Derivatives

Reading 28-FRM
Introduction to Derivatives

(Includes content from Chapter 01 - J.Hull - Options,Futures

and Other Derivatives 8th edition)
What is a Derivative?
• A derivative security is a financial security whose value depends on,
or is derived from, the value of another asset.
• Examples: futures, forwards, swaps, options…
• This other security is referred to as the underlying asset.
• The underlying assets include stocks, currencies, interest rates,
commodities, debt instruments, electricity, insurance payouts, the
weather, etc.
Why are derivatives important?
• Derivatives play a key role in transferring risks in the economy
• Many financial transactions have embedded derivatives
• The real options approach to assessing capital investment decisions has become widely
accepted
• Derivatives can be used:
• For financial risk management (i.e., hedging)
• For speculation
• To lock in an arbitrage profit
• For diversification of exposures
• As added features to a bond (e.g., convertible, callable)
• As employee compensation in the case of stock options
• Within a capital project as an embedded option (e.g., real or abandonment options).
How Derivatives Are Traded
• On exchanges such as the Chicago Board Options Exchange
• In the over-the-counter (OTC) market where traders working for banks, fund
managers and corporate treasurers contact each other directly
• The OTC market typically involves much larger trades than traditional exchanges.
• The OTC market is several times the size of the traditional exchange market. For
example, in 2017, the OTC market was over $530 trillion, while the exchange-
traded market was over $80 trillion.

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Size of OTC and Exchange-Traded Markets

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market

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2012
OTC trading
Advantages of OTC trading:
• Terms are not set by any exchange (i.e., not standardized so customization is
possible).
• Some new regulations since the credit crisis (e.g., standardized OTC derivatives
now traded on swap execution facilities, a central counterparty is now required
for standardized trades, and trades are now required to be reported to a central
registry)
• Greater anonymity (e.g., an interdealer broker only identifies the client at the
conclusion of the trade).
Disadvantages of OTC trading:
• OTC trading has more credit risk than exchange trading when it comes to
nonstandardized transactions.
The Lehman Bankruptcy (Business Snapshot 1.10)
• Lehman’s filed for bankruptcy on September 15, 2008. This was the biggest
bankruptcy in US history
• Lehman was an active participant in the OTC derivatives markets and got into
financial difficulties because it took high risks and found it was unable to roll
over its short term funding
• It had hundreds of thousands of transactions outstanding with about 8,000
counterparties
• Unwinding these transactions has been challenging for both the Lehman
liquidators and their counterparties

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Forward contracts
• An agreement to buy or sell an asset at a certain future time for a certain price.
• There is no standardization for forward contracts, and these contracts are traded
in the OTC market.
• Long position: agreeing to purchase the underlying asset at a future date for a
specified price.
• Short position: agreeing to sell the asset on that same date for that same price.
• Forward contracts are often used in foreign exchange situations as these
contracts can be used to hedge foreign currency risk.
Forward Price
• The forward price for a contract is the delivery price that would be applicable
to the contract if were negotiated today (i.e., it is the delivery price that would
make the contract worth exactly zero)
• The forward price may be different for contracts of different maturities

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Profit from a Long Forward Position (K=
delivery price=forward price at time contract is entered into)
(Agree to purchase at specific price)
Profit

Price of Underlying at
K Maturity, ST

Nếu giá cổ phiếu lớn hơn K, do hợp đồng ta chỉ mua ở K -> ta được payoff
Nếu giá <K, mua tại giá K -> mua bị lỗ

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

(Agree to sell at K price)

Profit

Price of Underlying
K at Maturity, ST

Đồ thị ngược lại

Giá cp >K -> phải bán với giá K -> lỗ
Giá thị trường < K -> bán với giá K -> lãi

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Forwards
• EXAMPLE: Calculating Forward Contract Payoffs
Compute the payoff to the long and short positions in a forward contract given that
the forward price is $25 and the spot price at maturity is $30.
• Answer:
Payoff to long position:
payoff = ST − K = $30 − $25 = $5
Payoff to short position:
payoff = K − ST = $25 − $30 = −$5
Foreign Exchange Quotes for GBP, May 24, 2010
Bid Offer
Spot 1.4407 1.4411

1-month forward 1.4408 1.4413

3-month forward 1.4410 1.4415

6-month forward 1.4416 1.4422

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Example
• On May 24, 2010 the treasurer of a corporation enters into a long forward contract to
buy £1 million in six months at an exchange rate of 1.4422
• This obligates the corporation to pay $1,442,200 for £1 million on November 24, 2010
• What are the possible outcomes?
Answer:
• If the spot exchange rate rose to 1.5000, at the end of the 6 months, the forward
contract would be worth $57,800 (= $1,500,000 - $1,442,200) to the corporation. It
would enable £1 million to be purchased at an exchange rate of 1.4422 rather than
1.5000.
• If the spot exchange rate fell to 1.3500 at the end of the 6 months, the forward contract
would have a negative value of $92,200 (= $1,350,000 - $1,442,200) to the corporation
because it would lead to the corporation paying $92,200 more than the market price for
the GBP.
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Futures Contracts
• Agreement to buy or sell an asset for a certain price at a certain time in the
future.
• Similar to forward contract, but futures contracts are highly standardized
regarding quality, quantity, delivery time, and location for each specific asset.
• Whereas a forward contract is traded OTC, a futures contract is traded on an
exchange.
• The commodities include pork bellies, live cattle, sugar, wool, lumber, copper,
aluminum, gold, and tin.
• The financial assets include stock indices, currencies, and Treasury bonds.
• Futures prices are regularly reported in the financial press.

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Exchanges Trading Futures
• CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade)
• NYSE Euronext
• BM&F (Sao Paulo, Brazil)
• TIFFE (Tokyo)
• and many more (see list at end of book)

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Examples of Futures Contracts
Agreement to:
• Buy 100 oz. of gold @ US$1400/oz. in December
• Sell £62,500 @ 1.4500 US$/£ in March
• Sell 1,000 bbl. of oil @ US$90/bbl. in April

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Options
• A contract that, in exchange for paying an option premium, gives the option buyer
the right, but not the obligation, to buy (sell) an asset at the prespecified
exercise (strike) price from (to) the option seller within a specified time period, or
depending on the type of option, a precise date (i.e., expiration date).
• 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)
• CBOE (Chicago board options exchange)

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American vs European Options
• An American-style option can be exercised at any time during its life (between
the issue date and the expiration date).
• A European-style option can be exercised only at maturity (at the actual
expiration date)
• American options will be worth more than European options when the right to
early exercise is valuable, and they will have equal value when it is not.

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How do options differ from futures and forwards?
Options Forwards or Futures
Give the holder the right to buy or sell the The holder is obligated to buy or sell
underlying asset, but the holder does not the underlying asset
have to exercise this right
There is a cost to acquiring an option. It costs nothing to enter into a forward
Option seller charges buyers a premium. or futures contract
Google Call Option Prices (June 15, 2010; Stock Price is bid 497.07, offer 497.25)
Source: CBOE

Strike Jul 2010 Jul 2010 Sep 2010 Sep 2010 Dec 2010 Dec 2010
Price Bid Offer Bid Offer Bid Offer
• The price of a call option
460 43.30 44.00 51.90 53.90 63.40 64.80
decreases as the strike price
480 28.60 29.00 39.70 40.40 50.80 52.30 increases, while the price of a
put option increases as the
500 17.00 17.40 28.30 29.30 40.60 41.30 strike price increases.
• Both types of option tend to
520 9.00 9.30 19.10 19.90 31.40 32.00 become more valuable as
their time to maturity
540 4.20 4.40 12.70 13.00 23.10 24.00 increases.
560 1.75 2.10 7.40 8.40 16.80 17.70

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Google Put Option Prices (June 15, 2010; Stock Price is bid 497.07, offer 497.25)
Source: CBOE

Strike Jul 2010 Jul 2010 Sep 2010 Sep 2010 Dec 2010 Dec 2010
Price Bid Offer Bid Offer Bid Offer
460 6.30 6.60 15.70 16.20 26.00 27.30

480 11.30 11.70 22.20 22.70 33.30 35.00

500 19.50 20.00 30.90 32.60 42.20 43.00

520 31.60 33.90 41.80 43.60 52.80 54.50

540 46.30 47.20 54.90 56.10 64.90 66.20

560 64.30 66.70 70.00 71.30 78.60 80.00

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Types of option positions
• There are four types of option positions:

1. A long position in a call option

2. A long position in a put option
3. A short position in a call option
4. A short position in a put option.
Call Option Payoff
• The payoff on a call option to the option buyer is calculated as follows:
CT = max(0, ST − X)
where:
• CT = payoff on call option
• ST = stock price at maturity
• X = strike price of option

The payoff to the option seller is −CT [= −max(0, ST − X)].

We should note that max(0, St − X), where time, t, is between 0 and T, is the payoff if the
owner decides to exercise the call option early.
Call Option Profit
• The price paid for the call option, C0, is referred to as the call premium. Thus, the
profit to the option buyer is calculated as follows:
profit = CT − C0
where:
• CT = payoff on call option
• C0 = call premium

• Conversely, the profit to the option seller is:

profit = C0 − CT
• For seller:
• ST < X: buyer will not
exercise the call option
 payoff = 0
 profit = - Co
• ST > X: buyer will
exercise the call option
 payoff= CT= ST – X
 profit = CT - Co
• Co = 5; X= 100; If ST = 120
• Buyer:
Payoff = 120-100 = 20
Profit = 120-100-5 = 20-5 = 15
• Seller:
Payoff = 100-120 = -20
Profit =100 – 120 +5 = 15
Put Option Payoff
• The payoff on a put option is calculated as follows:
PT = max(0, X − ST)
where:
• PT = payoff on put option
• ST = stock price at maturity
• X = strike price of option

The payoff to the option seller is −PT [=−max(0, X − ST)].

We should note that max(0, X − St), where 0 < t < T, is also the payoff if the owner
decides to exercise the put option early.
Put Option Payoff
• The price paid for the put option, P0, is referred to as the put premium. Thus, the
profit to the option buyer is calculated as follows:
profit = PT − P0
where:
• PT = payoff on put option
• P0 = put premium

• The profit to the option seller is:

profit = P0 − PT
For buyer:
• ST < X: buyer will
exercise the put option
Payoff = X - ST
 Profit = X – ST – Po

• ST >X : buyer will not

exersise the put option
payoff = 0
 Profit = - Po
• Po = 7; X= 70; If ST = 50
• Buyer:
Payoff = 70-50 = 20
Profit = 20 – 7 = 13
• Seller:
Payoff = 50-70 = -20
Profit = 50-70+7 = -13
• EXAMPLE: Calculating Payoffs and Profits From Options
Compute the payoff and profit to a call buyer, a call writer, put buyer, and put writer if the strike price for both the
put and the call is $45, the stock price is $50, the call premium is $3.50, and the put premium is $2.50.

Answer:
Call buyer:
• payoff = CT = max(0, ST − X) = max(0, $50 − $45) = $5
• profit = CT − C0 = $5 − $3.50 = $1.50
Call writer:
• payoff = −CT = −max(0, ST − X) = −max(0, $50 − $45) = −$5
• profit = C0 − CT = $3.50 − $5 = −$1.50
Put buyer:
• payoff = PT = max(0, X − ST) = max(0, $45 − $50) = $0
• profit = PT − P0 = $0 − $2.50 = −$2.50
Put writer:
• payoff = −PT = −max(0, X − ST) = −max(0, $45 − $50) = $0
• profit = P0 − PT = $2.50 − $0 = $2.50
Swap
• A derivative contract through which two parties exchange the cash flows or
liabilities from two different financial instruments.
• Swaps can be used to efficiently alter the interest rate risk of existing assets and
liabilities.
• Interest rate swap: an agreement between two parties to exchange interest
payments based on a specified principal over a period of time. In a plain vanilla
interest rate swap, one of the interest rates is floating, and the other is fixed.
• A currency swap exchanges interest rate payments in two different currencies
Derivatives Traders
Types of traders:

• Hedgers
• Speculators
• Arbitrageurs

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Hedgers
• Hedgers typically reduce their risks with forward contracts or options.
• By using forward contracts (at no cost), the trader is attempting to neutralize risk by fixing the
price the hedger will pay or receive for the underlying asset.
• Option contracts, in contrast, are more of an insurance policy that require the payment of a
premium, but will protect against downside risk while keeping some of the upside.
• An investor or business with a long exposure to an asset can hedge exposure by either entering
into a short futures contract or by buying a put option.
• An investor or business with a short exposure to an asset can hedge exposure by either entering
into a long futures contract or by buying a call option.
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

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Value of Microsoft Shares with and without Hedging

40,000 Value of Holding

($)
35,000

No Hedging
30,000 Hedging

25,000

Stock Price ($)

20,000
20 22 24 26 28 30 32 34 36 38

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• EXAMPLE: Hedging With a Forward Contract
Suppose that a company based in the United States will receive a payment of €10M in three
months. The company is worried that the euro will depreciate and is contemplating using a forward
contract to hedge this risk.
Compute the following:
1. The value of the €10M in U.S. dollars at maturity given that the company hedges the exchange
rate risk with a forward contract at 1.25 $/€.
2. The value of the €10M in U.S. dollars at maturity given that the company did not hedge the
exchange rate risk and the spot rate at maturity is 1.2 $/€.

Answer:
1. The value at maturity for the hedged position is:
€10,000,000 × 1.25 $/€ = $12,500,000
2. The value at maturity for the unhedged position is:
€10,000,000 × 1.2 $/€ = $12,000,000
• EXAMPLE: Hedging With a Put Option
Suppose that an investor owns one share of ABC stock currently priced at $30. The investor is worried about the possibility of
a drop in share price over the next three months and is contemplating purchasing put options to hedge this risk. Compute the
following:
1. The profit on the unhedged position if the stock price in three months is $25.
2. The profit on the unhedged position if the stock price in three months is $35.
3. The profit for a hedged stock position if the stock price in three months is $25, the strike price on the put is $30, and the
put premium is $1.50.
4. The profit for a hedged stock position if the stock price in three months is $35, the strike price on the put is $30, and the
put premium is $1.50.

Answer:
1. Profit = ST − S0 = $25 − $30 = –$5
2. Profit = ST − S0 = $35 − $30 = $5
3. Profit = ST − S0 + max(0, X − ST) − P0
= $25 − $30 + max(0, $30 − $25) − $1.50 = −$1.50
4. Profit = ST − S0 + max(0, X − ST) − P0
= $35 − $30 + max(0, $30 − $35) − $1.50 = $3.50
Speculators
• Speculators are effectively betting on future price movement.
• When a speculator uses the underlying asset, any potential gain or loss arises
only on the differential between the share purchase price and the future share
price.
• When a speculator uses options, the potential gain is magnified (assuming the
same initial dollar investment in shares as options) and the maximum loss is the
dollar investment in options.
• EXAMPLE: Speculating With Futures
An investor believes that the euro will strengthen against the dollar over the next three months and
would like to take a position with a value of €250,000. He could purchase euros in the spot market
at 0.80 $/€ or purchase two futures contracts at 0.83 $/€ with an initial margin of $10,000.
Compute the profit from the following:
1. Purchasing euros in the spot market if the spot rate in three months is 0.85 $/€.
2. Purchasing euros in the spot market if the spot rate in three months is 0.75 $/€.
3. Purchasing the futures contract if the spot rate in three months is 0.85 $/€.
4. Purchasing the futures contract if the spot rate in three months is 0.75 $/€.

Answer:
1. Profit = €250,000 × (0.85 $/€ − 0.80 $/€) = $12,500
2. Profit = €250,000 × (0.75 $/€ − 0.80 $/€) = −$12,500
3. Profit = €250,000 × (0.85 $/€ − 0.83 $/€) = $5,000
4. Profit = €250,000 × (0.75 $/€ − 0.83 $/€) = −$20,000
• EXAMPLE: Speculating With Options
An investor who has $30,000 to invest believes that the price of stock XYZ will increase over the
next three months. The current price of the stock is $30. The investor could directly invest in the
stock, or she could purchase 3-month call options with a strike price of $35 for $3. Compute the
profit from the following:
1. Investing directly in the stock if the price of the stock is $45 in three months.
2. Investing directly in the stock if the price of the stock is $25 in three months.
3. Purchasing call options if the price of the stock is $45 in three months.
4. Purchasing call options if the price of the stock is $25 in three months.
Answer:
1. Number of stocks to purchase = $30,000 / $30 = 1,000
Profit = 1,000 × ($45 − $30) = $15,000
2. Profit = 1,000 × ($25 − $30) = –$5,000
3. Number of call options to purchase = $30,000 / $3 = 10,000
Profit = 10,000 × [max(0, $45 − $35) − $3] = $70,000
4. Profit = 10,000 × [max(0, $25 − $35) − $3] = −$30,000
Arbitragers
• Arbitrageurs seek to earn a risk-free profit in excess of the risk-free rate through
the discovery and manipulation of mispriced securities.
• They earn a riskless profit by entering into equivalent offsetting positions in one
or more markets.
• Arbitrage opportunities typically do not last long as supply and demand forces
will adjust prices to quickly eliminate the arbitrage situation.
Arbitrage Example
EXAMPLE: Arbitrage of Stock Trading on Two Exchanges
Assume stock DEF trades on the New York Stock Exchange (NYSE) and the Tokyo Stock Exchange
(TSE). The stock currently trades on the NYSE for $32 and on the TSE for ¥2,880. Given the current
exchange rate is 0.0105 $/¥, determine if an arbitrage profit is possible.

Answer:
• Value in dollars of DEF on TSE = ¥2,880 × 0.0105 $/¥ = $30.24
• Arbitrageur could purchase DEF on TSE for $30.24 and sell on NYSE for $32.
• Profit per share = $32 − $30.24 = $1.76
Arbitrage Example
• A stock price is quoted as £100 in London and $140 in New York
• The current exchange rate is 1.4300
• What is the arbitrage opportunity?

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Risks From Using Derivatives
• If the bet one makes starts going in the wrong direction, the results can be
catastrophic (e.g., Barings Bank).
• Traders with instructions to hedge a position may use derivatives to speculate
due to the massive potential payoffs if speculation succeeds. This risk is known as
an operational risk when it is done in an unauthorized manner.
• It is important to set up controls to ensure that trades are using derivatives in for
their intended purpose. Risk limits should be set, and adherence to risk limits
should be monitored.
Hedge Funds
• Hedge funds are not subject to the same rules as mutual funds
and cannot offer their securities publicly.
• Mutual funds must
• disclose investment policies,
• makes shares redeemable at any time,
• limit use of leverage
• take no short positions.
• Hedge funds are not subject to these constraints.
• Hedge funds use complex trading strategies are big users of
derivatives for hedging, speculation and arbitrage

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Types of Hedge Funds
• Long/Short Equities
• Convertible Arbitrage
• Distressed Securities
• Emerging Markets
• Global macro
• Merger Arbitrage

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