Chapter 4: Derivative assets: properties and pricing

Chapter 4: Derivative assets: properties

and pricing

Aim of the chapter

The aim of this chapter is to introduce and price derivatives. As in the
previous chapter on APT, the valuation of derivatives relies on a no riskless
arbitrage argument.

Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
• discuss the main features of the most widely traded derivative securities
• describe the pay-off profiles of such assets
• understand absence-of-arbitrage pricing of forwards, futures and swaps
• construct bounds on option prices and relationships between put and
call prices
• price options in a binomial framework using the portfolio replicating
and the risk-neutral valuation methods.

Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapters 7 and 8.

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 21, 22 and 23.
Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 8 and 9.

Overview
A derivative asset is one whose pay-off depends entirely on the value of
another asset, usually called the underlying asset. In the last 20 years,
traded volume in these assets has increased tremendously. Derivatives
are widely used for hedging purposes by financial institutions and are
also used for speculative purposes. In this chapter we discuss the most
commonly traded types of derivative. We go on to introduce the underlying
principles of derivative pricing. We devote the final section of the chapter
to a more detailed description of the features and pricing of options.

Varieties of derivatives
Forwards and futures
Perhaps the oldest type of derivative asset is the simple forward
contract. A forward is an agreement between two parties (called A and
B) and has the following features.
1. Party A agrees to supply party B with a specified amount of a specified
asset, k periods in the future.
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2. In return, party B agrees to pay party A $F (the forward price) when

the goods are received.
Party A is said to hold a short position in the contract and party B a
long position.
Hence, the forward is just an agreement made today to undertake a given
transaction at some specified future date, known as the settlement
date. Currency and commodities are often traded using forwards, the
advantage of such transactions being that they allow an agent to remove
any price uncertainty regarding a transaction that must be undertaken in
the future.

Example
Assume that party B is American and that in three months he must pay ¥250,000 for a
Japanese machine he has purchased. Party B enters into a contract to buy yen three months
forward. Party A (the agent who is to supply the yen) specifies that the cost of ¥100 will be
$1.20. The total price that party B must pay in three months is therefore $3,000.

Closely related to forward contracts are futures contracts. In fact,

futures are refined versions of forwards. Although forwards are generally
bilaterally negotiated between two parties directly, futures are standardised
forward contracts that are exchange traded. The contracts give precise
specifications for the quality and quantity of the assets to be exchanged.
The major difference between futures and forwards is in the exchange of
monies involved. With a forward, the agent who is long pays the entire
forward price at the settlement date. Futures positions, however, are
marked to market. This occurs on a daily basis and means that any
increases/decreases in the value of the future are received/paid by the
party who is long day by day. At the settlement date, the current spot price
of the asset is transferred from the agent who is long to the agent who is
short.1 1
See pp.236–40 in
Grinblatt and Titman
Futures are traded on exchanges such as the London International (2002).
Financial Futures and Options Exchange (LIFFE), the Chicago Board of
Trade (CBOT) and the Chicago Mercantile Exchange (CME). Contracts
with very high volumes include those on government bonds, interest rates
and stock indices.

Options
The option is a less straightforward type of derivative. Although the
forward or future contract implies an obligation to trade once the contract
is entered into, the option (as its name suggests) gives the agent who is
long a right but not an obligation to buy or sell a given asset at a pre-
specified price. This price is known as the exercise price and is specified
in the option contract. Just as with the forward, another factor specified
in the contract is the date on which the exchange is to take place. If, on
the maturity date, the holder of an option decides to buy or sell in line
with the terms of the contract, he or she is said to have exercised his or
her right. A big difference between options and forwards is that, with an
option, the agent who is long must pay a price (or premium) at the outset.
This is essentially a price paid by the holder for the exercise choice he or
she faces at maturity.
Options to buy the specified asset are called call options. Options to sell
are called puts. Another distinction is made on the timing of the exercise
decision. With European options, the right can only be exercised on the

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 Chapter 4: Derivative assets: properties and pricing

maturity date itself. With American options, in contrast, the option can be
exercised on any date at or before maturity. American options are traded
far more frequently than their European counterpart, but for reasons of
simplicity, we will focus on the European variety.

Example
A 12-month European call option on IBM has exercise price $45. It gives me the right
to purchase IBM stock in one year at a cost of $45 per share. In line with the prior
discussion, I am under no obligation to buy at $45 such that, if the market price were less
than this amount, I could choose not to exercise and buy in the market instead.

Swaps
Swaps are another type of derivative, which do exactly what their name
says. Two counterparties agree to exchange (or swap) periodic interest
payments on a given notional amount of money (the notional principal)
for a given length of time.
A very common type of swap involves an exchange of interest payments
based on a market-determined floating rate (such as the London InterBank
Offer Rate (LIBOR)) for those calculated on a fixed-rate basis. Another
frequently traded variety of swap involves the exchange of interest
payments in different currencies. For example, fixed sterling interest
payments may be exchanged for fixed dollar interest payments.2 2
The notional principal
is not exchanged in an
interest rate swap (they
Derivative asset pay-off profiles would net out anyway)
but are generally
For now we are going to concentrate on forwards and options. As exchanged in currency
mentioned above, futures are closely related to forwards, and their pricing swaps.
is based on the technique presented below. The relationship between
forwards and swaps will be made clear later.
Before getting on to the principles of derivative pricing, let us take a look
at the pay-off profiles of the basic forward and option contracts. The pay-
off profile of a long forward position is shown in Figure 4.1. In the figure,
F is the price agreed upon in the forward contract, and S is the spot price
of the asset at the settlement date. Note that the pay-off profile is linear,
positive for values of S greater than F and negative when S is less than F.

Figure 4.1

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Understanding the forward pay-off is simple. If the spot price for the asset
at maturity exceeds the forward price, then the party that is long has
gained by entering into the forward (i.e. he’s got the asset for a lower price
than it would have cost if bought in the spot market). If the spot price at
maturity is lower than the forward price, then the long pay-off is negative,
as it would have been cheaper for the long party to buy the asset in the
spot market rather than entering into the forward. Obviously, the pay-off
of a short forward position is the negative of that shown in Figure 4.1.
Let’s now consider the pay-off to a holder of a European call option.
This is given in Figure 4.2 where the option’s exercise price is labelled
X. Remember that a call option gives the holder the right but not the
obligation to purchase the asset. What occurs when the price of the
spot asset at maturity exceeds the exercise price of the option? Well it is
cheaper to buy the asset using the option than in the spot market; hence
the option is exercised, and the holder makes a gain of the spot price less
the exercise price. When the spot price is lower than the exercise price,
then the holder would find it cheaper to buy the asset at spot and hence
does not exercise the option. The pay-off to the holder is then zero.

Figure 4.2
The pay-off to the holder of a European put is given in Figure 4.3. As the
put gives the holder the right to sell the underlying asset, the holder gains
when the exercise price exceeds the spot price and has a zero pay-off when
the spot price at maturity is greater than or equal to the exercise price.

Figure 4.3

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 Chapter 4: Derivative assets: properties and pricing

Each option must have one agent who is long and one who is short, with
the pay-offs to the long position given in Figures 4.2 and 4.3. An agent
who is short is said to have written the option, and his or her pay-offs
are the negative of those given above. Note that an agent with a long
option position never has a negative pay-off, whereas an agent who has
written an option never has a positive pay-off at maturity. The option
price, paid at the outset by the agent who is long to that who is short, is
the compensation to the writer of the option for holding a position that
exposes him or her to weakly negative cash flows.
The key to pricing options, and other derivative assets, is constructing
a portfolio of assets that is priced in the market and that has a pay-
off structure identical to that of the derivative. As the derivative and
replicating portfolio have identical pay-offs, absence-of-arbitrage
arguments imply that the cost of these portfolios must be identical. The
no-arbitrage price of the derivative is hence just the initial investment cost
needed to set up the replicating portfolio.

Pricing forward contracts

In the case of a forward contract, the derivation of the no-arbitrage price
is quite simple.3 Assume the current spot asset price is S0 and that the one- 3
Given the similarities
period, riskless rate of interest is r. We wish to value a k period forward discussed previously,
we can also use the
contract. It is easily verified that the k-period forward price (Fk) is given by
derived forward price to
the following expression: approximate the price of
Fk = S0(1 + r)k. (4.1) a futures contract.

Why is this the case? Well, consider the following pair of investment
strategies.
• The first is simply a long position in the forward contract. This costs
nothing at the present time and yields Sk – Fk at maturity.
• The second strategy involves buying a unit of the asset at spot and
borrowing Fk(1+r)–k at the risk-free rate for k periods. The k period pay-
off of this strategy is also Sk – Fk, and its net current cost is S0 – Fk(1+r)–k.
The pay-offs of the two strategies are identical. This implies that the two
investments should have identical costs. As the cost of investment in the
forward is zero, this implies that the following condition must hold:
S0 – Fk(1+r)–k = 0. (4.2)
Rearranging equation 4.2 we derive the no-arbitrage price for the k period
forward contract, which is precisely that given in equation 4.1.

Activity
The current value of a share in Robotronics is $12.50.
1. The one-year riskless rate is 6 per cent. What are the prices of three- and five-
year forward contracts on Robotronics stock?
2. Three-year forward contracts are currently being sold for $16 in the market.
Outline an investment strategy that could take advantage of the opportunities
this presents.

Some of the most active forward markets are those for foreign currency.
The forward pricing analysis above, however, is suited only for assets
valued in the domestic currency (e.g. individual stocks or stock indices).
To illustrate the pricing of currency forwards, consider the following

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analysis. A domestic investor (assumed to be located in the UK such that

the domestic currency is £) is assumed to face a spot exchange rate of
S and a k period forward rate of Fk. These rates are constructed as the
domestic currency price of one unit of foreign currency (i.e. the spot rate
implies an exchange rate of £S for $1). The one-period domestic interest
rate is denoted r and its foreign counterpart rf .
Again, let us compare two investment strategies that can be undertaken
assuming an investor currently holds £S. The first involves depositing this
cash in a domestic risk-free account for k periods. This yields £ S(1+r)k at
the maturity date of the investment. Alternatively, the investor could swap
his or her sterling for dollars at the spot exchange rate and invest the funds
at the US rate. As his or her £S is equivalent to $1 at the spot exchange
rate, this investment yields $ (1+rf)k in k periods. The investor can then sell
the proceeds for sterling using a forward contract yielding £ Fk(1+rf)k.
Note that both of these investments are riskless, assuming that the interest
rates are known and fixed and given that the spot and forward exchange
rates are known at the current date. Further, both investments cost £S.
This implies that the pay-offs from the two strategies should be identical.
Equating these returns we get:
S(1 + r)k = Fk(1 + rf )k. (4.3)
Rearranging equation 4.3, we get the no-arbitrage k period currency
forward price:

( (
1+r k
Fk = S 1 + r .
f
(4.4)

Note the simple generalisation of equation 4.1 implicit in equation 4.4.

The gross interest rate in equation 4.1 is just replaced by the ratio of
domestic to foreign rates in equation 4.4. In the international finance
literature, the currency forward rate expression in 4.4 is known as the
covered interest rate parity relationship.

Activity
The current spot exchange rate is £0.64 = $1. The riskless rate in the UK is currently 6
per cent and that in the US is 4 per cent. Using equation 4.4, derive the implied five- and
10-year forward exchange rates.

Binomial option pricing setting

Pricing options is far less straightforward than pricing forwards. To begin,
however, we introduce a binomial setting, in which the pricing of options 4
This is where the term binomial
turns out to be surprisingly straightforward. comes from in the name of our
method.
In order to make things as simple as possible, let us consider a binomial
setting in which all derivatives last only for one period (starting today and
ending tomorrow). Let us denote the current price of the underlying asset
by S0. Let us assume that uncertainty in this world is represented by the
price of the underlying asset, taking one of two values tomorrow.4 If the
state of the world is good, the price of the asset will rise tomorrow to SH,
with SH = (1+u)S0 and u>0. In contrast, if the state of the world is bad, the
price of the underlying asset will decrease to SL,, with SL = (1–d)S0 and d>0.
Let us now consider a one-period derivative asset. If the state of the world
is good tomorrow, then the derivative will pay KH, and if the state of the
world is bad tomorrow the derivative will pay KL. Finally we assume that
the one-period risk-free interest rate is rf (i.e. a safe bond costing one unit
of currency pays 1+ rf units of currency tomorrow).

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In order to price this derivate asset, we will consider two different methods:
• the portfolio replicating method
• the risk-neutral valuation method.

The portfolio replicating method

The portfolio replicating method prices the derivative asset using absence-
of-arbitrage arguments. First, this necessitates constructing a portfolio,
containing the underlying asset and the risk-free asset, that has identical
pay-offs to the derivative. Assume we purchase a units of the underlying
asset and b units of the risk-free asset.
If the state of the world tomorrow is good then the value of our portfolio
will be:
aSH + b(1 + rf ), (4.5)
when the pay-off of the derivative is KH. If the state tomorrow is bad the
portfolio is worth:
aSL + b(1 + rf ), (4.6)
and the derivative is worth KL. Note that equating the value of the
portfolio with the pay-off of the derivative in each state of the world
gives us two equations in two unknowns (a and b). These unknowns are
our initial holdings of the underlying and the risk-free asset. Solving the
two equations gives us precisely the portfolio weights we need to use to
replicate the option pay-off in both states of nature. This yields:
KH – KL
a = S – S . (4.7)
H L

and
SLKH – SHKL .
b= (4.8)
(1 + rf )(SL – SH)

We now know how to construct a portfolio, which has a pay-off profile

that replicates that of the derivative (i.e. regardless of the state of the
world, the portfolio and the derivative have the same value). If two assets
have identical pay-offs then absence-of-arbitrage arguments tell us that the
price/cost of the two assets must be identical. The cost of the replicating
portfolio is aS0 + b. It hence follows that:
K0 = aS0 + b. (4.9)
A practical example of how this technique might work for a European call
option is given below.

Example
A one-period European call option on ABC stock has an exercise price of 120. The current
price of ABC stock is 100, and if things go well, the price in the following period will be
150. If things go badly over the coming period, the future price will be 90. The risk-free
rate is 10 per cent. What is the no-arbitrage price of this option?
First we need to know the option pay-offs. In the bad state it pays zero, as the underlying
price is less than the exercise price. In the good state it pays the excess of the underlying
price over the exercise price (i.e. 30).
Next we construct the replicating portfolio. Using equations 4.3 and 4.4, the quantities of 5
You should check
the underlying and risk-free asset we must buy are 0.5 and –40.91 (i.e. we buy half a unit all these calculations
of stock and short 40.91 units of the risk-free asset).5 This portfolio replicates the option and further check that
the portfolio we’ve
pay-off, and therefore the option price is given by the cost of constructing the portfolio.
constructed does indeed
The call price (c) is hence: replicate the option
c = 0.5(100) – 40.91 = 9.09. pay-off.

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Activity
Using the stock price data from the previous example, price a European put option on
ABC stock with a strike price of 100.

The Risk-neutral valuation method

Using the portfolio replicating method, we find that the current price of
the derivative asset, relative to the current price of the underlying asset,
does not depend on the probability that the state of nature will be good
(or bad) tomorrow. Neither does it depend on investor risk preferences.
The reason for this is that information about probabilities or risk aversion
is already captured by the current price of the underlying asset on
which we base our valuation of the derivative asset. The fact that the
no-arbitrage price of the derivative asset in relation to the price of the
underlying asset is the same, regardless of risk preferences, serves as a
basis for a neat trick also known as the risk valuation method.
The risk-neutral valuation method is a procedure involving the following
steps.
1. Identifying the risk-neutral probabilities, that is, the probabilities which
are consistent with investors being risk-neutral. These probabilities are
the probabilities for which the current price of the underlying asset
is the present value of tomorrow’s asset prices, with the discount rate
being equal to the risk-free rate.
2. Calculating the current price of the derivative asset as the present value
of tomorrow’s derivative values using the risk-neutral probabilities
derived in the previous step and the risk-free rate as the discount rate.

Step 1: Obtaining risk-neutral probabilities

Let us denote the risk-neutral probability that the state of nature will be
good tomorrow by q. It hence follows that:
qSH + (1 – q)SL
S0 = . (4.10)
1 + rf
Equivalently, the risk-neutral probability q is given by the following
identity:
S0(1 + rf ) – SL rf + d
q= = . (4.11)
SH – SL u+d

Step 2: Calculating the current price of the derivative asset

The current price of the derivative asset can be expressed as the present
value of tomorrow’s derivative values using the risk-neutral probabilities in
equation 4.11 and the risk-free rate as the discount rate:
qKH + (1 – q)KL
K0 = . (4.12)
1 + rf
After substituting q from equation 4.11, we obtain:
(d + rf )KH + (u – rf )KL
K0 = . (4.13)
(1 + rf )(u + d)

Activity
Using the risk-neutral valuation method, price both a European call option and a
European put option on the ABC stock (introduced in the previous example) with a strike
price of 100.

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 Chapter 4: Derivative assets: properties and pricing

Activity
Show that the current price of the derivative obtained from the portfolio replicating
method in equation 4.9 is the same as the one obtained from the risk-neutral valuation
method in equation 4.13.

Comments on the binomial option pricing setting

The risk-neutral valuation method is very efficient at pricing multiple
derivative assets on the same underlying asset as the same risk-
neutral probabilities can be used to price all the derivatives. In these
circumstances, the portfolio replicating method is more tedious to use as
the replicating portfolio will typically be different for each derivative asset.
The assumptions we have made above may seem very restrictive. We
have restricted tomorrow’s price to take one of two values and assumed
that derivatives last only for one period. Extending the above model to
more than one period is straightforward, and this allows longer maturity
instruments to be priced. Also, we can shrink the length of time that we
have referred to as one period. It could represent one day, one hour or one
minute if we wanted. A binomial model for hourly prices, for example,
may be thought more reasonable than a binomial model for annual prices.
Then, using a multi-period derivative valuation we could price a one-
month option from a binomial model of hourly stock returns. The binomial
structure is not as restrictive as you might think.

Bounds on option prices and exercise strategies

The binomial model allows us to derive option prices under certain
assumptions on the behaviour of the price of the underlying asset. In this
section we present some arguments that place bounds on European option
prices and can be made without specification of a model for the underlying
price. In order to link up with the following section (on Black–Scholes
prices), we will present our arguments using a continuously compounded
risk-free rate, r. We assume unlimited borrowing and lending at this rate
along with our standard frictionless market assumptions of no transaction
costs and taxes. Finally, we also assume that the underlying asset pays out
no cash during the option lifetime (such that the option can’t be written on
dividend paying stock or coupon bonds, for example).

Upper bounds on European option prices

A call option is the right (but not the obligation) to purchase a unit of a
specified asset for price X. It should be obvious to you then that the option
can never be worth more than the stock. Hence, denoting the call option
price by c we have:
c ≤ S. (4.14)
As a European put gives the holder the right to sell a given quantity of
an asset for X, the put can never be worth more than X. Denoting the put
price by p we then have:6 6
Clearly both this and
the previous argument
p ≤ X. (4.15) hold for American
Further, if the put is European, we know that the value at maturity is at options as well as
European options.
most X. If there are T periods to maturity, a present-value argument then
implies that:
p ≤ Xe–rT. (4.16)

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Lower bounds on European option prices

No-arbitrage arguments can be simply employed to develop lower bounds
for European puts and calls. A lower bound for a European call option
price is given by:
c ≥ S – Xe–rT (4.17)
where X is the exercise price, and there are T periods to maturity. To show
this, consider the following argument. Assume I hold two portfolios.
Portfolio A consists of a European call option struck at price X, plus cash of
the amount Xe–rT. Portfolio B consists of the underlying stock.
Assume I invest the cash from portfolio A at the risk-free rate. This implies
that, when the option in portfolio A matures, I have cash worth X. If
at maturity the underlying price (ST) exceeds the exercise price, then I
exercise the call option using my cash, and the portfolio is worth ST. If at
maturity the underlying price is less than X, I do not exercise the option,
and hence my portfolio is worth X. The value of portfolio A at maturity can
be written as:
max(ST,X).
At the maturity date the value of portfolio B is always just ST. Hence,
portfolio A is always worth at least the same as portfolio B, and sometimes
(when exercise is not optimal) it is worth more. Reflecting this and to
prevent arbitrage, the price of buying portfolio A must exceed the cost of
portfolio B. This reasoning implies:
c + Xe–rT > S ⇒ c > S – Xe–rT. (4.18)
Also, an option must have positive value since, at the very worst, it is
not exercised as it is out of the money. This implies that 4.18 can be
generalised to:
c ≥ max[0,S – Xe–rT]. (4.19)
A similar argument to the above can be used to establish a lower bound on
the price of a European put. It’s easy to show that:
p > Xe–rT – S. (4.20)
To demonstrate this, consider two more portfolios. Portfolio 1 consists of a
European put and a unit of the underlying stock, and portfolio 2 consists
of Xe–rT in cash.
At the date at which the put matures, portfolio 1 is worth either X (if it’s
profitable to exercise the put, and hence you sell the unit of the underlying
for X) or ST (when exercise isn’t optimal and you’re left with the stock, as
the put expires with zero value). We can then write the value of portfolio
1 as:
max(X,ST).
Portfolio 2 is always worth X at the date when the put matures and is
hence weakly dominated in pay-off terms by portfolio 1. Therefore, to
prevent arbitrage, portfolio 1 should cost more to set up than portfolio 2,
implying:
p + S > Xe–rT ⇒ p > Xe–rT – S. (4.21)
Finally, again we know that the worst that can happen for a put option is
for it to expire, worth nothing. This implies that its value must exceed zero
in all circumstances. Thus:
p ≥ max[0,Xe–rT – S]. (4.22)

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Combining upper and lower bounds

A combination of the upper and lower bounds derived in the preceding
two sections can be formed graphically. This gives a set of permissible (in
the sense of not admitting arbitrage) put and call prices. As an example,
Figure 4.4 shows the permissible call price region (it is the shaded area of
the diagram).

Figure 4.4

Black–Scholes option pricing

Our previous pricing analysis was predicated on the assumption that stock
prices are well-represented by a discrete time, binomial model. In 1974,
Fischer Black and Myron Scholes presented an option pricing formula,
based on a continuous time process for the stock price. This analysis
gave exact prices for European puts and calls using a continuous time
version of the replication strategy followed in our binomial methodology.
Unfortunately, derivation of their pricing formula is beyond the scope of
the current presentation. However, due to its wide use in the financial
markets and the intuition it brings regarding the determinants of option
prices, we will describe the pricing formula below.
Assume we wish to price a European call on a stock that never pays
dividends. The current price of the stock is S, the exercise price of the
option under consideration is denoted X, and the option is to have a
maturity of T periods. The continuously compounded risk-free rate is
denoted r. One final parameter is needed to calculate the B–S price of the
call option. This is the instantaneous volatility of the stock price, and we
denote this parameter σ. It is the standard deviation of the change in the
logarithm of the stock price.
The famous B–S formula for the price of a European call option is given
below:
c = SN(d1) – Xe–rT N(d2) (4.23)
where
1n (S / Xe−rT ) σ√T (4.24)
d1= + The values of the
7

σ√T 2 cumulative standard

normal distribution
d2= d1 – σ√T (4.25)
function can be found
and N(.) represents the cumulative normal distribution function.7 in tables in the back
of any good statistical
textbook.

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Example
The current price of Glaxo Wellcome shares is £2.88. An investor writes a two-year call
option on Glaxo with exercise price £3.00. If the annualised, continuously compounded
interest rate is 8 per cent, and the volatility of Glaxo’s stock price is 25 per cent, what is
the B–S option price?
First we need to derive the values d1 and d2 defined as above. Using 4.24 and 4.25
these are 0.5139 and 0.1603. The values of the cumulative normal distribution function
at 0.5139 and 0.1603 are 0.696 and 0.564. Then, plugging all the available data into
equation 4.23 yields a call price of £0.5644.

What does equation 4.23 tell us about the determinants of call prices?
Well, there are clearly a number of influences on the price of an option,
and these are summarised below.
• The effect of the current stock price: the B–S equation tells us
that call option prices increase as the current spot asset price increases.
This is pretty unsurprising as a higher underlying price implies that the
option gives one a claim on a more valuable asset.
• The effect of the exercise price: again, as you would expect,
higher exercise prices imply lower option prices. The reason for this is
clear: a higher exercise price implies lower pay-offs from the option at
all underlying prices at maturity.
• The effect of volatility: Figure 4.2 gives the pay-off function of a
European call option. Note that, although extremely good outcomes
(underlying price very high) are rewarded highly, extremely bad
outcomes are not penalised due to the kink in the option pay-off
function. This would imply that an increase in the likelihood of extreme
outcomes should increase option prices, as large pay-offs are increased
in likelihood. The B–S formula verifies this intuition, as it shows that
call prices increase with volatility, and increased volatility implies a
more diverse spread of future underlying price outcomes.
• The effect of time to maturity: call option prices increase with time
to maturity for similar reasons that they increase with volatility. As the
horizon over which the option is written increases, the relevant future
underlying price distribution becomes more spread-out, implying increased
option prices. Furthermore, as the time to maturity increases, the present
value of the exercise that one must pay falls, reinforcing the first effect.
• The effect of riskless interest rates: call option prices rise when
the risk-free rate rises. This is due to the same effect as above, in that the
discounted value of the exercise price to be paid falls when rates rise.

Put–call parity
The B–S formula gives us a closed-form solution for the price of a
European call option under certain assumptions on the underlying asset
price process. However, as yet, we have said nothing about the pricing of
put options. Fortunately, a simple arbitrage relationship involving put and
call options allows us to do this. This relationship is known as put–call
parity. In what follows we assume the options have the same strike price
(X), time to maturity (T) and are written on the same underlying stock.
Consider an investment consisting of a long position in the underlying
asset and a put option, called portfolio A. The cost of this position is
S0 + p. A second portfolio, denoted B, comprises a long position in a call
option and lending Xe–rT. Hence the cost of this position is c + Xe–rT.

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What are the possible pay-offs of these positions at maturity? Given the
pay-off structure on the put shown in Figure 4.3, the pay-off on portfolio A
can be written as follows:
max[X – ST,0] + ST = max[X,ST]. (4.26)
Similarly, the pay-off on portfolio B can be written as:
max[0,ST – X] + X = max[X,ST]. (4.27)
Comparison of equations 4.26 and 4.27 implies that the two portfolios
always pay identical amounts. Hence, using no-arbitrage arguments,
portfolios A and B must cost the same amount. Equating their costs we have:
S + p = c + Xe–rT. (4.28)
Equation 4.28 is the put–call parity relationship. Given the price of a call,
the value of the underlying asset and knowledge of the riskless rate, we
can deduce the price of a put. Similarly, given the put price, we can deduce
the price of a call with similar features.

Example
A call option on BAC stock, with an exercise price of £3.75, costs £0.25 and expires
in three years. The current price of BAC stock is £2.00. Assuming the continuously
compounded (annual) risk-free rate to be 10 per cent, calculate the price of a put option
with three years to expiry and exercise price of £3.75.
From equation 4.28 we have:
p = c + Xe–rT – S.
Plugging in the data we’re given yields:
p = 0.25 + 3.75e–0.1(3) – 2 = 1.03.
Hence, the no-arbitrage put price is £1.03.

Substitution of the B–S call pricing equation gives a closed-form solution

for the put price. This equation allows us to deduce the effects of changing
the B–S parameters on put prices.
• The effect of underlying price: for the opposite reason to that
given for the call, put prices drop as underlying prices increase.
• The effect of the exercise price: similarly, put prices rise as
exercise prices rise.
• The effect of volatility: put options and call options are affected in
identical ways by volatility. Hence, as volatility increases, put prices rise.
• The effects of time to maturity: increased time to maturity will
lead to a greater dispersion in underlying prices at maturity, and hence
put prices should be pushed higher. However, as the holder of a put
receives the exercise price, discounting at higher rates makes puts less
valuable. The combined effect is ambiguous.
• The effect of the risk-free rate: puts are less valuable as interest
rates rise, due to a greater degree of discounting of the cash received.

Activity
ABC corporation’s shares currently sell at $17.50 each. The volatility of ABC stock is 15
per cent. Given a risk-free rate of 7 per cent, price a European call with strike price of
$15 and time to maturity 5 years. Use put-call parity to price a put with similar
specifications. What are the no-arbitrage prices of the call and the put if the risk-free
rate rises to 10 per cent?

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Pricing interest rate swaps

Recall the definition of an interest rate swap given earlier in the chapter.
Agent A contracts to give fixed interest payments (on a given principal) to
agent B. In return agent B agrees to deliver to agent A interest payments
(on the same principal) based on an agreed floating exchange rate. The
frequency and duration of these interest payments are also agreed in
advance. A very common choice of floating interest rate used in such
contracts is the London Interbank Offer Rate (LIBOR).
An example of such an agreement is as follows. Agent A agrees to pay
agent B payments on a $1m principal at a fixed 8 per cent rate. Agent
B agrees to pay interest payments of LIBOR plus 0.25 per cent. These
payments are to be made annually for the next 10 years.
Note that, from the previous example, the payments made by agent A at
every date till maturity are known and fixed (i.e. 8 per cent of $1 m). His
or her receipts, however, are uncertain. He or she gains a 0.25 per cent
premium above an ex-ante uncertain interest rate. Consider, for example,
the transaction at the second payment date. Agent A pays $50,000 and
receives LIBOR + 0.25 per cent. This looks identical to the cash flows
from a forward contract. Indeed, we can regard the transaction at every
payment date as a forward transaction. Hence the swap in entirety can
be considered a package of forwards. Using the forward pricing equations
given above, the swap is simply priced.
In the situation where interest payments in different currencies are exchanged,
the situation is slightly more murky, but the same basic principle maintains.
Swaps are just packages of forward contracts and can be priced as such.

Summary
This chapter has treated the nature and pricing of the most important
and heavily traded derivative securities. We have looked at the basic
specifications of forward, futures, option and swap contracts and what
these specifications imply for the pay-off functions of long and short
positions. Further, we have looked at methods that can be used to price
these securities. The basis of pricing is absence of arbitrage in all cases. We
looked most deeply at option contracts, detailing the relationships between
put, and call prices, and bounds on option prices, and finally we examined
the continuous time option pricing formula of Black and Scholes.
Although we’ve covered a lot of material here, the continual evolution and
innovation of derivatives markets and assets means that we missed much
more than we’ve treated. However, the basic features of derivatives pricing
that we’ve looked at can be extended to new and more complex securities.

A reminder of your learning outcomes

Having completed this chapter, and the essential reading and activities,
you should be able to:
• discuss the main features of the most widely traded derivative securities
• describe the pay-off profiles of such assets
• understand absence-of-arbitrage pricing of forwards, futures and swaps
• construct bounds on option prices and relationships between put and
call prices
• price options in a binomial framework using the portfolio replicating
and the risk-neutral valuation methods.
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 Chapter 4: Derivative assets: properties and pricing

Key terms
American option
binomial method
Black–Scholes
call option
covered interest rate parity relationship
derivative
European option
exercise price
forward contract
futures contracts
long position
marked-to-market
notional pricing
put option
risk-neutral method
settlement date
short position time to maturity
underlying price

Sample examination questions

1. Describe the main features of forward and futures contracts. How do
forward and futures contracts differ? Derive the no-arbitrage price of a
forward contract. (10%)
2. Describe the main features of options contracts. Show how to price a
standard European call option using a single-period binomial model.
(10%)
3. British Telecom shares are currently trading at 312p. Historically, the
(annualised) volatility of BT shares has been 20 per cent. Compute the
Black–Scholes price of a European call on BT equity, assuming a strike
price of 350p and time to maturity of six months. Assume that the risk-
free rate is 5 per cent. (5%)

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