Chapter 11 An Introduction To Derivative Markets and Securities

Lecture Presentation Software
to accompany
Investment Analysis and Portfolio Management

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Frank K. Reilly & Keith C. Brown
Chapter 11
Saif Ullah Economist_of_Pakistan@Yahoogroups.com Saifullah271@yahoo.com +923216633271
Chapter 11 - An Introduction to Derivative Markets and Securities

Questions to be answered: What distinguishes a derivative security such as a forward, futures, or option contract, from more fundamental securities, such as stocks and bonds? What are the important characteristics of forward, futures, and option contracts, and in what sense can the be interpreted as insurance policies?
SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

How are the markets for derivative securities organized and how do they differ from other security markets? What terminology is used to describe transactions that involve forward, futures, and option contracts? How are prices for derivative securities quoted and how should this information be interpreted?

What are similarities and differences between forward and futures contracts? What do the payoff diagrams look like for investments in forward and futures contracts? What do the payoff diagrams look like for investments in put and call option contracts? How are forward contracts, put options, and call options related to one another?

How can derivatives be used in conjunction with stock and Treasury bills to replicate the payoffs to other securities and create arbitrage opportunities for an investor? How can derivative contracts be used to restructure cash flow patterns and modify the risk in existing investment portfolios?
Derivative Instruments
Value is depends directly on, or is derived from, the value of another security or commodity, called the underlying asset Forward and Futures contracts are agreements between two parties - the buyer agrees to purchase an asset from the seller at a specific date at a price agreed to now Options offer the buyer the right without obligation to buy or sell at a fixed price up to or on a specific date
Why Do Derivatives Exist?

Assets are traded in the cash or spot market It is sometimes advantageous enter into a transaction now with the exchange of asset and payment at a future time Risk shifting Price formation Investment cost reduction
Call option is the right to buy Forward contracts are the right and full obligation to conduct a transaction involving another security or commodity - the underlying asset - at a predetermined date (maturity date) and at a predermined price (contract price)
This is a trade agreement
Futures contracts are similar, but subject to a daily settling-up process

Forward Contracts
Buyer is long, seller is short Contracts are OTC, have negotiable terms, and are not liquid Subject to credit risk or default risk No payments until expiration Agreement may be illiquid
Futures Contracts
Standardized terms Central market (futures exchange) More liquidity Less liquidity risk - initial margin Settlement price - daily marking to market
Options offer the buyer the right without obligation to buy or sell at a fixed price up to or on a specific date Buyer has the long position in the contract Seller (writer) has the short position in the contract Buyer and seller are counterparties in the transaction The transaction price agreed upon is the exercise or strike price
Options
Option to buy is a call option Option to sell is a put option Option premium - paid for the option Exercise price or strike price - price agreed for purchase or sale Expiration date
European options American options
Options
At the money:
stock price equals exercise price
In-the-money
option has intrinsic value
Out-of-the-money
option has no intrinsic value
Investing With Derivative Securities

Call option
requires up front payment allows but does not require future settlement payment
Forward contract
does not require front-end payment requires future settlement payment
Options Pricing Relationships

Call Option Stock price + Exercise price Time to expiration + Interest rate + Volatility of underlying stock price + Factor Put Option + + +
Profits to Buyer of Call Option

3,000 2,500 2,000 Profit from Strategy Exercise Price = $70 Option Price = $6.125
1,500
1,000 500
0
(500) (1,000) 40 50 60 70 80 90
Stock Price at Expiration
100
Profits to Seller of Call Option

1,000 500 0 Profit from Strategy
Exercise Price = $70

Option Price = $6.125
(500)
(1,000) (1,500)
(2,000)
(2,500) (3,000) 40 50 60 70 80 90
100
Profits to Buyer of Put Option

3,000 2,500 2,000 Exercise Price = $70 Profit from Strategy
1,500
1,000 500
Option Price
= $2.25
0
(500) (1,000) 40 50 60 70 80 90
100
Profits to Seller of Put Option

1,000 500 0 Exercise Price = $70 Profit from Strategy
(500)
(1,000) (1,500)
Option Price
= $2.25
(2,000)
(2,500) (3,000) 40 50 60 70 80 90
100
The Relationship Between Forward and Option Contracts

Put-call parity
Long in WYZ common at price of S0 Long in put option to deliver WYZ at X on T
Purchase for P0
Short in call option to purchase WYZ at X on T

Sell for C0
Net position is guaranteed contract (risk-free) Since the risk-free rate equals the T-bill rate:
(long stock)+(long put)+(short call)=(long T-bill)
Creating Synthetic Securities Using Put-Call Parity

Risk-free portfolio could be created using three risky securities:
stock, a put option, and a call option
With Treasury-bill as the fourth security, any one of the four may be replaced with combinations of the other three
Adjusting Put-Call Spot Parity For Dividends

The owners of derivative instruments do not participate directly in payment of dividends to holders of the underlying stock If the dividend amounts and payment dates are known when puts and calls are written those are adjusted into the option prices
(long stock) + (long put) + (short call) = (long T-bill) + (long present value of dividends)
Put-Call-Forward Parity
Instead of buying stock, take a long position in a forward contract to buy stock Supplement this transaction by purchasing a put option and selling a call option, each with the same exercise price and expiration date This reduces the net initial investment compared to purchasing the stock in the spot market
Put-Call-Forward Parity
The difference between put and call prices must equal the discounted difference between the common exercise price and the contract price of the forward agreement, otherwise arbitrage opportunities would exist
An Introduction To The Use Of Derivatives In Portfolio Management

Restructuring asset portfolios with forward contracts
shorting forward contracts tactical asset allocation to time general market movements instead of company-specific trends hedge position with payoffs that are negatively correlated with existing exposure converts beta of stock to zero, making a synthetic T-bill, affecting portfolio beta
An Introduction To The Use Of Derivatives In Portfolio Management

Protecting portfolio value with put coupons
purchasing protective puts keep from committing to sell if price rises asymmetric hedge portfolio insurance
Either
hold the shares and purchase a put option, or sell the shares and buy a T-bill and a call option
The Internet Investments Online

www.cboe.com www.cbot.com www.cme.com www.cme.com/educational/hand1.htm www.liffe.com www.options-iri.com
End of Chapter 11
An Introduction to Derivative Markets and Securities
Future topics Chapter 12

Major Financial Statements Analysis of Financial Ratios Evaluating Operating Performance Risk Analysis Analysis of Growth Potential Analysis of Non-U.S. Financial Statements Quality of Financial Statements Uses of Financial Ratios

Chapter 11 An Introduction To Derivative Markets and Securities

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Chapter 11 An Introduction To Derivative Markets and Securities

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Lecture Presentation Software

Investment Analysis and Portfolio Management

Frank K. Reilly & Keith C. Brown

Chapter 11 - An Introduction to Derivative Markets and Securities

Chapter 11 - An Introduction to Derivative Markets and Securities

Chapter 11 - An Introduction to Derivative Markets and Securities

Chapter 11 - An Introduction to Derivative Markets and Securities

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Why Do Derivatives Exist?

Futures contracts are similar, but subject to a daily settling-up process

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Investing With Derivative Securities

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Options Pricing Relationships

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Profits to Buyer of Call Option

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Profits to Seller of Call Option

Exercise Price = $70

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Profits to Buyer of Put Option

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Profits to Seller of Put Option

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

The Relationship Between Forward and Option Contracts

Short in call option to purchase WYZ at X on T

Creating Synthetic Securities Using Put-Call Parity

Adjusting Put-Call Spot Parity For Dividends

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

An Introduction To The Use Of Derivatives In Portfolio Management

An Introduction To The Use Of Derivatives In Portfolio Management

The Internet Investments Online

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Future topics Chapter 12

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