Financial derivatives

Martine Van Wouwe

University of Antwerp
Financial derivatives

Introduction

Definition: A financial contract is a derivative security if its value at
expiration date T is determined exactly by the market price of the
underlying cash instrument at time T (Ingersoll, 1987).

Types of derivatives

Derivative securities grouped under three general headings:
1.Futures and forwards
2.Options
3.Swaps

Forwards and options are basic building blocks
Swaps and some other complicated structures
are hybrid securities
can eventually be decomposed into sets of basic forwards and options

The price of the relevant cash instrument is denoted by
t
S and is
called the underlying security


A possible classification

Five main groups of underlying asset:
1. Stocks
2. Currencies
3. Interest rates
4. Indexes
5. Commodities (no financial assets)
f.i. - soft commodities: coffee
- metals: copper
- precious metals: gold
- energy: fuel oil
Another classification:
1.Cash-and-Carry Markets
- Derivative products are written on products of cash-and-carry
markets
- Examples of cash-and-carry products are: gold, silver, currencies
and T-bonds.
- One can borrow at risk-free rates
Buy and store the product
Insure it until the expiration date of any derivative contract
2.Price-Discovery Markets
Information can be discovered in the futures market, hence the terminology.
3.Expiration Date
- Relationship between F(t), the price of the derivative, and
t
S is
known exactly only at the expiration date T
- For forwards or futures: . ) (
T
S T F =
- Value of the futures contract should be equal to its cash equivalent
- At T t , F(t) may not be equal to
t
S


Forwards and Futures

Definition: A forward contract is an obligation to buy (sell) an
underlying asset at a specified forward price on a known date.

If a forward purchase is made, the holder of such a contract is said to be
long in the underlying asset.
If at expiration the cash price is higher than the forward price, the long
position makes a profit; otherwise there is a loss.

Futures and forwards are similar, major differences are:
Futures are traded in formalized exchanges, forwards are traded over-
the-counter
Futures are cleared through exchange clearing houses
Futures are market to market





Options

Forwards and futures obligate the holder to deliver or accept delivery
Options give the owner the right but not the obligation to purchase or sell
an asset.

Definition: European options

A European-type call option on a security
t
S is the right to buy the
security at a preset strike price K.
This right may be exercised at the expiration date T
Call option purchased for a price
t
C called the premium
A European put option gives the owner the right to sell an asset at a
specified price at expiration
Value of the option at expiry is the payoff of the option:
( )
( )
T T
T T
K-S S P
-K S S P
0, max ) (
0, max ) (
put
call
=
=




Swaps

Definition: A swap is the simultaneous selling and purchasing of cash flows
involving various currencies, interest rates, and a number of other financial
assets.





1. Futures and forwards

Forwards

A forward contract occurs in both forward and futures markets.
It involves a contract initiated at one time.
Performance in accordance with the terms of the contract occurs at
a subsequent time.

Example 1: basic type of forward contract

Having heard that a highly prized St. Bernard has just given birth to
a litter of pups, a dog fancier rushes to the kennel to see the pups.
After inspecting the pedigree of the parents, the dog fancier offers
to buy a pup from the breeder.
The exchange cannot be completed at this time, since the pup is too
young to be weaned.
The fancier and breeder agree that the dog will be delivered in six
weeks and that the fancier will pay the $400 in six weeks upon
delivery of the puppy.
This is not a conditional contract; both parties are obligated to
complete it as agreed.


Example 2

A foreign currency forward contract calls for the exchange of some
quantity of a foreign currency at a future date in exchange for a
payment at that later date.
At the time of contracting, the forward contract stipulates the price
to be paid at the time of delivery of the good.
Futures

A futures contract is a type of forward contract with highly
standardized and closely specified contract terms.
It calls for the exchange of some good at a future date for cash,
with the payment for the good to occur at that future date.
The purchaser undertakes to receive delivery of the good and pay
for it.
The seller promises to deliver the good and receive payment.
The price of the good is determined at the initial time of
contracting.
Futures contracts differ from other forward contracts:
1. Futures contracts always trade on an organized exchange.
2. They are always highly standardized with a specified quantity
of good, delivery date and delivery mechanism.
3. Performance is guaranteed by a clearinghouse: a financial
institution that guarantees the financial integrity of the market
to all traders.
4. They require that traders post margin in order to trade.

Reading Futures Prices

Settlement price
Is the price at which contracts are settled at the close of trading
for the day.
Is not always the last trade price of the day.

Most exchanges have a settlement committee for each commodity
meets immediately at the close of trading to establish the
settlement price
is responsible for establishing a settlement price that fairly
indicates the value of the futures contract at the close of trading


In many cases, the price for the last trade and the settlement price
are the same price, but they are conceptually distinct.
Difficulties arise for the settlement committee when a contract has
little trading activity

Example:
Suppose:
- last trade for a particular maturity of a given commodity
occurred three hours before the close of trading
- significant information pertaining to that commodity was
discovered after that last trade
Actual trade price for the contract does not represent what the
true economic price would be at the close of trading.
Settlement committee performs an important function by
establishing a settlement price that differs from the price on the
last recorded trade.

Open interest

Is the number of futures contracts for which delivery is currently
obligated.
Example:
- Assume that the December 2000 widget contract has just been
listed for trading, but that the contract has not traded yet.
- At this point, the open interest in the contract is zero.
- Trading begins and the first contract is bought.
- This purchase means that some other trader sold.
- This transaction creates one contract of open interest, because
there is one contract now in existence for which delivery is
obligated.
When a contract is distant from maturity, it tends to have relatively
little open interest.
As the contract approaches maturity, the open interest increases.
The nearby contract has the highest level of open interest.
The basis and spreads

A spread is the difference between two futures prices.
If the two prices for futures contracts are on the same underlying
good, but with different expiration dates, the spread is an
intracommodity spread.
If the two futures prices for futures contracts are for two
underlying goods, such as a weat futures and a corm futures, then
the spread is an intercommodity spread.


The definition of the basis depends upon a cash price of a
commodity at a specific location:

Basis = Current Cash Price Futures Price

Futures markets can exhibit a pattern of either normal or inverted
prices.
In a normal market, prices for more distant futures are higher
than for nearby futures.
Example: Gold Prices and the Basis

Contract Prices The Basis
CASH 353.70
JUL (this year) 354.10 -.40
AUG 355.60 -1.90
OCT 359.80 -6.10
DEC 364.20 -10.50
FEB (next year) 368.70 -15.00
APR 373.00 -19.30
JUN 377.50 -23.80
AUG
OCT
381.90
386.70
-28.20
-33.00
DEC 391.50 -37.80

In an inverted market, distant futures prices are lower than the
prices for contracts nearer to expiration.
Interpretation of the basis can be very important, particularly
for agricultural commodities.
For many commodities, the fact that the harvest comes at a
certain time each year introduces seasonal components into the
series of cash prices.

When the futures contract is at expiration, the futures price and
the spot price must be the same.
The basis must be zero, subject to the discrepancy due to
transaction costs.
This behavior over time is known as convergence.

Converging cash and futures price
As time progresses, and the futures contract approaches
maturity, the basis narrows.
At maturity: the basis is zero, this is consistent with the no-
arbitrage requirement that the futures price and cash price be
equal at the maturity of the futures contract.

Convergence of the basis to zero


Conclusions

Fluctuation in the basis is almost always much less than the
range of fluctuation in the futures price itself.
The basis is almost always much more stable than the futures
price or the cash price, when those prices are considered in
isolation.
Futures price may oscillate and cash price may swing widely,
but the basis tends to be relatively steady.
Relatively low variability of the basis is very important for
hedging and for certain types of speculation.

Spreads

Relationship among futures prices on the same good, an
intracommodity spread, indicates the relative price differentials
for a commodity to be delivered at two points in time.


Models of Futures Prices

1. Cost-of-carry model
Futures prices depend on the cash price of a commodity and
the cost of storing the underlying good from the present to the
delivery date of the futures contract.
2. Expectations model
Futures price today equals the cash price that traders expect to
prevail for the underlying good on the delivery date of the
futures contract.

Assumption: perfect market:
no transaction costs
no restrictions on free contracting between two parties
Cost-of-carry model in perfect markets

Cost-of-carry or carrying cost = total cost to carry a good
forward in time
Four basic categories:
1. Storage costs:
- Include the cost of warehousing the commodity in the
appropriate facility
- Also possible to store financial instruments: the owner
will leave the instrument in a bank vault
2. Insurance costs:
For many goods in storage, insurance is also necessary
3. Transportation costs
4. Financing costs
Carrying charge reflects only charges involved in carrying a
commodity from one time or one place to another, it does not
include the value of the commodity itself.
Cash and futures pricing relationships

The spot price is the price of a good for immediate delivery.

Carrying charges play a crucial role in determining
pricing relationships between spot and futures prices
relationships among prices of futures contracts of different
maturities

Cost-of-carry Rule 1: ( ) C S F
t
+ 1
0 , 0

where:
t
F
, 0
= the futures price at t =0 for delivery at time t
S
0
= the spot price at t =0
C = the cost of carry, expressed as a fraction of the spot price,
necessary to carry the good forward from the present to the
delivery date on the futures

Example: cash-and-carry gold arbitrage transactions
Prices for the analysis
Spot price of gold $400
Future price of gold (for delivery in 1 year) $450
Interest rate 10%

Transaction

Cash flow
t=0





t=1




Borrow $400 for 1 year at 10%.
Buy 1 ounce of gold in the spot market for $400.
Sell a futures contract for $450 for delivery of
1 ounce in 1 year.
Total cash flow
Remove the gold from storage.
Deliver the ounce of gold against the futures
contract.
Repay loan, including interest.
Total cash flow
+$400
- 400

0
$0
$0
+450
- 440
+$10

An arbitrage opportunity arises if the spot price is too low relative to
the futures price.
If the spot price is too high, we have a reverse cash-and-carry
arbitrage opportunity.

Cost-of-carry Rule 2: ( ) C S F
t
+ 1
0 , 0


If prices do not obey this rule, there will be an arbitrage opportunity.
Example: Reverse cash-and-carry gold arbitrage transactions
Prices for the analysis
Spot price of gold $400
Future price of gold (for delivery in 1 year) $450
Interest rate 10%

Transaction

Cash flow
t=0





t=1



Sell 1 ounce of gold short.
Lend the $420 for 1 year at 10%.
Buy 1 ounce of gold futures for delivery in 1 year.
Total cash flow
Collect proceeds from the loan ($420 times 1.1).
Accept delivery on the futures contract.
Use gold from futures delivery to repay short sale.
Total cash flow
+$420
- 420
0
$0
+$462
- 450
0
+$12

Transactions for arbitrage strategies

Market Cash-and-carry Reverse cash-and-carry
Debt Borrow funds. Lend short sale proceeds.
Physical Buy asset and store;
deliver against
futures.
Sell asset short; secure proceeds from
short sale.
Futures Sell futures. Buy futures; accept delivery; return
physical asset to honor short sale
commitment.

To prevent arbitrage, the following rules must hold:
To prevent cash-and-carry arbitrage: ( ) C S F
t
+ 1
0 , 0

To prevent reverse cash-and-carry arbitrage: ( ) C S F
t
+ 1
0 , 0


Together:
Cost-of-carry Rule 3: ( ) C S F
t
+ = 1
0 , 0


Spreads and the cost-of-carry

Cost-of-carry Rule 4:
The distant futures price must be less than or equal to the nearby
futures price plus the cost of carrying the commodity from the nearby
delivery date to the distant delivery date.

( ) C F F
n d
+ 1
, 0 , 0
, d > n
where
F
0,d
= the futures price at t =0 for the distant delivery contract maturing
at t=d
F
0,n
= the futures price at t =0 for the nearby delivery contract maturing
at t=n
C = the percentage cost of carrying the good from t=n to t=d

If this relationship did not hold, a trader could buy the nearby futures
contract and sell the distant contract.

Example: Gold forward cash-and-carry arbitrage
Prices for the analysis
Futures price for gold expiring in 1 year $400
Futures price for gold expiring in 2 years $450
Interest rate (to cover from year 1 to year 2) 10%

Transaction

Cash flow
t=0




t=1




t=2
Buy the futures expiring in 1 year.
Sell the futures expiring in 2 years.
Contract to borrow $400 at 10% for year 1 to year 2.
Total cash flow
Borrow $400 for 1 year at 10% as contracted at t=0.
Take delivery on the futures contract.
Begin to store gold for 1 year.
Total cash flow

Deliver gold honor futures contract.
Repay loan ($400 times 1.1).
Total cash flow
+$0
0
0
$0
+$400
- 400
0
+$0
+$450
- 440
+$10

Cost-of-carry Rule 5:
The nearby futures prices plus the cost of carrying the commodity from
the nearby delivery date to the distant delivery date cannot exceed the
distant future prices.
( ) C F F
n d
+ 1
, 0 , 0
, d > n



Example: Gold forward reverse cash-and-carry arbitrage
Prices for the analysis
Futures price for gold expiring in 1 year $400
Futures price for gold expiring in 2 years $450
Interest rate (to cover from year 1 to year 2) 10%

Transaction

Cash flow
t=0




t=1




t=2
Sell the futures expiring in 1 year.
Buy the futures expiring in 2 years.
Contract to lend $440 at 10% for year 1 to year 2.
Total cash flow
Borrow 1 ounce of gold for 1 year.
Deliver gold against the expiring futures.
Invest proceeds from delivery for 1 year.
Total cash flow

Accept delivery on expiring futures.
Repay 1 ounce of borrowed gold.
Collect on loan of $440 made at t=1.
Total cash flow
+$0
0
0
$0
$0
+ 440
- 440
$0
-$450
0
+484
+$34


Cost-of-carry Rule 6:
The distant futures price must equal the nearby futures price plus the
cost of carrying the commodity from the nearby to the distant delivery
date.
( ) C F F
n d
+ = 1
, 0 , 0
, d > n

The cost-of-carry model in imperfect markets

In actual markets, traders face a variety of direct transaction costs.
In every market, there is a bid-asked spread.
A market maker on the floor of the exchange must try to sell at a
higher price (the asked price) than the price at which he or she is
willing to buy (the bid price). The difference between the asked price
and the bid price is the bid-asked spread.
Assumptions:
- Transaction costs are a fixed percentage of the transaction amount T.
- Transaction costs apply to the spot market, not to the futures market.
No-arbitrage bounds are bounds within which the futures price must
remain to prevent arbitrage:
( )( ) ( )( ) C T S F C T S
t
+ + + 1 1 1 1
0 , 0 0

Futures prices and expectations

Example:
- Consider a tropical fruit that can be harvested on only one day
per year, July 4.
- The fruit is so delicate that it must be consumed on that day or it
will spoil.
How would a futures contract on such a fruit be priced?
The cost-of-carry model breaks down for the pricing of such a
futures contract.
Cash-and-carry arbitrage strategies do not apply to this fruit.

Assume that market participants expect the price of the fruit in the
next harvest to be $10 each, this price is the expected future spot
price.
In this event, the futures price must be equal, or at least closely
approximate, the expected future spot price; otherwise profitable
speculative strategies would arise.
The role of speculation

The presence of speculators in the marketplace ensures that the
futures price approximately equals the expected future spot price.
Too great a divergence between the futures price and the expected
future spot price creates attractive speculative opportunities.
In response, profit-seeking speculators will trade as long as the
futures price is sufficiently far away from the expected future spot
price.
Basic idea: ( )
t t
S E F
0 , 0

with
( )
t
S E
0
= the expectation at t=0 of the spot price to prevail at time t
2. Options
Pricing of options: The arbitrage theorem

Introduction
Arbitrage means taking simultaneous positions in different assets
so that one guarantees a riskless profit higher than the riskless
return given by Treasury bills
If such profits exist: arbitrage opportunity
Price of a security is at a fair level, or the security is correctly
priced: no arbitrage opportunities at those prices
Determining arbitrage-free prices is at the center of valuing
derivative assets.







Asset prices
Definition: Securities such as options, futures, forwards, and stocks
will be represented by a vector of asset prices denoted by
t
S
(t represents time)

This array groups all securities in financial markets under one
symbol: ( ) ) ( ),..., (
1
t S t S S
N t
= with [ ) , 0 t .

) (
1
t S may be a bond, ) (
2
t S may denote a particular stock, ) (
3
t S may
be a call option written on this stock, ) (
4
t S may represent the
corresponding put option, and so on.



Returns and payoffs

Definition: Vector W denotes possible states of the world:
( )
K
w w W ,...,
1
= , each
i
w represents a distinct outcome that may occur.

These states are mutually exclusive, and at least one of them is
guaranteed to occur.

In general, financial assets will have different values and give different
payouts at different states of the world
i
w .




Definition: Symbol
ij
d denotes the number of units of account paid
by one unit of security i in state j.
These payoffs will have two components.
The first component is capital gains or losses. Asset values appreciate
or depreciate.
The second component of the
ij
d is payouts such as dividends or
coupon interest payments. Some assets do not have such payouts.
Call and put options and discount bonds are among these.

Discount bond

Definition: A discount bond or zero-coupon bond is a bond that
provides no coupons

For the N assets under consideration, the payoffs
ij
d can be grouped in a
matrix D:

=
NK N
K
d d
d d
D
K
M M M
K
1
1 11

Divide the ith row of D by the corresponding
i
S to obtain the gross returns.



Portfolio

Definition: A portfolio is a particular combination of assets.

If a portfolio delivers the same payoff in all states of the world, then its value
is known exactly and the portfolio is riskless.


A basic example of asset pricing

Assumption: time consists of now and a next period, separated by a small
but noninfinitesimal interval of length .

Consider a case where the market participant is interested in only three assets:
A risk-free asset such as a Treasury bill, gross return is (1+r).
This return is risk-free: constant regardless of the realized state of the world.
Second security is an underlying asset, a stock S(t). The S(t) can assume one of
only two possible values during the interval .
Third security is a derivative asset, a call option with premium C(t) and a strike
price
0
C . The option expires next period and will assume two possible
values, because the underlying asset has two possible values.

Setup is fairly simple: three assets (N=3) and two states of the world (K=2).


Asset prices will form a vector
t
S of three elements only: ( ) ) ( ), ( ), ( t C t S t B S
t
= ,
B(t) is riskless borrowing or lending
S(t) is a stock
C(t) is the value of a call option written on this stock
t indicates the time for which these prices apply

Payoffs will be grouped in a matrix
t
D with three rows and two columns:

+ +
+ +
+ +
=
) ( ) (
) ( ) (
) ( ) 1 ( ) ( ) 1 (
2 1
2 1
t C t C
t S t S
t B r t B r
D
t
,
where r is the riskless rate of return.

Let B(t)=1 and =1.

Arbitrage theorem:
Given the
t
S and
t
D defined above and that the two states have positive
probabilities of occurrence,
if positive constants
1
and
2
can be found such that asset prices satisfy
( )

+ +
+ +
+ +
=

,
) 1 ( ) 1 (
) 1 ( ) 1 (
) 1 ( ) 1 (
) (
) (
1
2
1
2 1
2 1

t C t C
t S t S
r r
t C
t S
then there are no arbitrage possibilities; and
if there are no arbitrage opportunities, then positive constants
1
and
2

satisfying ( ) can be found.

Relationship in ( ) is called a representation

What do the constants
1
and
2
represent?

If a security pays 1 in state 1, and 0 in state 2, then
1
) 1 ( ) ( = t S
Investors are willing to pay
1
units for an insurance policy that
offers one unit of account in state 1 and nothing in state 2

2
indicates how much investors would like to pay for an
insurance policy that pays 1 in state 2 and nothing in state 1
By spending
1
+
2
one can guarantee 1 unit of account in the
future, regardless of which state is realized
This is what the first row of representation ( ) shows

1
and
2
are called state prices

Representation () implies . ) 1 ( ) 1 ( 1
2 1
r r + + + =

Define
1 1
) 1 (
~
r P + = and
2 2
) 1 (
~
r P + =
Because of the positivity of state prices and because of
2 1
) 1 ( ) 1 ( 1 r r + + + = ,
1
~
0 <
i
P and 1
~ ~
2 1
= + P P

The
i
P
~
s can be interpreted as two probabilities associated with the
two states under consideration and are called risk-adjusted synthetic
probabilities

Risk-adjusted probabilities exist if there are no arbitrage opportunities

Representation ( ) implies three separate equalities:
2 1
) 1 ( ) 1 ( 1 r r + + + =
) 1 ( ) 1 ( ) (
2 2 1 1
+ + + = t S t S t S
) 1 ( ) 1 ( ) (
2 2 1 1
+ + + = t C t C t C


We obtain
( ) [ ( ) ] ) 1 ( 1 ) 1 ( 1
1
1
) (
2 2 1 1
+ + + + +
+
= t S r t S r
r
t S

( ) [ ( ) ] ) 1 ( 1 ) 1 ( 1
1
1
) (
2 2 1 1
+ + + + +
+
= t C r t C r
r
t C
or
[ ] ) 1 (
~
) 1 (
~
1
1
) (
2 2 1 1
+ + +
+
= t S P t S P
r
t S
[ ] ) 1 (
~
) 1 (
~
1
1
) (
2 2 1 1
+ + +
+
= t C P t C P
r
t C

Terms inside the brackets can be interpreted as some sort of expected
values calculated using the risk-adjusted probabilities

Current prices of all assets under consideration become equal to their
discounted expected payoffs, the discounting is done using the risk-free
rate


The true expected values are then:

[ ] ) 1 ( ) 1 ( )) 1 ( (
2 2 1 1
true
+ + + = + t S P t S P t S E
[ ] ) 1 ( ) 1 ( )) 1 ( (
2 2 1 1
true
+ + + = + t C P t C P t C E .

These are risky assets that satisfy
)) 1 ( (
1
1
) (
true
+
+
< t S E
r
t S
)) 1 ( (
1
1
) (
true
+
+
< t C E
r
t C .

For risky assets we generally have
) (
)) 1 ( (
) ( for premium risk 1
true
t S
t S E
t S r
+
= + +
) (
)) 1 ( (
) ( for premium risk 1
true
t C
t C E
t C r
+
= + +

This implies the following inequalities for risky assets:
)) 1 ( (
1
1
) (
true
+
+
< t S E
r
t S
)) 1 ( (
1
1
) (
true
+
+
< t C E
r
t C .

The importance of the no-arbitrage assumption in asset pricing now
becomes clear. If no-arbitrage implies the existence of positive
constants such as
1
,
2
, we can always obtain from these constants
the risk-adjusted probabilities
2 1
~
,
~
P P and work with synthetic
expectations that satisfy
) ( )) 1 ( (
1
1
~
t S t S E
r
P
= +
+

) ( )) 1 ( (
1
1
~
t C t C E
r
P
= +
+
.


Price of a call option

Most desirable way of pricing a call option: closed-form formula
for
t
C that expresses
t
C as a function of the underlying asset price
and the relevant parameters.
Option is out-of-money: if at expiration the option holder faces
K S
T
< , the option will have no value: 0 =
T
C
Option is in-the-money: if at time T, K S
T
> , the option will have
some value: K S C
T T
=
Both possibilities:
[ ] 0 , S max
T
K C
T
= .

T
C will equal the greater of the two values inside the brackets

Call Options
Example: European call option with a strike price of $60 to purchase
100 shares
Current stock price is $58
Expiration date of the option is in exactly four months
Price of an option to purchase one share is $5
Initial investment is $500
Option is European the investor can only exercise on the
expiration date
If stock price on this date is less than $60, the investor will clearly
choose not to exercise, the investor loses the whole of the initial
investment of $500
If stock price is above $60 on the expiration date (e.g. $75), the
option will be exercised
- By exercising the option, the investor is able to buy 100 shares
for $60 per share
- If the shares are sold immediately, the investor makes a gain of
$15 per share, or $1500, ignoring transaction costs
- Net profit to the investor is $1000.
Figure 1 shows how the investors net profit or loss on an option to
purchase one share varies with the final stock price in the example

In general, call options should always be exercised at the expiration date
if the stock price is above the strike price.


Figure 1 Profit from writing a European call option on one share.
Option price = $5; strike price = $60


Put Options

Whereas the purchaser of a call option is hoping that the stock price will
increase, the purchaser of a put option is hoping that it will decrease.
Example: European put option to sell 100 shares with a strike price
of $90
Current stock price is $85
Expiration date of the option is in three months
Price of an option to sell one share is $7
Initial investment is $700
Because the option is European, it will be exercised only if the stock
price is below $90 at the expiration date
Suppose that the stock price is $75 on this date. The investor can buy
100 shares for $75 per share and, under the terms of the put option,
sell the same shares for $90 to realize a gain of $15 per share, or
$1500. When the $700 initial cost of the option is taken into account,
the investors net profit is $800. If the final stock price is above $90,
the put option expires worthless, and the investor loses $700.

Figure 2 shows the way in which the investors profit or loss on an
option to sell one share varies with the terminal stock price in this
example.



Figure 2 Profit from buying a European put option, on one share.
Option price = $7; strike price = $90

Early exercise
Exchange-traded stock options are usually American rather than
European but are mostly traded as European
Investor in the foregoing examples would not have to wait until the
expiration date before exercising the option
There are some circumstances under which it is optimal to exercise
American options prior to maturity

Option Positions
There are two sides to every option contract
On one side is the investor who has taken the long position (i.e. has
bought the option)
On the other side is the investor who has taken a short position (i.e.
has sold or written the option)
The writer of an option receives cash up front, but has potential
liabilities later
The writers profit or loss is the reverse of that for the purchaser of
the option.
Figures 3 and 4 show the variation of the profit or loss with the final
stock price for writers of the options considered in Figures 8 and 9



Figure 3 Profit from writing a European call option on one share.
Option price = $5; strike price = $90



Figure 4 Profit from writing a European put option on one share. Option
price = $7; strike price = $90


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
Payoff from a long position in a European call option is
( ) 0 , max K S
T
.
Payoff to the holder of a short position in the European call option is
( ) ( ) 0 , min 0 , max -
T T
S K K S = .
Payoff to the holder of a long position in a European put option is
( ) 0 , max
T
S K .
Payoff from a short position in a European put option is
( ) ( ) 0 , min 0 , max - K S S K
T T
= .




Figure 5 Payoffs from positions in European options: (a) long call,
(b) short call, (c) long put, (d) short put. Strike price = K; price of asset at
maturity =
T
S

Bounds for option prices

Assumptions:

1.No transaction costs.
2.All trading profits (net of trading losses) are subject to the same
tax rate
3.Borrowing and lending are possible at the risk-free interest rate
4.No arbitrage opportunities

Notation:
S (or
0
S ): current stock price
K: strike price of option
T : time to expiration of option

T
S : stock price at maturity
r: continuously compounded risk-free interest rate for an
investment maturing in time T

A
C : value of American call option to buy one share

A
P : value of American put option to sell one share
C: value of European call option to buy one share
P: value of European put option to sell one share

Remark: r is the nominal rate of interest, not the real rate of interest.
We can assume that r>0; otherwise, a risk-free investment would
provide no advantages over cash. (Indeed, if r<0, cash would be
preferable to a risk-free investment.)

Upper bounds

An American or European call option gives the holder the right to
buy one share of a stock for a certain price.
Option can never be worth more than the stock
Stock price is an upper bound to the option price:
C S and
A
C S .

An American or European put option gives the holder the right to sell
one share of a stock for K.
No matter how low the stock price becomes, the option can never
be worth more than K:
P K and
A
P K .

For European options, we know that at maturity the option cannot be
worth more than K. It follows that it cannot be worth more than the
present value of K today:
rT
K P

e .

Lower bounds for calls on non-dividend-paying stocks

A lower bound for the price of a European call option on a non-
dividend-paying stock is:
rT
K S

e

Numerical example:
S =$20, K=$18, r=10% per annum, and T=1 year. In this case,
71 . 3 e 18 20 e
1 . 0
= =
rT
K S =$3.71
Suppose: European call price is $3.00.
An arbitrageur can buy the call and short the stock to provide a cash
inflow of $20.00-$3.00=$17.00.
If invested for one year at 10% per annum, the $17.00 grows to
17
1 . 0
e =$18.79. At the end of the year, the option expires.
If the stock price is greater than $18.00, the arbitrageur exercises the
option to buy the stock for $18.00, closes out the short position, and
makes a profit of $18.79-$18.00=$0.79.
If the stock price is less than $18.00, the stock is bought in the
market and the short position is closed out. The arbitrageur then
makes an even greater profit. For example, if the stock price is
$17.00, the arbitrageurs profit is $18.79-$17.00=$1.79.
Lower bounds for calls on non-dividend-paying stocks

Consider the following two portfolios:
Portfolio 1: one European call option plus an amount of cash equal to
rT
K

e
Portfolio 2: one share

In portfolio 1, the cash, if it is invested at the risk-free interest rate, will grow
to K in time T.
If K S
T
> , the call option is exercised at maturity and portfolio 1 is worth
T
S .
If K S
T
< , the call option expires worthless and the portfolio is worth K.
Hence, at time T, portfolio 1 is worth ) , max( K S
T
.

Portfolio 2 is worth
T
S at time T. Hence, portfolio 1 is always worth as much
as, and can be worth more than, portfolio 2 at the options maturity. It
follows that in the absence of arbitrage opportunities this must also be true
today. Hence, S K C
rT
+

e or
rT
K S

e C .

Because the worst that can happen to a call option is that it expires worthless
its value cannot be negative. This means that 0 C , and therefore that
) 0 , e max( C
rT
K S

.

Lower bounds for calls on non-dividend-paying stocks

Example
Consider a European call option on a non-dividend-paying stock with
stock price is $51
exercise price is $50
time to maturity is six months
risk-free rate of interest is 12% per annum
This means: S =51, K=50, T=0.5, and r=0.12.
A lower bound for the option price is
rT
K S

e , or
91 . 3 $ e 50 51
5 . 0 12 . 0
=

.




Lower bounds for European puts on non-dividend-paying stocks

For a European put option on a non-dividend-paying stock, a lower bound for
the price is S K
rT

e .

Numerical example:
S =$37, K=$40, r=5% per annum, and T=0.5 years. In this case,
01 . 2 $ 37 e 40 e
5 . 0 05 . 0
= =

S K
rT
.
Consider the situation where the European put price is $1.00.
An arbitrageur can borrow $38.00 for six months to buy the put and the
stock
At the end of the six months, the arbitrageur will be required to repay
96 . 38 $ 38e
5 . 0 05 . 0
=

If the stock price is below $40.00, the arbitrageur exercises the option to
sell the stock for $40.00, repays the loan, and makes a profit of
$40.00-$38.96=$1.04.
If the stock price is greater than $40.00, the arbitrageur discards the
option, sells the stock, and repays the loan for an even greater profit.
For example, if the stock price is $42.00, the arbitrageurs profit is
$42.00-$38.96=$3.04.

Lower bounds for European puts on non-dividend-paying stocks

Consider the following two portfolios:
Portfolio 3: one European put option plus one share
Portfolio 4: an amount of cash equal to
rT
K

e

If K S
T
< , the option in portfolio 3 is exercised at option maturity, and
the portfolio becomes worth K.
If K S
T
> , the put option expires worthless, and the portfolio is worth
T
S
at this time.
Hence, portfolio 3 is worth ) , max( K S
T
at time T.
Assuming the cash is invested at the risk-free interest rate, portfolio 4 is
worth K at time T. Hence, portfolio 3 is always worth as much as, and can
sometimes be worth more than, portfolio 4 at time T. It follows that in the
absence of arbitrage opportunities portfolio 3 must be worth at least as much
as portfolio 4 today. Hence,
rT
K S P

+ e or S K P
rT


e .
Because the worst that can happen to a put option is that it expires worthless,
its value cannot be negative. This means that
) 0 , e max( S K P
rT


.


Lower bounds for European puts on non-dividend-paying stocks

Example
Consider a European put option on a non-dividend-paying stock with
stock price is $38
exercise price is $40
time to maturity is three months
risk-free rate of interest is 10% per annum
This means: S =38, K=40, T=0.25, and r=0.10.
A lower bound for the option price is S K
rT

e , or
01 . 1 $ 38 e 40
25 . 0 1 . 0
=

.



Put-call parity: important relationship between P and C.

Suppose:
Portfolio 1: one European call option plus an amount of cash equal to
rT
K

e
Portfolio 2: one European put option plus one share
Both are worth ( ) K S
T
, max at expiration of the options.

Because the options are European, they cannot be exercised prior to the
expiration date. The portfolios must, therefore, have identical values today.
This means that
S P K C
rT
+ = +

e .

This relationship is known as the put-call parity.
It shows that the value of a European call with a certain exercise price and
exercise date can be deduced from the value of a European put with the same
exercise price and date, and vice versa.

If the put-call parity does not hold, there are arbitrage opportunities.

Put-call parity: example

Suppose:
stock price is $31,
exercise price is $30,
risk-free interest rate is 10% per annum,
price of a three-month European call option is $3,
price of a three-month European put option is $2.25.
In this case,
26 . 32 $ e 30 3 e
12 / 3 1 . 0
= + = +
rT
K C
25 . 33 $ 31 25 . 2 = + = + S P .

Put-call parity

Remark: American options
Put-call parity holds only for European options. However, it is possible to derive
some results for American option prices. It can be shown that
rT
A A
K S P C K S

e .

Example
An American call option on a non-dividend-paying stock with exercise price
$20.00 and maturity in five months is worth $1.50.
Suppose that the current stock price is $19.00 and the risk-free interest rate is
10% per annum. From the inequality above, we have
12 / 5 1 . 0
e 20 19 20 19


A A
P C
or
1 18 . 0
A A
C P
showing that
A A
C P lies between $1.00 and $0.18.
With
A
C at $1.50,
A
P must lie between $1.68 and $2.50.

Pricing of options: Black and Scholes (B-S) model

Black and Scholes proved that the valuation of the European call is given by:
( ) ( ) ( )
2
rT -
1
e , d N K d N S T S C =
with
T
T r
K
S
d

)
2
1
( ln
2
1
+ +

=
and
T d d =
1 2
,
where N(.) is the cumulative normal density function
( ) x d N
x
d
d e
2
1
2
2
1

,
and the volatility of the underlying asset.


Example 1
Suppose:
underlying asset S=18
strike price K=15
short-term interest rate r=10%
maturity date T=0.25
volatility =15%

Compute the discounted value of the strike price:
6296 . 14 e 15 e
) 25 . 0 ( 1 . 0
= =
-rT
K .
Calculate the values of
1
d and
2
d :
( ) [ ]
8017 . 2
075 . 0
21013 . 0
25 . 0 15 . 0
25 . 0 ) 5 . 0 ( ) 15 . 0 ( 1 . 0 15 / 18 ln
2
1
= =
+ +
= d

7267 . 2 25 . 0 15 . 0
1 2
= = d d
Replace these values in the formula:
( ) 7267 . 2 e 15 ) 8017 . 2 ( 18
) 25 . 0 ( 1 . 0
N N C

=
3659 . 3 ) 996 . 0 ( 6296 . 14 ) 997 . 0 ( 18 = =


Example 2
Suppose:
underlying asset S=18
strike price K=15
short-term interest rate r=10%
maturity date T=0.25
volatility =15%

The put price is
0045 . 0 ) 003 . 0 ( 18 ) 004 . 0 ( 629 . 14 ) 997 . 0 1 ( 18 ) 996 . 0 1 ( 629 . 14 = = = P



Example 3

When the put-call parity relationship applies, the put price is given by
0045 . 0 e 15 18 3659 . 3 e
) 25 . 0 ( 1 . 0 -
= + = + =
rT
K S C P



Example 4
Suppose:
volatility =0.15
underlying asset S=18
strike price K=15
interest rate r=0.1
time to maturity T is 6 months

The call price is 3.7461 and the put price is 0.0084.

Since
rT
K S P C
-
e = we have:
73 . 3 = P C
73 . 3 e
-
=
rT
K S




Option Strategies: Introduction

Question: what is the evolution of the underlying asset?
Asset buy call
Asset buy put
combinations of option transactions = option strategies

Rule of thumb: The more risk, the more profit.



Terminology:

out
money the at
in

means

CALL PUT
in strike price < current
market value
strike price > current
market value
at strike price = current
market value
strike price = current
market value
out strike price > current
market value
strike price < current
market value

Option Strategies:

Terminology and notation:
ABN AMRO C APR 06 4.35

ABN AMRO: underlying asset
C: Call option
APR: the maturity date is the third Friday of April
06: year 2006
4.35: strike price

the assets have to be bought by multiples of 100


Call Option
Buy a call (long call):
right to buy the underlying asset at the maturity date at
the preset strike price
pay a premium
Write a call (short call):
duty (obligation) to sell the underlying asset at the
maturity date at the strike price
receive a premium

Put Option
Buy a put (long put):
right to sell the underlying asset at the maturity date at
the preset strike price
pay a premium
Write a put (short put):
duty (obligation) to buy the underlying asset at the
maturity date at the strike price
receive a premium
Simple strategies

1. Long call
Expectation: asset
Method: buy call

Example
Underlying asset: ABN AMRO current market value = 14.40
Buy C OKT 06 14.00
Premium: 1.90


Evolution:

Market value Intrinsic value option Premium Result


12 0 -1,9 -1,9
12,5 0 -1,9 -1,9
13 0 -1,9 -1,9
13,5 0 -1,9 -1,9
14 0 -1,9 -1,9
14,5 0,5 -1,9 -1,4
15 1 -1,9 -0,9
15,5 1,5 -1,9 -0,4
15,9 1,9 -1,9 0
16 2 -1,9 0,1
16,5 2,5 -1,9 0,6
17 3 -1,9 1,1
17,5 3,5 -1,9 1,6
18 4 -1,9 2,1
18,5 4,5 -1,9 2,6
19 5 -1,9 3,1


Conclusion
Limited loss (= payed premium)
Unlimited profit
Break-even-point = 15.9
profit

loss
2. Short call
Expectation: asset value or stable
Method: sell/write call

Example
Underlying asset: FORTIS current market value = 22.70
Sell C APR 06 23.00
Premium: 0.80



Evolution:

Market value Intrinsic value option premium result


20 0 0,8 0,8
21 0 0,8 0,8
21,5 0 0,8 0,8
22 0 0,8 0,8
22,5 0 0,8 0,8
23 0 0,8 0,8
23,5 -0,5 0,8 0,3
23,8 -0,8 0,8 0
24 -1 0,8 -0,2
24,5 -1,5 0,8 -0,7
25 -2 0,8 -1,2
26 -3 0,8 -2,2
27 -4 0,8 -3,2







Conclusion
Limited profit (= received premium)
Unlimited loss
Break-even-point = 23.8

3. Long put
Expectation: asset value
Method: buy put

Example
Underlying asset: Ph current market value = 15.55
Buy P OKT 06 16.00
Premium: 3.05


Evolution:

Market value Intrinsic value option Premium Result


9 7 -3,05 3,95
10 6 -3,05 2,95
11 5 -3,05 1,95
12 4 -3,05 0,95
12,95 3,05 -3,05 0
13 3 -3,05 -0,05
14 2 -3,05 -1,05
15 1 -3,05 -2,05
16 0 -3,05 -3,05
17 0 -3,05 -3,05
18 0 -3.05 -3.05



Conclusion
Limited loss (= payed premium)
Unlimited profit
Break-even-point = 12.95


profit
loss
4. Short put
Expectation: asset value or stable
Method: sell/write put

Example
Underlying asset: K current market value = 6.23
Sell P APR 06 6.00
Received premium: 0.40

Evolution:

Market value Intrinsic value option Premium Result


1 -5 0,4 -4,6
2 -4 0,4 -3,6
3 -3 0,4 -2,6
4 -2 0,4 -1,6
5 -1 0,4 -0,6
5,6 -0,4 0,4 0
6 0 0,4 0,4
7 0 0,4 0,4
8 0 0,4 0,4
9 0 0,4 0,4
10 0 0,4 0,4



Conclusion
Limited profit (= received premium)
Unlimited loss
Break-even-point = 5.6


profit
loss

Combinations of strategies


Definition: A combination is an option trading strategy that involves
taking a position in both calls and puts on the same stock.

1. Spread
combination of

put short put with long

call short with call long

goal
Risk reduction
Extra profit by limited increase or decrease


1.1. Call spread
Expectation: small increase
Method: buy call
write call with higher strike price

Example
Underlying asset: ABN AMRO current market value = 24.40
Buy C OKT 06 24.00
Sell C OKT 06 26.00
Payed premium: 1.90
Received premium: 1.00


Evolution

Market value Intrinsic value option premium result

long call 14 short call 16

22 0 0 -0,9 -0,9
23 0 0 -0,9 -0,9
24 0 0 -0,9 -0,9
24,9 0,9 0 -0,9 0
25 1 0 -0,9 0,1
26 2 0 -0,9 1,1
27 3 -1 -0,9 1,1
28 4 -2 -0,9 1,1
29 5 -3 -0,9 1,1



Conclusion
Limited profit
Limited loss
Break-even-point = 24.9


Comparison to long call:

Conclusion
A more limited loss
A more limited profit
More profit for small increase
Less profit for large increase
1.2. Put spread
Expectation: small decrease
Method: buy put
write put with smaller strike price

Example
Underlying asset: Ph current market value = 15.55
Buy P OKT 06 16.00
Sell P OKT 06 14.00
Payed premium: 3.05
Received premium: 2.00



Evolution

Market value Intrinsic value option premium result

long put 16 short put 14

12 4 -2 -1,05 0,95
13 3 -1 -1,05 0,95
14 2 0 -1,05 0,95
14,95 1,05 0 -1,05 0
15 1 0 -1,05 -0,05
16 0 0 -1,05 -1,05
17 0 0 -1,05 -1,05
18 0 0 -1,05 -1,05
19 0 0 -1,05 -1,05



Conclusion
Limited profit
Limited loss
Break-even-point = 14.95


profit
loss
Comparison to long put:

Conclusion
A more limited loss
A more limited profit
More profit for a small decrease
Less profit for a large decrease
1.3. Butterfly spread
Expectation: small increase within a certain range
Method: buy 2 calls
write 2 calls

Example
Underlying asset: A current market value = 7.55
Buy C OKT 06 8.00
Sell twice C OKT 06 10.00
Buy C OKT 06 12.00
Payed premiums: 1.25 and 0.35
Received premiums: 20.60

Evolution



Current
market value
Intrinsic
value
option premium result

long call 8
short call
10
long call
12

6 0 0 0 -0,4 -0,4
7 0 0 0 -0,4 -0,4
8 0 0 0 -0,4 -0,4
8,4 0,4 0 0 -0,4 0
9 1 0 0 -0,4 0,6
10 2 0 0 -0,4 1,6
11 3 -1 0 -0,4 0,6
11,6 3,6 -1,6 0 -0,4 0
12 4 -2 0 -0,4 -0,4
13 5 -3 1 -0,4 -0,4
14 6 -4 2 -0,4 -0,4


loss loss
profit
Conclusion
A limited profit within a certain range
A limited loss outside the range
Break-even-points: 8.4 and 11.6

Why two times a short call?
to reduce the loss (double premium!)
more profit if current market value equals 10


2. Straddle
combination of

put short and call short

put long and call long

with equal exercise prices


2.1. Long straddle
Expectation: large market value movements
Method: buy call
buy put

Example
Underlying asset: VNU current market value = 24.11
Buy C JUL 06 24.00
Buy P JUL 06 24.00
Payed premiums: 2.35 and 2.55

Evolution

Current value Intrinsic value option premium result

long call 24 long put 24

18 0 6 -4,9 1,1
19 0 5 -4,9 0,1
19.1 0 4,9 -4,9 0
20 0 4 -4,9 -0,9
21 0 3 -4,9 -1,9
22 0 2 -4,9 -2,9
23 0 1 -4,9 -3,9
24 0 0 -4,9 -4,9
25 1 0 -4,9 -3,9
26 2 0 -4,9 -2,9
27 3 0 -4,9 -1,9
28 4 0 -4,9 -0,9
28,9 4,9 0 -4,9 0
29 5 0 -4,9 0,1
30 6 0 -4,9 1,1



Conclusion
Unlimited loss outside a certain range
Limited loss within the considered range
Break-even-points: 18.9 and 28.9
Big investment
For a stabilized situation: enormous loss
loss
profit profit
2.2. Short straddle
Expectation: stabilized situation
Method: write call
write put

Example
Underlying asset: VNU current market value = 24.11
Sell C JUL 06 24.00
Sell P JUL 06 24.00
Received premiums: 2.35 and 2.55

Evolution
Current value Intrinsic value option premium result

short call 24 short put 24

18 0 -6 4,9 -1,1
19 0 -5 4,9 -0,1
19,1 0 -4,9 4,9 0
20 0 -4 4,9 0,9
21 0 -3 4,9 1,9
22 0 -2 4,9 2,9
23 0 -1 4,9 3,9
24 0 0 4,9 4,9
25 -1 0 4,9 3,9
26 -2 0 4,9 2,9
27 -3 0 4,9 1,9
28 -4 0 4,9 0,9
28,9 -4,9 0 4,9 0
29 -5 0 4,9 -0,1
30 -6 0 4,9 -1,1



Conclusion
Limited loss within a certain range
Unlimited loss outside the considered range
Break-even-points: 19.1 and 28.9
For a stabilized situation: biggest profit

loss
loss
profit
3. Strangle
combination of

put short and call short

put long and call long

with different exercise prices
Goal: reduction of investments
Disadvantage: the profit probability decreases

3.1. Long strangle
Expectation: large market value movements
Method: buy call with exercise price > current value
buy put with exercise price < current value

Example
Underlying asset: VNU current market value = 24.11
Buy C JUL 06 26.00
Buy P JUL 06 22.00
Payed premiums: 1.40 and 1.60




Evolution

Current value Intrinsic value option premium result

long call 26 long put 22

17 0 5 -3 2
18 0 4 -3 1
19 0 3 -3 0
20 0 2 -3 -1
21 0 1 -3 -2
22 0 0 -3 -3
23 0 0 -3 -3
24 0 0 -3 -3
25 0 0 -3 -3
26 0 0 -3 -3
27 1 0 -3 -2
28 2 0 -3 -1
29 3 0 -3 0
30 4 0 -3 1
31 5 0 -3 2



Conclusion
Unlimited profit outside a certain range
Limited loss within the range
Break-even-points: 19 and 29
Stabilized situation: biggest loss

loss
profit prprofit
Comparison to long straddle:

Conclusion
A more limited loss but a wider range than the straddle
A more limited profit


3.2. Short strangle
Expectation: a stabilized situation
Method: write call with exercise price > current value
write put with exercise price < current value

Example
Underlying asset: VNU current market value = 24.11
Sell C JUL 06 26.00
Sell P JUL 06 22.00
Received premiums: 1.40 and 1.60


Evolution

Current value Intrinsic value option premium result

short call 26 short put 22

17 0 -5 3 -2
18 0 -4 3 -1
19 0 -3 3 0
20 0 -2 3 1
21 0 -1 3 2
22 0 0 3 3
23 0 0 3 3
24 0 0 3 3
25 0 0 3 3
26 0 0 3 3
27 -1 0 3 2
28 -2 0 3 1
29 -3 0 3 0
30 -4 0 3 -1
31 -5 0 3 -2



Conclusion
Limited profit within a certain range
Unlimited loss outside the range
Break-even-points: 19 and 29
For a stabilized situation: biggest profit

profit
loss loss
Comparison to short straddle:

Conclusion
A more limited loss
A more limited profit but for a wider range than for the straddle

Options as insurance

Assumption: you have certain assets in your portfolio

1. Covered written call
Goal: protect the assets
Method: write call for the assets in portfolio

Example
Underlying asset: F current market value = 12.70
Buy 100 assets F 12.70
Sell C APR 06 13.00
Received premium: 0.80


Evolution

Current value Asset premium result

Intrinsic value
option

8 0 -12,7 0,8 -3,9
9 0 -12,7 0,8 -2,9
10 0 -12,7 0,8 -1,9
11 0 -12,7 0,8 -0,9
11,9 0 -12,7 0,8 0
12 0 -12,7 0,8 0,1
13 0 -12,7 0,8 1,1
14 -1 -12,7 0,8 1,1
15 -2 -12,7 0,8 1,1
16 -3 -12,7 0,8 1,1



Conclusion
A more limited loss for asset value depreciation
A more limited profit for increasing market value


asset
asset
2. Put as insurance
Goal: protect assets
Expectation: small depreciation but good forecasts
Method: buy put on the assets in portfolio

Example
Underlying asset: F current market value = 12.70
Buy 100 assets F 12.70
Buy P APR 06 13.00
Payed premium: 1.00



Evolution
Market value
Intrinsic value
option Asset premium result


8 5 -12,7 -1 -0,7
9 4 -12,7 -1 -0,7
10 3 -12,7 -1 -0,7
11 2 -12,7 -1 -0,7
12 1 -12,7 -1 -0,7
13 0 -12,7 -1 -0,7
13,70 0 -12,7 -1 0
14 0 -12,7 -1 0,3
15 0 -12,7 -1 1,3
16 0 -12,7 -1 2,3




Conclusion
Limited loss for asset value depreciation
A more limited profit for increasing asset value


asset
asset
3. Swaps
Swaps

A swap is an agreement between two parties to exchange
sequences of cash flows over a period in the future.
Example:
- Party A might agree to pay a fixed rate of interest on $1 million
each year for five years to Party B.
- In return, Party B might pay a floating rate of interest on
$1 million each year for five years.
The parties that agree to the swap are known as counterparties.
The cash flows that the counterparties make are generally tied to
the value of debt instruments or to the value of foreign currencies.
Therefore, the two basic kinds of swaps are interest rate swaps
and currency swaps.
The swaps market

Futures markets trade highly standardized contracts.
Options traded on exchanges have highly specified contract terms.
Example: the S&P 500 futures contract is based on a particular set
of stocks, for a particula dollar amount, with only four fixed
maturity dates per year.
Futures and exchange-traded options generally have a fairly short
horizon.
In many cases, futures contracts are listed only one to two years
before they expire.
Even when it is possible to trade futures for expiration in three
years or more, the markets do not become liquid until the contract
comes much closer to expiration.
For exchange-traded stock options, the longest time to maturity is
generally less than one year.
Characteristics of the swaps market

To consummate a swap transaction, one potential counterparty
must find a counterparty that is willing to take the opposite side of
a transaction.
If one party needs a specific maturity, or a certain pattern of cash
flows, it could be difficult to find a willing counterparty
Because a swap agreement is a contract between two
counterparties, the swap cannot be altered or terminated early
without the agreement of both parties.
For futures and exchange-traded options, the exchanges effectively
guarantee performance on the contracts for all parties.
By its very nature, the swaps market has no such guarantor.
Plain vanilla swaps

The basic swap is known as a plain vanilla swap, which can be an
interest rate swap or a foreign currency swap.


Interest rate swaps

In a plain vanilla interest rate swap, one counterparty agrees to
pay a sequence of fixed rate interest payments and to receive a
sequence of floating rate interest payments.
This counterparty has the pay-fixed side of the deal.
The opposing counterparty agrees to receive a sequence of
fixed rate interest payments and to pay a sequence of floating
rate payments.
This counterparty has the receive-fixed side of the deal.
The swap agreement specifies the tenor: a time over which the
periodic interest payments will be made.
Example

The LIBOR is the London Interbank Offered Rate and represents
the rate at which large international banks lend to each other.
LIBOR-based loans are essentially privately negotiated business
loans that may have a variety of maturities.
Floating rates in the swaps market are most often set as equaling
LIBOR, which is also called LIBOR flat.
Assumptions:
- five year tenor
- annual payments on a $1 million notional principal amount
- party A agrees to pay a fixed rate of 9 percent, or $90 000, to
party B each year (party A is the pay-fixed counterparty)
- party B agrees to pay a floating rate of LIBOR to party A
(party B is the receive-fixed counterparty)
The LIBOR maturity for this plain vanilla swap will be the one-
year LIBOR rate, because there is one year between each of the
payments on the swap.
Conceptually, the two parties also exchange the principal amount
of $1 million.
Actually making the transaction of sending each other $1 million
would not make practical sense
Consequence: principal amounts are generally not exchanged.
The determination of LIBOR occurs at one settlement date, with
payment occuring at the next settlement date.
LIBOR at the time of negotiation is 8.75 percent.
Future course of LIBOR is unknown.
In each period, the fixed rate payment will be $90 000.
The floating rate payment at a given time t depends on the level
of LIBOR at period t-1.
At the inception of the swap agreement, LIBOR is observed
(8.75 percent) and this determines the floating rate payment that
occurs in the first period ($87 500).
The second payment, which occurs at t=2, depends on LIBOR at
t=1, and this is unknown when the swap is negotiated.
Table: Cash flows for a plain vanilla interest rate swap

Year LIBOR
t
Floating rate obligation
Party B pays party A
Fixed rate obligation
Party A pays party B
0 8.75%
1 LIBOR
1
=? LIBOR
0
$1000000=
0.0875$1000000=$87500
$90000
2 LIBOR
2
=? LIBOR
1
$1000000 $90000
3 LIBOR
3
=? LIBOR
2
$1000000 $90000
4 LIBOR
4
=? LIBOR
3
$1000000 $90000
5 N/A LIBOR
4
$1000000 $90000

A plain vanilla interest rate swap
Foreign currency swaps

In a plain vanilla currency swap, one party holds one currency
and desires a different currency.
The swap arises when one party provides a certain principal in
one currency to its counterparty in exchange for an equivalent
amount of a different currency.
Each party will pay interest on the currency it receives in the
swap, and this interest payment can be made at either a fixed or a
floating rate.
Example

Party C has Euros and is anxious to swap them for US dollars.
Party D holds US dollars and is willing to exchange them for Euros

Parties C and D may be able to engage in a currency swap

Four possibilities for making interest payments:
1.Party C pays a fixed rate on dollars received, and party D pays
a fixed rate on Euros received
2.Party C pays a floating rate on dollars received, and party D
pays a fixed rate on Euros received
3.Party C pays a fixed rate on dollars received, and party D pays a
floating rate on Euros received
4.Party C pays a floating rate on dollars received, and party D
pays a floating rate on Euros received

Simplest kind of currency swap: each party pays a fixed rate of
interest on the currency it receives.

The fixed-for-fixed currency swap involves 3 different sets of
cash flows:
1. At initiation: the two parties exchange cash.
2. The parties make periodic interest payments to each other
during the life of the swap agreement, and these payments are
made in full without netting.
3.At termination: the parties exchange the principal.

Motivation for the currency swap: need for funds denominated in
a different currency.
Is different from interest rate swap: both parties deal in a single
currency and can pay the net amount.
Motivation for swaps

Swap market was seen as a means of obtaining fixed rate financing at
a cheaper rate than was otherwise avaliable
Commodity swaps
In a commodity swap, the counterparties make payments based on
the price of a specified amount of a commodity, with one party
paying a fixed price, while the second party pays a floating price.
In general, the commodity is not actually exchanged, and the parties
make only net payments.
Chase Manhattan Bank created the first commodity swap in 1986.
Example:
- A rice farmer produces 200 tons of rice annually.
- The farmer is anxious to avoid the price fluctuations of the spot
rice market, particularly as import restrictions in Japan and
Korea wax and wane.
- The farmer is uncomfortable trying to use the futures market in
rice due to its low liquidity and uncertain future.
- Therefore, the farmer seeks a swap arrangement in which he
takes the receive-fixed side of the deal.
- The farmer might agree to receive a fixed payment per ton for
each of the next five years and promise to pay the actual market
price of rice each year.

Equity swaps

The amount of the periodic interest payments is a fraction of a
dollar amount specified in the swap agreement, which is called
the notional principal.

In an equity swap, the counterparties exchange payments based
on a notional principal specified as a stock portfolio.

Equity swaps are similar to interest rate swaps:
- underlying notional principal
- fixed tenor
- one party has a receive-fixed/pay-floating commitment, the
other has a pay-fixed/receive-floating position.




Swaptions

A swaption is an option on a swap that can be either American or
European.
A receiver swaption gives the holder the right to enter a
particular swap agreement as the fixed-rate receiver.
A payer swaption gives the holder the right to enter a particular
swap agreement as the fixed-rate payer.
Ownership gives a right but not an obligation.
The swap agreement underlying the swaption is defined with
respect to all of its terms:
- tenor
- notional principal
- fixed rate
- floating rate index
For the swaption, there is a stated expiration date.
We may think of a receiver swaption as a call option on a bond
that pays a fixed rate of interest:
If the owner of a receiver swaption exercises, he will be in the
position of the owner of a bond who receives fixed interest
payments.
The floating payments that he makes play the role of the exercise
price.
A payer swaption is analogous to a put option on a bond.
When the owner of a payer swaption exercises, he will be in the
position of an issuer of a fixed rate bond, because the exercise of
the payer swaption requires a sequence of fixed rate interest
payments in exchange for inflows at a floating rate.
Market completeness

A complete market is a market in which any and all identifiable
payoffs can be obtained by trading the securities available in the
market.
Financial derivatives play a valuable role in financial markets
because they help to move the market closer to completeness.
If two financial markets are the same, except one includes
financial derivatives, the market with financial derivatives will
allow traders to shape the risk more exactly and return
characteristics of their portfolios, thereby increasing the welfare of
traders and the economy in general
Speculation

Financial derivatives have a reputation for being risky.
These instruments can prove tremendously risky in the hands of
uninformed traders.
The risks associated with financial derivatives are not necessarily
evil, because they provide very powerful instruments for
knowledgeable traders to expose themselves to calculated and
well-understood risks in pursuit of profit.

Trading efficiency

Traders can use a position in one or more financial derivatives as a
substitute for a position in the more fundamental underlying
instruments.
Example 1: an option position can mimic the profit or loss
performance of an underlying stock index.
Example 2: an interest rate futures contract can serve as a
substitute for investment in a portfolio of Treasury securities.
The concept of arbitrage

Many alternative definitions of arbitrage.
In academic arbitrage, it is possible to trade to generate a riskless
profit without investment.
An arbitrageur is a person who engages in arbitrage.
4. Interest rate derivatives
Interest rate derivatives
Instruments whose payoffs are dependent in some way
on the level of interest rates
More difficult to value than equity and foreign exchange
derivatives
Reasons:
1. Behavior of an individual interest rate is more
complicated than that of a stock price or an
exchange rate
2. For the valuation of many products, it is
necessary to develop a model describing the
behavior of the entire zero-coupon yield curve
3. Volatilities of different points on the yield curve
are different
4. Interest rates are used for discounting as well as
for defining the payoff from the derivative
Using Blacks model to price European
options
Consider a European call option on a variable with value V
Define:
T: time to maturity of the option
F: forward price of V for a contract with maturity T
F
0
: value of F at time zero
K: strike price of the option
P(t,T): price at time t of a zero-coupon bond paying $1 at
time T
V
T
: value of V at time T
s: volatility of F
Blacks model calculates the expected payoff from the
option assuming
1. V
T
has a lognormal distribution with the standard
deviation of lnV
T
equal to
2. the expected value of V
T
is F
0
It then discounts the expected payoff at the T-year risk-
free rate by multiplying by P(0,T).
The payoff from the option is max(V
T
-K,0) at time T.
The lognormal assumption implies that the expected
payoff is
E(V
T
)N(d
1
)-KN(d
2
)
with
E(V
T
) = the expected value of V
T
and
T
Because we assume that E(V
T
) = F
0
and discount at the
risk-free rate, the value of the option is
( ) [ ]
( ) [ ]
T d
T
T K V E
d
T
T K V E
d
T
T

=
+
=
1
2
2
2
1
2 / / ln
2 / / ln
[ ]
[ ]
T d
T
T K F
d
T
T K F
d

=
+
=
1
2
0
2
2
0
1
2 / / ln
2 / / ln
[ ] ) ( ) ( ) , 0 (
2 1 0
d N K d N F T P c =
Blacks model can be extended to allow for the situation
where the payoff is calculated from the value of the
variable V at time T, but the apyoff is actually made at
some later time T
*
.
The expected payoff is discounted from time T
*
instead
of time T.
[ ] ) ( ) ( ) , 0 (
2 1 0
*
d N K d N F T P c =
[ ]
[ ]
T d
T
T K F
d
T
T K F
d

=
+
=
1
2
0
2
2
0
1
2 / / ln
2 / / ln
European swap options
Swap options, or swaptions, are options on interest
rate swaps
They are another increasingly popular type of interest
rate option
They give the holder the right to enter into a certain
interest rate swap at a certain time in the future.
Many large financial institutions that offer interest
rate swap contracts to their corporate clients are also
prepared to sell them swaptions or buy swaptions
from them
Example how a swaption might be used
Consider a company that knows that in six months it
will enter into a five-year floating-rate loan
agreement and knows that it will wish to swap the
floating interest payments for fixed interest payments
to convert the loan into a fixed-rate loan.
At a cost, the company could enter into a swaption
giving it the right to receive six-month LIBOR and
pay a certain fixed rate of interest, say 8% per annum,
for a five-year period starting in six months.
If the fixed rate exchanged for floating on a regular
five-year swap in six months turns out to be less than
8% per annum, the company will choose not to
exercise the swaption and will enter into a swap
agreement in the usual way.
However, if it turns out to be greater than 8% per
annum, the company will choose to exercise the
swaption and will obtain a swap at more favorable
terms than those available in the market.
Swaptions provide companies with a guarantee that the
fixed rate of interest they will pay on a loan at some
future time will not exceed some level
They are an alternative to forward swaps (sometimes
called deferred swaps).
Forward swaps involve no up-front cost but have the
disadvantage of obligating the company to enter into a
swap agreement.
With a swaption, the company is able to benefit from
favorable interest rate movements while acquiring
protection from unfavorable interest rate movements.
The difference between a swaption and a forward swap
is analogous to the difference between an option on
foreign exchange and a forward contract on foreign
exchange.
Relation to bond options
An interest rate swap can be regarded as an
agreement to exchange a fixed-rate bond for a
floating-rate bond.
At the start of a swap, the value of the floating-rate
bond always equals the notional principal of the
swap.
A swaption can therefore be regarded as an option to
exchange a fixed-rate bond for the notional principal
of the swap.
If a swaption gives the holder the right to pay fixed
and receive floating, it is a put option on the fixed-
rate bond with strike price equal to the notional
principal.
If a swaption gives the holder the right to pay floating
and receive fixed, it is a call option on the fixed-rate
bond with a strike price equal to the principal.
Valuation of European swap options
The swap rate for a particular maturity at a particular
time is the fixed rate that would be exchanged for
LIBOR in a newly issued swap with that maturity.
The model usually used to value a European option
on a swap assumes that the relevant swap rate at the
maturity of the option is lognormal
Consider a swaption where we have the right to pay a
rate s
K
and receive LIBOR on a swap that will last n
years starting in T years.
Suppose that
- there are m payments per year under the swap
- the notional principal is L
- the swap rate for an n-year swap at the maturity of the
swaption is s
T
- both s
T
and s
K
are expressed with a compounding
frequency of m times per year
By comparing the cash flows on a swap where the rate is
s
T
to the cash flows on a swap where the fixed rate is s
K
,
we see that the payoff from the swaption consists of a
series of cash flows equal to
( ) 0 , max
K T
s s
m
L

The cash flows are received m times per year for the n
years of the life of the swap.
Suppose that the payment dates are T
1
, T
2
, , T
mn
,
measured in years from today (it is approximately true
that T
i
= T + i/m).
Each cash flow is the payoff from a call option on s
T
with strike price s
K
Using , the value of the
cash flow received at time T is
where s
0
is the forward swap rate and
( ) ) ( ) ( ) , 0 (
2 1 0
*
d N K d N F T P c =
( ) ( ) ( ) [ ]
2 1
0
, 0 d N s d N s T P
m
L
K i

[ ]
[ ]
T d
T
T s s
d
T
T s s
d
K
K

=
+
=
1
2
0
2
2
0
1
2 / / ln
2 / / ln
The total value of the swaption is
Defining A as the value of a contract that pays 1/m at
times T
i
(1 i mn), the value of the swaption
becomes
where
( ) ( ) ( ) [ ]

=
mn
i
K i
d N s d N s T P
m
L
1
2 1
0
, 0
( ) ( ) [ ]
2 1
0
d N s d N s A L
K

( )

=
=
mn
i
i
T P
m
A
1
, 0
1
If the swaption gives the holder the right to receive a
fixed rate of s instead of paying it, the payoff from the
swaption is
This is a put option on s
T
. As before, the payoffs are
received at times T
i
(1 i mn).
Since the value
of the swaption is
( ) 0 , max
T K
s s
m
L

[ ] ) ( ) (
1 0 2
d N s d N s A L
K

( )[ ] ) ( ) ( , 0
1 0 2
*
d N F d N K T P p =
Example
Suppose that the LIBOR yield curve is flat at 6% per
annum with continuous compounding.
Consider a swaption that gives the holder the right to
pay 6.2% in a three-year swap starting in five years.
The volatility for the swap rate is 20%.
Payments are made semiannually
The principal is $100
In this case:
[ ]
0035 . 2
e e e e e e
2
1
8 06 . 0 5 . 7 06 . 0 7 06 . 0 5 . 6 06 . 0 6 06 . 0 5 . 5 06 . 0
=
+ + + + + =

A
A rate of 6% per annum with continuous compounding
translates into 6.09% with semiannual compounding.
In this example: s
0
= 0.0609, s
K
= 0.062, T = 5, s = 0.2,
so that
The value of the swaption is
( )
2636 . 0 5 2 . 0
1836 . 0
5 2 . 0
2 / 5 2 . 0 062 . 0 / 0609 . 0 ln
1 2
2
1
= =
=
+
=
d d
d
( ) ( ) [ ]
( ) ( ) [ ]
07 . 2 $
2636 . 0 062 . 0 1836 . 0 0609 . 0 0035 . 2 100
2 1
0
=
=

N N
d N s d N s A L
K