon
using the average of the bid-ask spread. They usually lose their
effectiveness when the bid-ask spread is considered.

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 Basics
• Market Efficiency – We normally talk about financial markets as
being efficient information processors.
– Markets efficiently incorporate all publicly available information into financial
asset prices.
– The mechanism through which this is done is by investors buying/selling
based upon their discovery and analysis of new information.
– The limiting factor in this is the transaction costs associated with the market.
– For this reason, it is better to say that financial markets are efficient to within
transactions costs. Some financial economists say that financial markets are
efficient to within the bid-ask spread.
– Now, to a large degree for this class we can ignore the bid-ask spread, but
there are some points where it will be particularly relevant, and we will
consider it then.

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 Basics
• Before we begin to examine specific contracts, we need
to consider two additional risks in the market:
– Credit risk – the risk that your trading partner might not honor
their obligations.
• Familiar risk to anybody that has traded on ebay!
• Generally exchanges serve to mitigate this risk.
• Can also be mitigated by escrow accounts.
– Margin requirements are a form of escrow account.

– Liquidity risk – the risk that when you need to buy or sell an
instrument you may not be able to find a counterparty.
• Can be very common for “outsiders” in commodities markets.

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 Basics
• So now we are going to begin examining the basic
instruments of derivatives. In particular we will look at
(tonight):
– Forwards
– Futures
– Options
• The purpose of our discussion is to simply provide a basic
understanding of the structure of the instruments and
the basic reasons they might exist.

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FORWARD CONTRACT
 Forward Contracts
A forward contract is an agreement between two parties to buy
or sell an asset at a certain future time for a certain future
price.
– Forward contracts are normally not exchange traded.
– The party that agrees to buy the asset in the future is said to
have the long position.
– The party that agrees to sell the asset in the future is said to
have the short position.
– The specified future date for the exchange is known as the
delivery (maturity) date.

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 Forward Contracts
The specified price for the sale is known as the delivery price, we
will denote this as K.
– Note that K is set such that at initiation of the contract the value of the
forward contract is 0. Thus, by design, no cash changes hands at time 0 .

As time progresses the delivery price doesn’t change, but the

current spot (market) rate does. Thus, the contract gains (or
loses) value over time.
– Consider the situation at the maturity date of the contract. If the spot
price is higher than the delivery price, the long party can buy at K and
immediately sell at the spot price ST, making a profit of (ST-K), whereas
the short position could have sold the asset for S T, but is obligated to sell
for K, earning a profit (negative) of (K-S T).

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 Forward Contracts
• Example:
– Let’s say that you entered into a forward contract to buy wheat at
$4.00/bushel, with delivery in December (thus K=$3.64.)
– Let’s say that the delivery date was December 14 and that on
December 14th the market price of wheat is unlikely to be exactly
$4.00/bushel, but that is the price at which you have agreed (via the
forward contract) to buy your wheat.
– If the market price is greater than $4.00/bushel, you are pleased,
because you are able to buy an asset for less than its market price.
– If, however, the market price is less than $4.00/bushel, you are not
pleased because you are paying more than the market price for the
wheat.
– Indeed, we can determine your net payoff to the trade by applying
the formula: payoff = ST – K, since you gain an asset worth ST, but you
have to pay $K for it.
– We can graph the payoff function:
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 Forward Contracts
Payoff to Futures Position on Wheat
Where the Delivery Price (K) is $4.00/Bushel

2
Payoff to Forwards

0
0 1 2 3 4 5 6 7 8
-1

-2

-3

-4
W heat Market (Spot) Price, Decembe r 14

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 Forward Contracts
• Example:
– In this example you were the long party, but what about the
short party?
– They have agreed to sell wheat to you for $4.00/bushel on
December 14.
– Their payoff is positive if the market price of wheat is less than
$4.00/bushel – they force you to pay more for the wheat than
they could sell it for on the open market.
• Indeed, you could assume that what they do is buy it on the open market
and then immediately deliver it to you in the forward contract.
– Their payoff is negative, however, if the market price of wheat
is greater than $4.00/bushel.
• They could have sold the wheat for more than $4.00/bushel
had they not agreed to sell it to you.
– So their payoff function is the mirror image of your payoff
function:
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 Forward Contracts
Payoff to Short Futures Position on Wheat
Where the Delivery Price (K) is $4.00/Bushel

2
Payoff to Forwards

0
0 1 2 3 4 5 6 7 8
-1

-2

-3

-4
W heat Market (Spot) Price, December 14

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 Forward Contracts
• Clearly the short position is just the mirror image of the long
position, and, taken together the two positions cancel each
other out:

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 Forward Contracts
Long and Short Positions in a Forward Contract
For Wheat at $4.00/Bushel

3
Short Position
2

1
Long Position
Payoff

0
0 1 2 3 4 5 6 7 8
-1

-2
Net
Position
-3

-4
W heat Price

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FUTURE CONTRACT
 Futures Contracts
• A futures contract is similar to a forward contract in that it is an
agreement between two parties to buy or sell an asset at a
certain time for a certain price. Futures, however, are usually
exchange traded and, to facilitate trading, are usually
standardized contracts. This results in more institutional detail
than is the case with forwards.

• The long and short party usually do not deal with each other
directly or even know each other for that matter. The exchange
acts as a clearinghouse. As far as the two sides are concerned
they are entering into contracts with the exchange. In fact, the
exchange guarantees performance of the contract regardless of
whether the other party fails.

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 Futures Contracts
• The largest futures exchanges are the Chicago Board of Trade
(CBOT) and the Chicago Mercantile Exchange (CME).

• Futures are traded on a wide range of commodities and

financial assets.

• Usually an exact delivery date is not specified, but rather a

delivery range is specified. The short position has the option
to choose when delivery is made. This is done to
accommodate physical delivery issues.
– Harvest dates vary from year to year, transportation schedules change,
etc.

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 Futures Contracts
• The exchange will usually place restrictions and conditions on
futures. These include:
– Daily price (change) limits.
– For commodities, grade requirements.
– Delivery method and place.
– How the contract is quoted.

• Note however, that the basic payoffs are the same as for a
forward contract.

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OPTION CONTRACT
 Options Contracts
• Options on stocks were first traded in 1973. That was the
year the famous Black-Scholes formula was published, along
with Merton’s paper - a set of academic papers that literally
started an industry.
• Options exist on virtually anything. Tonight we are going to
focus on general options terminology for stocks. We will get
into other types of options later in the class.
• There are two basic types of options:
– A Call option is the right, but not the obligation, to buy the underlying
asset by a certain date for a certain price.
– A Put option is the right, but not the obligation, to sell the underlying
asset by a certain date for a certain price.

• Note that unlike a forward or futures contract, the holder of the options
contract does not have to do anything - they have the option to do it or
not.
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 Options Contracts
• The date when the option expires is known as the exercise
date, the expiration date, or the maturity date.
• The price at which the asset can be purchased or sold is
known as the strike price.
• If an option is said to be European, it means that the holder
of the option can buy or sell (depending on if it is a call or a
put) only on the maturity date. If the option is said to be an
American style option, the holder can exercise on any date
up to and including the exercise date.
• An options contract is always costly to enter as the long
party. The short party always is always paid to enter into the
contract
– Looking at the payoff diagrams you can see why…

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 Options Contracts
• Let’s say that you entered into a call option on IBM stock:
– Today IBM is selling for roughly $78.80/share, so let’s say you
entered into a call option that would let you buy IBM stock in
December at a price of $80/share.
– If in December the market price of IBM were greater than $80,
you would exercise your option, and purchase the IBM share for
$80.
– If, in December IBM stock were selling for less than $80/share,
you could buy the stock for less by buying it in the open market,
so you would not exercise your option.
– Thus your payoff to the option is $0 if the IBM stock is less than
$80
– It is (ST-K) if IBM stock is worth more than $80
– Thus, your payoff diagram is:

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 Options Contracts
Long Call on IBM
with Strike Price (K) = $80

80

60

40
Payoff

20

0
0 20 40 60 K = 80 100 120 140 160
-20
IBM Terminal Stock Price

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 Options Contracts
– What if you had the short position?
– Well, after you enter into the contract, you have granted the
option to the long-party.
– If they want to exercise the option, you have to do so.
– Of course, they will only exercise the option when it is in their
best interest to do so – that is, when the strike price is lower
than the market price of the stock.

• So if the stock price is less than the strike price (ST<K), then the long
party will just buy the stock in the market, and so the option will
expire, and you will receive $0 at maturity.
• If the stock price is more than the strike price (ST>K), however, then
the long party will exercise their option and you will have to sell
them an asset that is worth ST for $K.

– We can thus write your payoff as:

payoff = min(0,ST-K),
which has a graph that looks like:
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 Options Contracts
Short Call Position on IBM Stock
with Strike Price (K) = $80

21.25

0
Payoff to Short Position

0 20 40 60 80 100 120 140 160

-21.25

-42.5

-63.75

-85
Ending Stock Price

57
 Options Contracts
• This is obviously the mirror image of the long position.
• Notice, however, that at maturity, the short option position
can NEVER have a positive payout – the best that can
happen is that they get $0.
– This is why the short option party always demands an up-front
payment – it’s the only payment they are going to receive. This
payment is called the option premium or price.
• Once again, the two positions “net out” to zero:

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 Options Contracts

Long and Short Call Options on IBM

with Strike Prices of $80

100
80
60
Long Call
40
20
Net Position
Payoff

0
-20 0 20 40 60 80 100 120 140 160

-40
-60
-80 Short Call
-100
Ending Stock Price

59
 Options Contracts
• Recall that a put option grants the long party the right to sell
the underlying at price K.
• Returning to our IBM example, if K=80, the long party will
only elect to exercise the option if the price of the stock in the
market is less than $80, otherwise they would just sell it in
the market.
• The payoff to the holder of the long put position, therefore is
simply
payoff = max(0, K-ST)

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 Options Contracts
Payoff to Long Put Option on IBM
with Strike Price of $80

80
70
60
50
Payoff

40
30
20
10
0
-10 0 20 40 60 80 100 120 140 160

Ending Stock Price

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 Options Contracts
• The short position again has granted the option to the long
position. The short has to buy the stock at price K, when the
long party wants them to do so. Of course the long party will
only do this when the stock price is less than the strike price.
• Thus, the payoff function for the short put position is:
payoff = min(0, ST-K)

• And the payoff diagram looks like:

62
 Options Contracts
Short Put Option on IBM
with Strike Price of $80

0
0 20 40 60 80 100 120 140 160

-21.25
Payoff

-42.5

-63.75

-85
Ending Stock Price

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 Options Contracts
• Since the short put party can never receive a positive payout
at maturity, they demand a payment up-front from the long
party – that is, they demand that the long party pay a
premium to induce them to enter into the contract.

• Once again, the short and long positions net out to zero:
when one party wins, the other loses.

64
 Options Contracts
Long and Short Put Options on IBM
with Strike Price s of $80

100
Long Position
80
60
Net Position
40
20
Payoff

0
-20 0 20 40 60 80 100 120 140 160
-40 Short Position
-60
-80
-100
Ending Stock Price

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 Options Contracts
• The standard options contract is for 100 units of the
underlying. Thus if the option is selling for $5, you would have
to enter into a contract for 100 of the underlying stock, and
thus the cost of entering would be $500.
• For a European call, the payoff to the option is:
– Max(0,ST-K)
• For a European put it is
– Max(0,K-ST)
• The short positions are just the negative of these:
– Short call: -Max(0,ST-K) = Min(0,K-ST)
– Short put: -Max(0,K-ST) = Min(0,ST-K)

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 Options Contracts
• Traders frequently refer to an option as being “in the money”, “out
of the money” or “at the money”.

– An “in the money” option means one where the price of the
underlying is such that if the option were exercised immediately, the
option holder would receive a payout.
• For a call option this means that St>K
• For a put option this means that St<K

– An “at the money” option means one where the strike and exercise
prices are the same.

– An “out of the money” option means one where the price of the
underlying is such that if the option were exercised immediately, the
option holder would NOT receive a payout.
• For a call option this means that St<K
• For a put option this means that St>K.

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 Options Contracts
Long Call on IBM
with Strike Price (K) = $80

80

60

At the money
40
Out of the money
Payoff

In the money
20

0
0 20 40 60 K = 80 100 120 140 160
-20
IBM Terminal Stock Price
T

68
 Options Contracts
• One interesting notion is to look at the payoff from just
owning the stock – its value is simply the value of the stock:

69
 Options Contracts
Payout Diagram for a Long Position in IBM Stock

180

160

140

120

100
Payoff

80

60

40

20

0
0 20 40 60 80 100 120 140 160
Ending Stock Price

70
 Options Contracts
• What is interesting is if we compare the payout from a
portfolio containing a short put and a long call with the
payout from just owning the stock:

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 Options Contracts
Payout Diagram for a Long Position in IBM Stock

200

150
Stock
100
Long Call
Payoff

50

0
0 20 40 60 80 100 120 140 160
-50
Short Put

-100
Ending Stock Price

72
 Options Contracts
• Notice how the payoff to the options portfolio has the same
shape and slope as the stock position – just offset by some
amount?

• This is hinting at one of the most important relationships in

options theory – Put-Call parity.

• It may be easier to see this if we examine the aggregate

position of the options portfolio:

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 Options Contracts
Payout Diagram for a Long Position in IBM Stock

200

150

100
Payoff

50

0
0 20 40 60 80 100 120 140 160
-50

-100
Ending Stock Price

74
 Options Contracts
• We will come back to put-call parity in a few weeks, but it is well
worth keeping this diagram in mind.

• So who trades options contracts? Generally there are three types

of options traders:

– Hedgers - these are firms that face a business risk. They wish to get rid
of this uncertainty using a derivative. For example, an airline might use
a derivatives contract to hedge the risk that jet fuel prices might change. 

– Speculators - They want to take a bet (position) in the market and simply
want to be in place to capture expected up or down movements.

– Arbitrageurs - They are looking for imperfections in the capital market.

75
FINANCIAL ENGINEERING
 Financial Engineering
• When we start examining the actual pricing of derivatives,
one of the fundamental ideas that we will use is the “law of
one price”.
• Basically this says that if two portfolios offer the same cash
flows in all potential states of the world, then the two
portfolios must sell for the same price in the market –
regardless of the instruments contained in the portfolios.
– This is only true to “within transactions costs”, i.e. the bid-ask spread
on each individual instrument.
– Sometimes one portfolio will have such lower transactions costs that
the law will only approximately hold.

77
 Financial Engineering
• Financial engineering is the notion that you can use a
combination of assets and financial derivatives to construct
cash flow streams that would otherwise be difficult or
impossible to obtain.
• Financial engineering can be used to “break apart” a set of
cash flows into component pieces that each have different
risks and that can be sold to different investors.
• Collateralized Bond Obligations do this for “junk” bonds.
• Collateralized Mortgage Obligations do this for residential
mortgages.
• Financial engineering can also be used to create cash flows
streams that would otherwise be difficult to obtain.

78
 Financial Engineering
• The Schwab/First Union equity-linked CD is a good example of
financial engineering.
• When it was issued (in 1999), the stock market was (and had
been) incredibly “hot” for several years.
– Many investors wanted to be in the market, but did not want to risk
the market going down in value.
• The equity-linked CD was designed to meet this need.
– As we will demonstrate, an investor could “roll their own” version of
this, but in doing so would have incurred significant transaction costs.
• Plus, many small investors (to whom this was targeted) probably could
not get approval to trade options.

79
 Financial Engineering
• The Contract:
– An investor buys the CD (Certificate of Deposit) today, and then
earns 70% of the simple rate of return on S&P 500 index over
the next 5.5 years.
– If the S&P index ended up below the initial index level (so that
the appreciation was negative), then the investor received their
full initial investment back, but nothing else.
– Thus, the payoff to the CD was simply:
– So let’s say that you invested $10,000, and that in June of 1999
the index was 1300 (so that you were, in essence, buying
$10,000/1,300 or 7.69 units of the index).

80
 Financial Engineering
• In 5.5 years your payoff will be based upon the index
level. Potential index levels and payoffs include:
Index Simple Rate of Return Cash Received
1000 - 23.07% $10,000
1200 - 7.69% $10,000
1300 0.00% $10,000
1400 7.69% $10,538
1500 15.38% $11,076
2000 53.85% $13,769
(Note that on 12/30/2004 the S&P 500 was at 1211.92!)
• The following chart demonstrates the payouts .

81
 Financial Engineering
Payoff to Equity Linked Swap

18000
16000
14000
12000
10000
Payoff

8000
6000
4000
2000
0
0 500 1000 1500 2000 2500
S&P 500 Level

82
 Financial Engineering
• Now, the first thing about that chart that you should notice is
that it looks an awful lot like the shape of a call option,
although the slope of the upward-sloping part is not as steep.
• This is our first indication that we may be able to decompose
this into two simpler securities.
• Indeed, one way of decomposing this security would be to
assume that we bought a bond that paid $10,000 at time 5.5,
and that we bought 5.38 call options with a strike of 1300
(70% of 10,000/1300.)
• The next graph demonstrates this position’s payoff.

83
 Financial Engineering
Bond Plus Call Payoff

18000

16000

14000

12000
Option Payoff
10000
Payoff

Bond Payoff
8000
Net
6000

4000

2000

0
0 500 1000 1500 2000 2500 3000
Index Value

84
 Financial Engineering
• This position is ALSO identical to a position consisting of:
– $10,000/1300 = 7.692 units of the index.
– $10,000/1300 = 7.692 put options on the index (K=1300)
– (-(1-.7)*$10,000/1300 = -2.30769) CALL options on the index.

• The reason for the short call options is because the CD only
gives us 70% of the return on the index, so we have to sell
back some of that return via the call option (note that we
will earn a premium for this.)

• The following chart shows this:

85
 Financial Engineering

Long Index, Long Put, Short Call

25000

20000

15000
Index Payoff
Payoff

Put Position
10000
Call Position
Net
5000

0
0 500 1000 1500 2000 2500 3000
-5000
Index

86
 Financial Engineering
• Now, all three of these should sell for the same price – but there will be
some differences because of transactions costs.
– Really, this is why the Schwab equity-linked CD can work: investors (retail
investors) are willing to turn to the “prepackaged” asset to avoid
transaction costs (and to avoid timing difficulties with unwinding their
position.)
• Let’s just think of this as a bond and .7 long call options for a moment.
• Clearly the call cannot be free, since the investor holds this option they
must pay something for it. How much do they pay?
– The interest that they could have earned on this money had they invested
in a traditional CD.
– At that time 5.5 year CDs were yielding 6%, so the investor “gives up”
$3,777 dollars in year 5.5 dollars.

($10, 000*1.065.5 )  10, 000  3, 777

87
Thank you