Financial Derivatives

Chapter 1: Introduction to derivatives: Derivatives are financial instruments whose returns are derived from those of other financial instruments with the aim of hedging financial risks. That is, their performance depends on how other financial instruments perform. Derivatives serve a valuable purpose in providing a means of managing financial risk. **All derivatives are priced based on arbitrage theory. The derivative is priced in a way that makes no room for arbitrage. Arbitrage is to make riskless profit, but investment is associated always with risk. Financial Instrument: a contract between two parties that gives a claim for one party to future cash flows, its an asset & liability at the same time and has a market price. An asset is an item of ownership having positive monetary value. A liability is an item of ownership having negative monetary value. A security is a tradable instrument representing a claim on a group of assets. A contract is an enforceable legal agreement. Business risk vs. Financial risk: Business risks are risks are related to the underlying nature of the business and deal with such matters as the uncertainty of future sales or the cost of inputs. On the other hand Financial risks are risks deals with uncertainties such as interest rates, exchange rates, stock prices, and commodity prices. Derivatives can be based on real assets, which are physical assets and include agricultural commodities, metals, and sources of energy. And they can be also based on financial assets which are stocks, bonds/loans, and currencies. Cash markets or spot markets the markets for assets, purchases and sales require that the underlying asset be delivered either immediately or shortly thereafter. Payment usually is made immediately, although credit arrangements are sometimes used. The sale is made, the payment is remitted, and the good or security is delivered. On the other hand, Derivative markets are markets for contractual instruments whose performance is determined by the way in which another instrument or asset performs and the good or security is to be delivered at a later date. Derivative Instruments:
1. Forwards:

Forward: a forward is a deal between two parties to buy or sell an underlying asset sometime in the future at a price agreed upon today. This is an OTC type of deals and is binding for both parties. Forward contract can be customized. OTC -Over The Counter- means that they have no physical facilities for trading; there is no building or formal corporate body organized as the market, an over-the-counter market consisting of direct communications among major financial institutions.

Financial Derivatives
Any OTC agreement has credit risk- The risk of borrower's failure to meet a contractual obligation **Forward price of a Forward contract for currencies exchange is based on interest rate differential between two currencies. In other words, forward rate must equate the interest rate differential between two currencies so that there would be NO room for arbitrage. ISDA: International Swap & Derivatives agreement: sort of regulation on OTC agreements between banks.
2. Future Contract:

Future contract: is similar to forward contract-is also a contract between two partiesa buyer and a sellerto buy or sell something at a future date at a price agreed upon today-, But futures are exchange traded which means that its guaranteed against the risk that either party might default, is subject to a daily settlement procedure, standardized (specific quantities& dates), have listing requirements, all commodities have future contracts In the daily settlement, investors who incur losses pay the losses every day to investors who make profits. Futures prices fluctuate from day to day, and contract buyers and sellers attempt both to profit from these price changes and to lower the risk of transacting in the underlying goods.
3. Swap:

A swap is a deal between two parties to exchange a series of future cash flows linked to an underlying asset or a benchmark, exclusively over-the-counter. Interest rate swaps make up more than half of the over-the-counter derivatives market. LIBOR: London Interbank Offered Rate: is the average interest rate that leading banks in London charge when lending to other banks. Floating Interest Rate; An interest rate that is allowed to move up and down with the rest of the market or along with an index, A floating interest rate can also be referred to as a variable interest rate because it can vary over the duration of the debt obligation. This contrasts with a fixed interest rate, in which the interest rate of a debt obligation stays constant for the duration of the agreement. Fixed-For-Floating Swap: An advantageous arrangement between two parties (counterparties), in which one party pays a fixed rate, while the other pays a floating rate. Through an interest rate swap, each party can swap its interest rate with the other to obtain its preferred interest rate

Financial Derivatives

4. Options:

An option is a contract between two parties holder (buyer) & writer (seller) that gives the holder, the right but not the obligation to buy call or sell put an underlying asset sometime in the future at a price called exercise price agreed upon today and for that right the holder pays a premium. An option to buy something is referred to as a call; an option to sell something is called a put. *Options are the only derivative tools that are exchange traded and OTC. Important concepts in derivative markets:
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Risk Preference:

Risk aversion vs. risk neutrality: risk neutral, meaning that investors are indifferent to the risk, on the other hand, risk averse is a description of an investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk. Although most individuals are indeed risk averse, it may surprise you to find that in the world of derivative markets, we can actually pretend that most people are risk neutral.
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Short Selling:

A typical transaction in the stock market involves one party buying stock from another party. It is possible, however, that the party selling the stock does not actually own the stock. That party could borrow the stock from a broker. That person is said to be selling short or, sometimes, shorting. He is doing so in the anticipation of the price falling, at which time the short seller would then buy back the stock at a lower price, capturing a profit and repaying the shares to the broker. A short seller views the stock as being worth less than the market price. Establishing a short position creates a liability. The short seller is obligated to someday buy back the stock and return it to the broker. Short selling, however, can be quite beneficial in that the risk of short positions can be useful in offsetting the risk of long positions. Downward markets Upward markets
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go short go long

Repurchase agreement:

A repurchase agreement (known as repos) is a legal contract between a seller and a buyer; the seller agrees to sell currently a specified asset to the buyeras well as buy it back (usually) at a specified time in the future at an agreed future price. The seller is effectively borrowing money from the buyer at an implied interest rate.

Financial Derivatives
Return and Risk Return: a measure of an investments performance and represents an increase in investors wealth. Dollar return measures investment performance as total dollar profit or loss. Percentage return It represents the percentage increase in the investors wealth that results from making the investment. Risk: the uncertainty of future outcomes. The return investors expect is composed of the risk-free rate and a risk premium.
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Risk-return trade-off arises because all investors seek to maximize expected return subject to a minimum level of risk.

An efficient market is one in which the price of an asset equals its true economic value, which is called the theoretical fair value. Spot and derivative markets are normally quite efficient. ****Arbitrage and the Law of One Price Arbitrage: is a process where the arbitrageur attempts to make riskless profits in the cases where the asset is priced differently in two markets. *****The following example is extremely important, is there an arbitrage opportunity or not??:

Theres an arbitrage opportunity

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Financial Derivatives
1st: weve to know which stock is overpriced and which one is underpriced, S1 is overpriced and S2 is under priced

****Markets ruled by the law of one price have the following four characteristics: Investors always prefer more wealth to less. Given two investment opportunities, investors will always prefer one that performs at least as well as the other in all states and better in at least one state. o If two investment opportunities offer equivalent outcomes, they must have equivalent prices. o An investment opportunity that produces the same return in all states is risk-free and must earn the risk-free rate.
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***The Role of Derivative Markets: Derivative markets provide a means of managing risk, discovering prices, reducing transaction costs, improving liquidity, selling short, and promoting a more efficient market.
1. Risk Management:

Because derivative prices are related to the prices of the underlying spot market goods, they can be used to reduce or increase the risk of owning the spot items. Derivative market participants seeking to reduce their risk are called hedgers. Hedgers use derivatives to get rid of risk that their business imposes on them. Derivative market participants seeking to increase their risk are called speculators. Speculators use derivative to assume risk voluntarily in the hope of realizing returns, setting risk to an acceptable level through the use of derivative. On the other side of hedging is speculation. Unless a hedger can find another hedger with opposite needs, the hedgers risk must be assumed by a speculator. Derivative markets provide an alternative and efficient means of speculating.
2. Price Discovery:

Forward and futures markets are an important source of information about prices, Futures markets, in particular, are considered a primary means for determining the spot price of an asset. o Advertisement of future items allows it to be used in pricing spot items.
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Future prices indicate what market participants expect the future spot price to be Derivative provide very valuable information about the volatility of the underlying asset

Financial Derivatives
3. Operational Advantages a. b. c.

Transaction costs are lower than spot market Liquidity is higher than spot market Ease of short selling as compared to the spot market

4. Market efficiency

Arbitrageurs are constantly on the search of inefficiencies and their exploitation of these inefficiencies eliminates them and benefits the economy. The ease and low cost of transacting in these markets facilitate the arbitrage trading and rapid price adjustments that quickly eradicate these profit opportunities. Criticisms of Derivative Markets: Zero Sum Game
1. Zero sum game: Unlike financial markets, derivative markets neither create nor

destroy wealththey merely provide a means to transfer risk. 2. Speculation: Derivative markets allow the transfer of risk from those wanting to remove or decrease it to those wanting to assume or increase it. These markets require the presence of speculators willing to assume risk to in order to accommodate the hedgers wishing to reduce it. 3. Comparison to gambling
4. Counter argument o Derivatives -unlike the stock market- neither create nor destroy wealth. It merely

transfers risk o Gambling only benefits participants and few other indirectly. Derivatives benefits the economy and provides better opportunities in managing risk. Misuses of Derivatives: o High leverage: huge gains and losses from small price changes o Inappropriate use: The temptation to speculate when one should be hedging is a risk that even the knowledgeable often succumb to.

All derivatives are based on the random performance of something. Identify and discuss this something.

Financial Derivatives

Chapter 2: Options: Call Options: A call option is an option to buy an asset at a fixed pricethe exercise price. A call in which the stock price exceeds the exercise price is said to be in-the-money (S>X). If the stock price is less than the exercise price, the call option is said to be out-of-the-money (S<X). Out-of-the-money calls should never be exercised. If the stock price equals the exercise price, the option is at-the-money. Either the call buyer or writer may have been using the option to protect a position in the stocka strategy called hedging. Suppose that immediately after a call is purchased, the stock price increases. Because the exercise price is constant, the call option is now more valuable. New call options with the same terms will sell for higher premiums. Therefore, older call options with the same expiration date and exercise price must also sell for higher premiums. Similarly, if the stock price falls, the calls price also will decline. Clearly the buyer of a call option has bullish expectations about the stock. Put Options: A put option is an option to sell an asset, such as a stock. Since the put allows the holder to sell the stock for a fixed price, a decrease in the stock price will make the put more valuable. Conversely, if the stock price increases, the put will be less valuable. It should be apparent that the buyer of a put has bearish expectations for the stock. The put buyer expected the stock price to fall, while the writer expected it to remain the same or rise. Since the put allows the holder to sell the stock for a fixed price, a decrease in the stock price will make the put more valuable. Conversely, if the stock price increases, the put will be less valuable. It should be apparent that the buyer of a put has bearish expectations for the stock. Characteristics of well organized traded options: An exchange is a legal corporate entity organized for the trading of securities, options, or futures. It provides a physical facility and specifies rules and regulations governing the transactions in the instruments trading thereon. In the options markets, organized exchanges evolved in response to the lack of standardization and liquidity of over-thecounter options.
1. Listing Requirements: 7

Financial Derivatives
The options exchange specifies the assets on which option trading is allowed. The exchange also specifies minimum requirements that a stock must meet to maintain the listing of options on it. o All options of a particular typecall or puton a given stock are referred to as an option class. An option series is all the options of a given class with the same exercise price and expiration.
o 2. Contract Size: standardized size, an exception to the standard contract size occurs

when either a stock splits or the company declares a stock dividend.

3. Exercise Prices: On options exchanges the exercise prices are standardized.

Exchanges prescribe the exercise prices at which options can be written. Investors must be willing to trade options with the specified exercise prices. Of course, over-thecounter transactions can have any exercise price the two participants agree on.
4. Expiration Dates: Expiration dates of over-the-counter options are tailored to the

buyers and writers needs. On the options exchanges, each stock is classified into a particular expiration cycle. The expiration cycles are (1) January, April, July, and October; (2) February, May, August, and November; and (3) March, June, September, and December. These were called the January, February, and March cycles.
5. **Position and Exercise Limits: The purpose of position and exercise limits is to

prevent a single individual or group from having a significant effect or control on the market. Position limits that define the maximum number of options an investor can hold on one side of the market. For example, because they are both bullish strategies, a long (buyer) call and a short (seller) put on the same stock are transactions on the same side of the market. An exercise limit is the maximum number of options that can be exercised on any five consecutive business days by any individual or group of individuals acting together. Option traders:
1. Market Maker: is responsible for meeting the publics demand for options. When

someone from the public wishes to buy (sell) an option and no other member of the public is willing to sell (buy) it, the market maker completes the trade. This type of system ensures that if a private investor wishes to buy a particular option, there will be a seller willing to make an offer, and if one buys an option and later wants to sell it, there will be a buyer available. The market maker offers the public the convenience of immediate execution of trades. The market maker is essentially an entrepreneur. To survive, the market maker must profit by buying at one price and selling at a higher price. One way this is done is by quoting a bid price and an ask price. The bid price is the maximum price the market maker will pay for the option. The ask price is the minimum price the market maker will accept for the option. The ask price is set higher than the bid price. The difference between the ask and bid price is called the bid-ask spread.

Financial Derivatives
2. Floor Broker: The floor broker executes trades for members of the public. The floor

broker executes orders for nonmembers and earns either a flat salary or a commission on each order executed, a good broker will work diligently to obtain the best price for the customer.
3. Order Book Official: (OBO) or board broker, an employee of the exchange. 4. Registered option traders (ROTs), who buy and sell options for themselves or act

as brokers for others.

5. Off-Floor Option Traders

Mechanism of trading: An individual who wants to trade options must first open an account with a brokerage firm. The individual then instructs the broker to buy or sell a particular option. The broker sends the order to the firms floor broker on the exchange on which the option trades. A market order instructs the floor broker to obtain the best price. Role of the Clearinghouse: After the trade is consummated, the clearinghouse enters the process. The clearinghouse, formally known as the Options Clearing Corporation (OCC), is an independent corporation that guarantees the writers performance.
a. Buyer and seller instruct their respective brokers to conduct an options transaction. b. Buyer's and seller's brokers request that their firms' floor brokers execute the

transaction. c. Both floor brokers meet in the pit on the floor of the options exchange and agree on a price. d. Information on the trade is reported to the clearinghouse. e. Both floor brokers report the price obtained to the buyer's and seller's brokers. f. Buyer's and seller's brokers report the price obtained to the buyer and seller. g. Buyer deposits premium with buyer's broker. Seller deposits margin with seller's broker. h. Buyer's and seller's brokers deposit premium and margin with their clearing firms. i. Buyer's and seller's brokers' clearing firms deposit premium and margin with clearinghouse.

An American option can be exercised on any day up through the expiration date. European options can be exercised only on the expiration date.
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Financial Derivatives
The Securities and Exchange Commission (SEC) is the primary regulator of the options market in the U.S; oversee the securities industry, which includes stocks, bonds, options, and mutual funds. The SECs general purpose is to ensure full disclosure of all pertinent information on publicly offered investments. It has the authority to establish certain rules and procedures and to investigate possible violations of federal securities laws. The primary purpose of the exchange-traded regulatory system is to protect the public. The bid-ask spread is the cost of immediacythe assurance that market makers are willing and able to buy and sell the options on demand.

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Financial Derivatives
Explain the difference between an American option and a European option. What do they have in common?

Chapter 3: Principals of option pricing: Because a call option need not be exercised, its minimum value is zero. The expression Max (0, S0 X) means Take the maximum value of the two arguments, zero or S0 X. o The maximum value of a call is the price of the stock o A longer-lived American call must always be worth at least as much as a shorterlived American call with the same terms. o An option with the stock price near the exercise price is like a close game. A deep-in or out-of-the-money option is like a game with one team well ahead. A close game and an option nearly at-the-money are situations to which people are more willing to allocate scarce resourcesfor example, time to watch the game or money to buy the option. o The time values increase with the time to expiration. For a given time to expiration, the time values are highest for the calls with an exercise price of 125, the exercise price closest to the stock price. o The price of a European call must be at least as high as the price of an otherwise identical European call with a higher exercise price. o The price of an American call must be at least as high as the price of an otherwise identical American call with a higher exercise price. o The difference in the prices of two European calls that differ only by exercise price cannot exceed the present value of the difference in their exercise prices. o The difference in the prices of two American calls that differ only by exercise price cannot exceed the difference in their exercise prices. o The price of a European call must at least equal the greater of zero or the stock price minus the present value of the exercise price. o For European calls, a longer-lived call will always be worth at least as much as a shorter-lived call with the same terms. o An American call will be at least as valuable as a European call with the same terms. o The price of a call is directly related to the volatility of the underlying stock. o At expiration the call price is its intrinsic value
o o

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Financial Derivatives

Chapter 4: Binominal Model: two-state model two outcomes or states, one period The one-period binomial option pricing formula provides the option price as a weighted average of the two possible option prices at expiration, discounted at the riskfree rate. o An option is priced by combining the stock and option in a risk-free hedge portfolio such that the option price can be inferred from other known values. o Riskless portfolio is called a hedge portfolio; a riskless portfolio should earn the riskfree rate. o If the call were overpriced, a riskless hedge could generate a riskless return in excess of the risk-free rate. o A riskless portfolio that will earn more than the risk-free rate violates the law of one price.
o o

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