Introduction

OPTIONS, FUTURES AND OTHER DERIVATIVE INSTRUMENTS

Chapter 1 in

Fundamentals of Futures and Options Markets,

John C. Hull, Prentice Hall

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Nature of Derivatives or contingent claims

A derivative is an instrument whose value depends on the values of other more basic underlying variables

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Types of derivatives
Options Forward Futures Swaps Convertibles bonds Interest rate caps ...

similarities, differences, links

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

History
Futures Trading may go back to 2000 B.C. in India. 600 B.C. Options on olives (Greece) 1730 Rice Futures traded in Osaka (Japan) Organised Forward markets in Europe (17th Century) Modern Futures Trading started in 19th Century U.S.A., Chicago Grain Market.

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Boom in derivatives trading in the 70's

Abandonment of Bretton Woods Agreement on fixed exchange rates. Increased Interest Rate Volatility Increased Commodity Price Volatility (e.g. oil, gold)

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Introduction
The business world is confronted with greater financial price risk Need for financial risk management Eliminate Risk Forecast future prices: nearly impossible Manage/Transfer/Hedge Risk Arbitrage profit

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Building Blocks
A Futures contract, or a swap is a package of forwards Option is a package of a forward and a riskless security A Forward is a package of options similarities, differences, links
Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Futures & Forward Contracts

A futures or a forward contract is an agreement to BUY or SELL an asset at a certain time in the future for a certain price Examples
Agreement to buy 100 oz. of gold @ US$400/oz. in December Agreement to sell 62,500 @ 1.5000 US$/ in March Earn a 4% rate of interest on a US$ deposit for a 3-month period starting in 6 months

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Futures & Forward Prices

The futures or forward price for a particular contract is the price at which you agree to buy or sell, that is, the delivery price applicable to that contract today It is different for contracts of different maturities Normally the price in the contract is chosen so that the contracts initial value is 0

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Futures & Forward Prices

A future price
is determined by supply and demand on the floor of the exchange (futures) in the same way as a spot price is reported in the financial press

A forward price
is determined by an over-the-counter (OTC) agreement between two parties
Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Futures & Forwards

Forwards All characteristics are negotiable (maturity, size) Counter-part risk (default risk) Futures Exchange traded Standardized
Guaranteed by the exchange (no default risk) Liquidity risk
Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Characteristics of a Futures Contract

It is traded on an exchange market The party that has agreed to: BUY has what is termed a LONG position SELL has what is termed a SHORT position It costs nothing to enter (initial value is 0) Other issues settlement procedure, margins, delivery procedure, ...
Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Futures Contract
Unlimited profit Limited profit

X X

Limited loss

Unlimited loss

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Futures Contract

long

short

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Example
January: an investor enters into a long futures contract to buy 100 oz of gold @ $400 in April
April: the price of gold $415 per oz April: the price of gold $388 per oz

What is the investors profit/loss?

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Options Contracts
An OPTION is a contract between two parties which gives one, the holder, the right to buy or to sell the underlying asset by a certain date for a certain price A CALL option is an option to BUY A PUT option is an option to SELL Therefore he has to pay a premium

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Options contracts
European option
can be exercised only on the maturity date

American option
can be exercised at any time during its life

Price in the contract

exercise price strike price

It costs to enter into an options contract

Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Options contracts
Participants in options markets:
Buyers of calls (holder, owner) LONG POSITION Sellers of calls (writer) SHORT POSITION Buyers of puts (holder, owner) LONG POSITION Sellers of puts (writer) SHORT POSITION

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Call Option Relations

strike price
IN THE FUTURE*

transfer of underlying assets call option holder - right to buy call option writer - obligation to sell -

TODAY

creation of option by selling right to option holder premium

* if option holder decides to exercise

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Put Option Relations

strike price
IN THE FUTURE*

transfer of underlying assets put option holder - right to sell put option writer - obligation to buy -

TODAY

creation of option by selling right to option holder premium

Aline Muller HEC Management School of the University of Lige 2011-2012

* if option holder decides to exercise

Options, Futures and other Derivative Securities

Introduction

Call option
Unlimited profit

Call option on one (hundred) IBM share.

Limited loss = premium

Option price C = $5 Strike price K=$140

Owner, buyer long position

Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Call option
Limited profit = premium

Call option on one (hundred) IBM share. Option price C = $5 Strike price K=$140
Unlimited loss

Writer, seller short position

Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Put option
Unlimited profit

Put option on one (hundred) Exxon share.

Limited loss = premium

Option price P = $7 Strike price K=$90

Buyer, owner long position

Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Put option
Limited profit = premium

Put option on one (hundred) Exxon share. Option price P = $7 Strike price K=$90

Unlimited loss

Writer, seller short position

Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Futures versus Options

A FUTURES contract gives the holder the OBLIGATION to buy or sell at a certain price An OPTION gives the holder the RIGHT to buy or sell at a certain price

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Payoff of call
Buyer
max(St-X,0)

Writer
-max(St-X,0) = min(X-St,0)

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Payoff of put
Buyer
max(X-St,0)

Writer
-max(X-St,0) = min(St-X,0)

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Participants (in the futures and options game)

Hedgers

want to reduce/eliminate risk want to take on risk for suitable compensation provide liquidity in exchange for bid/ask spread try to profit from pricing inconsistencies

Speculators

Market makers Arbitrageurs

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Motivation
To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another These motives were also the causes of the rapid development of the derivatives markets in the 70's.
Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Hedging using Futures

Current exchange rate of the September futures price Size of futures contract 1.6920 1.6850 62,500

In July, Company A knows she must pay 1 million in September for imports: Long position in 16 futures contracts. This locks in an exchange rate of 1.6850 In July, Company B knows she must receive 3 million in September for exports: Short position in 48 futures contracts. This locks in an exchange rate of 1.6850

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

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Introduction

Hedging Using Options

Current spot price of DELL shares DELL October 150 Put (size=100 shares) In August, an investor owns 500 shares and wants protection against decline over the next 2 months He buys 5 put option contract (Cost: $2000)
Outcome if October spot price Shares (in thousands) Put (in thousands) Portfolio (in thousands)
Options, Futures and other Derivative Securities

$152 $4

130 65 10 75

150 75 0 75

160 80 0 80

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Value of DELL Shares with / without Hedging

200,000 Value of Holding ($)

150,000 No Hedging 100,000 73,000 Hedging

Stock Price ($) 0 0 100 200 300 400

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Speculation Using futures

Feeling that will strengthen relative to the $ Current (February) exchange rate 1.6470 April futures price 1.6410

Strategies

Buy 250,000 for $411,750, deposit the in an account. Go long in 4 futures contracts to buy 250,000 for $410,250 in April

Outcomes

Exchange rate in April buy and deposit long futures

1.600 -11,750 -10,250

1.700 13,250 14,750

when interest rates are taken into account both strategies yield the same profit or loss
Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

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Introduction

Speculation Using Options

In September a speculator with $7,800 to invest thinks that the price of Exxon will increase:
Current stock price Exxon December call with an 80 strike $78 $3

Alternative Strategies
Buy 100 shares of Exxon Buy 2,600 December call options (26 contracts)

Outcomes if share price

shares call options

90
1,200 18,200

70
-800 -7,800

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

No-Arbitrage Pricing
NOW (time t) MATURITY (time T)

Portfolio A
Must be equal, o/w arbitrage

No intermediate cash flows

Portfolio B

Portfolios have same final value

Or, Portfolio = 0 at time t Portfolio = 0 at time T

Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Arbitrage
Profit without any risk Stock traded on NYSE and LSE
Quotes NYSE LSE value $172 100 $1.75

Arbitrage strategy

buy 100 shares on NYSE at $172 sell 100 shares on LSE at 100 convert 10,000 into $17,500

Profit: $17,500 - 17,200 = $300 Arbitrage opportunities cannot last for long
Options, Futures and other Derivative Securities Aline Muller HEC Management School of the University of Lige 2011-2012

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Introduction

Gold: An Arbitrage Opportunity?

Suppose that: The spot price of gold is US$390 The quoted 1-year futures price of gold is US$425 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

Introduction

Oil: An Arbitrage Opportunity?

Suppose that: The spot price of oil is US$19 The quoted 1-year futures price of oil is US$25 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity?

Options, Futures and other Derivative Securities

Aline Muller HEC Management School of the University of Lige 2011-2012

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