Foundational Concepts

• In this lecture, we will cover important concepts that we use frequently when we deal with
derivatives

Exposures to the Underlying

• If you are (financially) exposed to an something, your net worth change with the price of that
something. In this course, we call that something the underlying

• There are two type of exposures to underlying

– Long exposure: You gain if the price of the underlying goesup. For example, you are long
the underlying if you own it or you plant to sell it.
– Short exposure: You lose if the price of the underlying goes up. For example, you are
short the underlying if you borrowed it or you plant to buy it.

• you can create a short or long exposure by taking a short or long position of the underlying.

Trading Positions in the Underlying

• There are two main type of positions:

– Long position: Borrow cash and use the cash to get the asset. You benefit if the asset
price goes up.
– Short position: Borrow the asset and sell it to get cash. You benefit if the asset price
goes down.
∗ Refer to section 1-3a in Chapter 1 of ?

• Notes:

– Even if you buy using your money, you are losing the interest payment you would have
earned if you did not buy the asset and, instead, you bought the risk free asset (e.g. time
deposit). Using you own money to buy an asset is effectively same as borrowing from
yourself.
– To close the long position, you sell the asset.
– To close the short position, you buy the asset and hand it over to the lender.
– If you sell something you already own, then you are not shorting it, you are closing the
long position.
– Long position are indicated by positive sign. Short positions are indicated by negative
sign.
– Establishing a long position, creates an asset. Establishing a short position creates a
liability.

• Example: If you buy 100 shares of STC stock, the value of your position will be +100 × SST C

• Example: If you short sell 100 shares of Apple, the value of your position will be −100 × SApple

• Why the value of short sale is in negative? because you are liable to the lender for the stock
value. That is, you have to pay the lender back which means there is money outflow.

• Example:

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 Current Price Expected Return Standard Deviation
A 100 SR 8% 15%
B 100 SR 11% 20%
C 100 SR 11% 20%

If you have 100 SR, can you earn more than 12% using the above assets?

• Answer: yes, short A and use the proceeds plus the cash you have and invest the sum in B.
You get 14%. What happen to the risk?

Notes on Short Selling the Underlying

• When you short an asset, your broker borrows the asset from someone else (might be the
broker himself) and sells it for you.

• Investors with short positions must pay the broker any income entitled to the asset owner
such as dividends or interest payments. The broker then transfers these payments to the asset
owner.

– For example, assume that Apple announced it will pay $10 dividends in Sept. 15, 2014.
Moreover, assume that you have sold short 100 shares of Apple. That is, your broker
borrowed 100 shares from someone, sold them and gave you the proceeds. If you decide
to keep this position until Sept. 15, 2014, then you have to pay $1000 to you broker who,
in turn, would pass it to the shares owner.

• Who has the voting right of the shares shorted?

– Remember, there are three parties here: the share lender (the true owner), the investor
who short sells the share (borrows it from the lender) and the purchaser who buy the
share from the investor.
– Voting rights clearly goes to the purchaser. How about the lender? he will lose the voting
right. Brokers will make them sign that their shares could be shorted especially if they
bough them on the margin.
– There is margin requirements for short selling.
∗ In shorting stocks or similar assets that are sold in the spot market, the proceeds of
the short sale is held with the broker in an account called a margin account. Moreover,
the broker will ask for more cash than the proceeds to be put in the accounts and
called initial margin. The shoring investor can’t cash out the money (proceeds plus
the initial margin) but the cash can be used to buy other assets which then becomes
the collateral in the margin account. They cash (or the assets) are their to cover any
loss you the short seller might incur if the asset price goes up. If the loss is large, the
broker might ask you to pay more money to maintain a certain level of cash in the
margin account.

Arbitrage
• Definition: An arbitrage opportunity is a trading strategy (or a portfolio) that costs you
nothing to form at t = 0 but has a strictly positive probability of having a strictly positive
cash flow in the future.

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 – Three things: it costs you nothing, has no likelihood of loss, and it has a likelihood of
gain.
– Effectively, an arbitrage portfolio offers you something for noting.
– Formally, there is an arbitrage opportunity if you can design a portfolio that satisfies:

V0 = 0 (Cost nothing at time 0) (1)

P r(Vt ≥ 0) = 1 (Never lose money at time t) (2)
P r(Vt > 0) > 0 (there is a chance to gain at time t) (3)

where Vt denote the portfolio value at time t.

• Example 1

There are three assets: A, B and C. At time 0, they have these prices: PA = 100, PB = 150
and PC = 200. If an equally weighted portfolio consists of one unit of asset A and and one
unit of asset B is trading at a value different than 250, say 260 then there will be an arbitrage
opportunity.

– If the portfolio of A and B is more than 250, say 260, you can short sell the portfolio, get
260 and buy A at 100 and B at 150. At any time in future (could be a moment later)
you can deliver back A and B that you shorted to close your short positions. Effectively,
you start with nothing out of your pocket, but you gained 260 − (100 + 150) = 10.

• Example 2:
The table below shows you the price of two assets, A and B, now and in one week later de-
pending on the sate of the market.

Asset Now if Market is Up if Market is Down

B 100 150 50
A 100 200 60

given the above table, is there an arbitrage opportunity?

– Note that asset A gives you more than asset B in all scenarios but it is trading at the
same price of asset B.
– That is, A gives you for sure more cash flows than B regardless of whatever happening
to the market. Yet, price of A is same as price of B !!
– Smart investors would short sell B and buy A. Thus, they pay nothing out of their
pockets. One week later use the cash flow from asset A, in any scenario, is more than
what is needed to buy back asset B (that you shorted) and deliver is back.
– This example shows us that there should be no way that two assets where one has greater
cash flow than the other in all scenario and yet it traded at the same price.

• Example 3:

if a company stock price is trading at S0 today and, in one week from now, it either goes up
to Sup or down to Sdown . If the interest rate for one week is r. How S0 , Sup , Sdown and r are
related to avoid arbitrage opportunity?

Answer: Sdown < S0 (1 + r) < Sup how? (Exercises)

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 • Why the concept of arbitrage is important?

– Because we can use it to price any new derivative instrument given as a function of prices
of existing assets without running into the complexity of equilibrium modelling (supply
and demand analysis).
– The assumption is that a market with no arbitrage opportunities have fair prices.
– We call this arbitrage-free pricing.

Leverage
• Leverage: magnifying the chance of profit (and loss) with little investment.

• You know from previous courses that you could leverage by borrowing

– Assume you have 100 SR, and there is investment that may generate 10% of return
– if you use only your equity (the 100 SR), your expected return in 10%
– if you borrow 1000 SR at 5% and invest it with your equity, your expected return is

(1000 + 100)1.1 − (1000)1.5

− 1 = 60%
100

– Without borrowing, your return is expected to be 10%. With borrowing it jumped to

60%.
– Note that the loss is also magnified. Try a loss of 10% in the instrument.

• Also, you could use derivatives to design levered positions.

– Example: compare the return on investment in a stock versus that on a call option on
the same stock.
– Example: entering into a forward contract is a leveraged position. You pay nothing in
the beginning of the contract but you have the chance to gain. If you gain, your return
in infinity. If you lose you loss is minus infinity.

• Also, you can designed levered position by using short positions

– Example: short a stock and use the funds to buy another stock of the same price. You
pay nothing from your pocket. You could gain a lot if the stock you shorted goes down
and the one you bought goes up. You also may go bankrupt if the reverse happens.

• In short, you can use derivatives to magnify the amount of gain (and loss) from a very small
amount of investment (it might be zero). Hedge funds industries are using derivatives to
multiply the gain of carefully designed investments they expect to gain positive return.

The Payoff Diagram

• Please refer to the Excel file ”L1-Cash Flows”.

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Origin and Development of Derivates Markets
• refer to ? Section 2-2 page 31

Types of Derivatives Markets

• Market structure is important to risk managers primarily through its impact on liquidity.

• A successful market, whether it exists in a physical location or electronic, brings together

”many” buyers and sellers and is able to reduce search and transaction costs.

• Derivative instruments can be traded either in exchanges or in over the counter (OTC) markets.

• Exchanges:

– Refer to Section 2-3 page 37

– Products are standardized with features defined by the exchange
– Ordered are guaranteed to be fulfilled by the exchange which becomes the counter-party
to all derivative trades on the exchange. This protects against the risk of an order not
being fulfilled.
– Benefits of Exchanges: Liquidity + Clearing and Settlement: Refer to Section 2-5 page
51

• OTC: a telephoned- or computer-linked networks of dealers:

– Over the Counter (OTC): refer to Section 2-4 page 46

– Products are tailored to the needs of the traders.
– However, the counter-party risk is higher. There is no third party to guarantee that the
contract obligation will be honoured.
– Analogy: real estate agents are kind of over the counter markets.

Derivatives in KSA
• Most of derivatives are structured by banks in the OTC markets.

• Recently, Tadawol exchange is trading futures on MSIC 30 index.

References