STAT0013 Introductory Slides

Introduction to Derivatives
Alexandros Beskos
Department of Statistical Science, University College London

(a.beskos@ucl.ac.uk)
October 14, 2022, STAT0013
A Beskos (a.beskos@ucl.ac.uk) Meeting 2 Oct 14, 2022, STAT0013 1 / 41

Outline
1 Introduction to Derivatives
Forward Contract
Futures Contract
Option
Hedging
Speculation
2 No Arbitrage
Arbitrage Opportunities and Pricing
Arbitrage and Put-Call Parity

1. Motivation
▶ Our course distinguishes between two types of financial objects:

▶ Underlying measurable traded assets: e.g. oil, interest rates, exchange
rates.
▶ Derivative securities: contracts based on these assets.

1. Motivation
▶ Our course distinguishes between two types of financial objects:

▶ Underlying measurable traded assets: e.g. oil, interest rates, exchange
rates.
▶ Derivative securities: contracts based on these assets.
▶ Example: a piece of paper which says, ‘I will pay you $1 million for
every dollar the price of oil is over $100 on 1st December 2021’.
▶ Such contracts act as insurance – for example, an airline might find
such a contract useful.
▶ Key question: what is such a piece of paper worth?
▶ Answer comes in two parts: modelling and arbitrage.

1. Motivation
▶ For example, I could sell you such a contract for£1, 000.
▶ What I am selling you is a piece of paper promising to pay you £1

million if the price of oil goes over $100.
▶ If the price stays under $100, I keep the £1, 000, and you get nothing.
▶ Financial institutions are selling extremely complex financial

derivatives to their clients, so they have to make sure they price these
derivatives correctly and manage them effectively.

1. Introduction to Derivatives
▶ Definition: A derivative is an instrument whose value depends on the

values of other more basic underlying securities.

▶ Definition: A derivative is an instrument whose value depends on the

values of other more basic underlying securities.
▶ Examples:
▶ Forward contracts and Futures contracts: an agreement to buy (or sell)
an asset on a specified future date for a specified price.
▶ Options, i.e. the option to buy or sell something in the future.
▶ Swaps; they involve the exchange of future cash flows.
▶ Where can we buy a derivative?

▶ Organized exchanges (standard products).
▶ Over the counter (from financial institutions, can be non-standard
products).

▶ Why are derivatives useful?

▶ We can use them to protect ourselves from future uncertainty (hedge
the risk).
▶ We can use them to speculate on the future direction of the market.
▶ We can use them to change the nature of an asset or liability, often its
risk profile (e.g., to swap a fixed rate loan with a floating rate loan) or its
tax status.
▶ We can use them to change the nature of an investment without selling
one portfolio and buying another.

▶ Why are derivatives useful?

▶ We can use them to protect ourselves from future uncertainty (hedge
the risk).
▶ We can use them to speculate on the future direction of the market.
▶ We can use them to change the nature of an asset or liability, often its
risk profile (e.g., to swap a fixed rate loan with a floating rate loan) or its
tax status.
▶ We can use them to change the nature of an investment without selling
one portfolio and buying another.
▶ Who uses derivatives?
▶ Hedgers (aim to reduce risk).
▶ Speculators (‘gamble’ on the future direction of the markets).
▶ Arbitrageurs (aim to make money without any risk).

1.1 Simplest Form of Derivative: Forward Contract
▶ Definition: A forward contract is a customized agreement between two

private parties to buy or sell asset S at future date T for price K
(Delivery or Strike Price).

1.1 Simplest Form of Derivative: Forward Contract
▶ Definition: A forward contract is a customized agreement between two

private parties to buy or sell asset S at future date T for price K
(Delivery or Strike Price).
▶ The agent who agrees to buy the underlying asset is said to have a long
position, the other agent assumes a short position.
▶ Delivery (Expiry) Date: the settlement date T .
▶ Delivery Price: the specified price K.
▶ Forward Price F (t, T ): the delivery price which would make the
contract have zero value at time t.
▶ A forward contract can be contrasted with a spot contract (buy or sell
now). It is an over-the-counter product. Usually no money changes
hands until maturity.

1.1 Forward Contract
▶ Forward contracts are designed to neutralize risk by fixing the price

that the hedger will pay or receive for the underlying asset.


▶ During the life-time of contract F (t, T ) need not (and will not)
necessarily be equal to delivery price K. We will find F (t, T ).
▶ There are two basic positions on forward contracts: long and short. The
long position agrees to buy the asset when the contract expires. The
short position agrees to sell the asset when the contract expires.


▶ During the life-time of contract F (t, T ) need not (and will not)
necessarily be equal to delivery price K. We will find F (t, T ).
▶ There are two basic positions on forward contracts: long and short. The
long position agrees to buy the asset when the contract expires. The
short position agrees to sell the asset when the contract expires.
▶ Example: A piece of paper which says ‘I will buy 1000 litres of petrol for
£1, 000 next January 1st ’ is a forward contract.
▶ A forward contract can be used, for instance, to hedge foreign currency
risk. The buyer has thus eliminated the uncertainty - we say the buyer
has hedged his position.

▶ Example: An American trader expects to buy £1m in 6 months and

wants to hedge against exchange rate movements. She enters into an
agreement to sell dollars and buy pounds after 6 months at a rate 1.20.
She is long in pounds and short in dollars.
▶ If after 6 months the rate is 1.3, then she would need $1.3m to buy
£1m. Due to the forward contract, she can actually pay only $1.2m ⇒
she makes a profit because of the forward contract.
▶ If the rate falls to 1.1, then she would need $1.1m to buy £1m, but
under the forward contract she has to buy it at 1.2 ⇒ she has a loss
because of the forward contract.

▶ Example: An American trader expects to buy £1m in 6 months and

wants to hedge against exchange rate movements. She enters into an
agreement to sell dollars and buy pounds after 6 months at a rate 1.20.
She is long in pounds and short in dollars.
▶ If after 6 months the rate is 1.3, then she would need $1.3m to buy
£1m. Due to the forward contract, she can actually pay only $1.2m ⇒
she makes a profit because of the forward contract.
▶ If the rate falls to 1.1, then she would need $1.1m to buy £1m, but
under the forward contract she has to buy it at 1.2 ⇒ she has a loss
because of the forward contract.
▶ The crucial point is that entering into the forward contract means that
she has fixed the dollar amount she will pay for the £1m in 6 months
time.

1.2 Futures Contract
▶ Definition: A futures contract is similar to a forward one, but has

differences:

1.2 Futures Contract
▶ Definition: A futures contract is similar to a forward one, but has

differences:
(a) It is traded on an exchange. Everything about the contract and the

underlying asset is well specified.
(b) The value of the contract is calculated daily and any profit or losses are
adjusted day-by-day in an account that you have with a broker
(margin account).
(c) Closing out a futures position means entering into offsetting. Most
contracts are closed out before maturity and delivery never happens.
(d) Again, there are two basic positions on stock futures: long and short.
The long position agrees to buy the stock when the contract expires.
The short position agrees to sell the stock when the contract expires.

1.2 Futures Contracts
▶ Example: It is October and you enter into a futures contract to be given

50 shares of IBM stock on April 1st . The contract has a price of
£5, 000.
▶ But, if the market value of the stock goes up before April 1st , you can
sell the contract early for a profit.
▶ Assume that the price of IBM stock rises to £105 a share on March 1st .
If you sell the contract of 50 shares, you will get a price of (around)
£5, 250, and make a £250 profit.

1.3 Option
▶ A very common form of derivative studied in this course is an option.
▶ Definition: Option is a financial instrument giving you the right – but

not the obligation – to buy or sell an asset S at (or by) a specified date
T at a specified price K, which is called exercise or strike price.

1.3 Option

▶ (Long) call options give you the right to buy, (long) put options give
you the right to sell.
▶ European options give you the right to buy/sell on the specified date,
the expiry date, on which the option expires or matures.

1.3 Option

▶ (Long) call options give you the right to buy, (long) put options give
you the right to sell.
▶ European options give you the right to buy/sell on the specified date,
the expiry date, on which the option expires or matures.
▶ American options gives the right to buy/sell at any time prior to expiry.
▶ A short position is the opposite of a long position: one that buys the
option has a long position, one that sells it has a short position.

1.3 European Option Payoff
▶ A (long) European call option will be exercised if the asset price is

above the strike price at the option expiration date, and then the buyer
of the option will receive a payoff worth ST − K, where K is the strike
price and ST is the value of the asset at the option expiration date.
▶ If the asset price is below the strike price at the option expiration date,
then the option will not be exercised, and will be worthless.
▶ Therefore a (long) European call option has a payoff function
max[ST − K, 0].

1.3 European Option Payoff
▶ A (long) European call option will be exercised if the asset price is

above the strike price at the option expiration date, and then the buyer
of the option will receive a payoff worth ST − K, where K is the strike
price and ST is the value of the asset at the option expiration date.
▶ If the asset price is below the strike price at the option expiration date,
then the option will not be exercised, and will be worthless.
▶ Therefore a (long) European call option has a payoff function
max[ST − K, 0].
▶ A (short) European call option has a payoff function min[K − ST , 0].
▶ Similarly, the payoff function for a long put option is max[K − ST , 0]

and for a short put option is min[ST − K, 0].

1.3 Option Payoff
▶ Example:
▶ A piece of paper that says ‘I have the right to buy 1000 litres of petrol for
£1, 000 next January 1st ’ is a (long) call option.

1.3 Option Payoff
▶ Example:
▶ A piece of paper that says ‘I have the right to buy 1000 litres of petrol for
£1, 000 next January 1st ’ is a (long) call option.
▶ If the market price ST on 1st January is more than £1, 000, it is worth
exercising the option. You will make a payoff of ST − 1, 000.
▶ If the market price ST is less than £1, 000, it is not worth exercising
the option, and you will have a payoff of 0.
▶ The value (or payoff) of the option on January 1st will be
max[ST − 1, 000, 0], a function of the (random) price ST .

1.3 Option Payoff
▶ Example: Similarly a (long) put option says ‘I have the right to sell 1000
litres of petrol for £1, 000’.

1.3 Option Payoff
▶ Example: Similarly a (long) put option says ‘I have the right to sell 1000
litres of petrol for £1, 000’.
▶ If ST ≥ 1, 000, there is no point exercising the option.
▶ If ST ≤ 1, 000, it is worth exercising, to have a payoff of 1, 000 − ST .
▶ Overall, we receive max[1, 000 − ST , 0].
▶ Put and call options are exercised in complementary cases.

1.3 Option Payoff
▶ Example: Let St denote the value of the Google share at time t.

▶ Assume that today is time t = 0 and S0 = $627. Then, the payoff from
a European call option with strike price $550 and maturity time T = 1
year, is:
▶ ST − 550, if ST ≥ 550 at time T .
▶ 0, if ST ≤ 550 at time T .

1.3 Option Payoff
▶ Example: Let St denote the value of the Google share at time t.

▶ Assume that today is time t = 0 and S0 = $627. Then, the payoff from
a European call option with strike price $550 and maturity time T = 1
year, is:
▶ ST − 550, if ST ≥ 550 at time T .
▶ 0, if ST ≤ 550 at time T .
▶ Question: How much would you pay for this option today?
▶ Answer (later on in the course): Pricing options by means of the

Black-Scholes pricing formula.

1.3 Option Payoff

1.4 Hedging
▶ Derivatives can be used for a number of reasons, in particular, options

can be used to:
(a) Hedge: We can use them to protect ourselves from future uncertainty
(hedge the risk).
(b) Speculate: We can use them to speculate on the future direction of the
market. As we shall see, options provide leverage for speculation.
▶ Forward contracts can be used for hedging.
▶ Other types of hedging can be based on options contracts, where the

objective is not to fix a price, but to provide insurance.

1.4 Hedging
▶ Hedging: Making an investment to reduce the risk of adverse price

movements in an asset.

1.4 Hedging

▶ Example: An investor owns 1000 shares at £102 each. She wants to
hedge the risk of a fall in share price and buys 6-month European put
options with a strike price of £100 for £4 each. Thus, she pays
£4, 000 to buy the option to sell the shares for £100 each in 6 months.

1.4 Hedging

▶ Example: An investor owns 1000 shares at £102 each. She wants to
hedge the risk of a fall in share price and buys 6-month European put
options with a strike price of £100 for £4 each. Thus, she pays
£4, 000 to buy the option to sell the shares for £100 each in 6 months.
▶ If the share price goes below £100, she can exercise the options, thus
having assets of £(100, 000 − 4, 000) = £96, 000.
▶ If the share price stays above £100, she keeps (or sells) the shares. The
value of the asset is above £100, 000 (she did pay £4, 000 for the
options).
▶ In any case, her total asset value – originally £102, 000 – cannot fall
below £96, 000.
1.5 Speculation
▶ A case of speculation using forward contracts is the following.
▶ Example: An agent believes that the $/£ exchange rate will increase,
and wants to exploit this change in the rate.
▶ She takes the risk and enters a 3-month long forward contract, where
she agrees to buy £100, 000 at a $/£ rate of 1.35.
▶ If the rate actually goes up, say to 1.4, she can buy for $1.35 an asset
worth $1.4, so she makes a profit of (1.4 − 1.35) × 100, 000 = $5, 000.

1.5 Speculation
▶ The way speculators use options is more complex.
▶ Example: You have $100, 000 to invest and you think that Google share
is going to be in 1 year close to its current level, S0 = $627.
▶ Suppose that the price of 1 European call option with strike price $550
and a maturity of 1 year is $2.

1.5 Speculation
▶ The way speculators use options is more complex.
▶ Example: You have $100, 000 to invest and you think that Google share
is going to be in 1 year close to its current level, S0 = $627.
▶ Suppose that the price of 1 European call option with strike price $550
and a maturity of 1 year is $2.
▶ You have two strategies:
▶ You buy 100, 000/627 ≈ 160 shares.
▶ You buy 50, 000 European call options.

1.5 Speculation
▶ Suppose that after 1 year, the price of Google shares has gone up to
$635. Let us see our profit is in each case:
▶ If we bought the shares, then we have made a profit is
160 × (635 − 627) = $1, 280 dollars.
▶ If we bought the European call options, then we exercise the options,
buy 50, 000 shares each at $550, when each is worth of $635. Our profit
is 50, 000 × (635 − 550 − 2) = $4, 150, 000 dollars.

1.5 Speculation
▶ Suppose that after 1 year, the price of Google shares has gone up to
$635. Let us see our profit is in each case:
▶ If we bought the shares, then we have made a profit is
160 × (635 − 627) = $1, 280 dollars.
▶ If we bought the European call options, then we exercise the options,
buy 50, 000 shares each at $550, when each is worth of $635. Our profit
is 50, 000 × (635 − 550 − 2) = $4, 150, 000 dollars.
▶ Suppose that in 1 year, the price of a share has gone down to $500:
▶ If we bought the shares, then we do nothing and lose
160 × (627 − 500) = $20, 320.
▶ if we bought the European call options, then the options are worthless at
expiration and we lost all $100, 000 dollars.
▶ The profit from buying options can be much higher, but you should
have a good appetite for risk.

Further Reading for Introduction to Derivatives
▶ http:
//www.imf.org/external/bopage/pdf/98-1-20.pdf
▶ http://fisher.osu.edu/fin/faculty/stulz/
publishedpapers/milkeninstitutepubpaper.pdf
▶ See also the Additional Material section on the Moodle webpage of the
course.
▶ See also the section titled Short and Long Positions for Call and Put
options in the Old Course Notes on Moodle for more on the notions of
long/short positions for derivatives.

2. No Arbitrage
▶ Given a model, we need to decide what a contract is worth.
▶ A key idea here is that of no arbitrage principle – no risk-free money

(markets move to remove such opportunities).
▶ Arbitrage involves making money with no risk. If there were arbitrage
opportunities, then immediately someone would capitalize on them,
thus affecting the market prices through demand/supply and
eliminating the opportunity.
▶ Assume that assets are divisible into arbitrary fractions, there are no
transactions costs, and short selling is possible.

2. No Arbitrage
▶ Definition: No arbitrage is a situation in which all relevant assets are

appropriately priced and there is no way for one’s gains to outpace
market gains without taking on more risk.
▶ Short selling: Reverses order of buying and selling. Short selling allows
the seller to sell an asset that she does not own and buy it at a later
point of time (at the price it will then have).
▶ We will work under the assumption that arbitrage opportunities do not
occur and we will rely on this hypothesis for the pricing of financial
instruments.

2. No Arbitrage
▶ Definition: No arbitrage is a situation in which all relevant assets are

appropriately priced and there is no way for one’s gains to outpace
market gains without taking on more risk.
▶ Short selling: Reverses order of buying and selling. Short selling allows
the seller to sell an asset that she does not own and buy it at a later
point of time (at the price it will then have).
▶ We will work under the assumption that arbitrage opportunities do not
occur and we will rely on this hypothesis for the pricing of financial
instruments.
▶ Is it reasonable to assume no arbitrage in general?
▶ Assuming an arbitrage-free context is important in financial models,

though the concept is mainly theoretical. Arbitrage opportunities may
exist in a real market.

2. Pricing via No Arbitrage
▶ Example: From March 24th to 31st , 2009, HSBC issued rights to buy
shares at the price of $28/share.
▶ Such a right is similar to a call option since it gives the right (with no
obligation) to buy shares at the strike price K = $28. On March 24st
the HSBC share price closed at $41.70.

▶ Example: From March 24th to 31st , 2009, HSBC issued rights to buy
shares at the price of $28/share.
▶ Such a right is similar to a call option since it gives the right (with no
obligation) to buy shares at the strike price K = $28. On March 24st
the HSBC share price closed at $41.70.
▶ How can one evaluate the price, say $R, of the right to buy 1 share?
▶ This question can be answered by looking for arbitrage opportunities.
There are two ways to buy the stock:
▶ Directly buy a share on the market at $41.70. Total cost: $41.70.
▶ First purchase the right at price $R and then a share at $28.
Total cost: $R + $28.

▶ Case 1: $R + $28 < $41.70.

▶ There is an arbitrage opportunity if $R + $28 < $41.70:
▶ Investor: Buy the right at price $R, then buy the stock at $28, when it is
actually worth $41.70. The profit would be:
$41.70 − ($R + $28) > 0
▶ Case 2: $R + $28 > $41.70.

▶ There is an arbitrage opportunity if $R + $28 > $41.70:
▶ Bank: Sell the right at price $R, and a stock at $28 when it is worth
$41.70. The net position of the bank would then be:
($R + $28) − $41.70 > 0

▶ In the absence of arbitrage opportunities, the above argument implies

that $R should satisfy
$R + $28 − $41.70 = 0
▶ That is, the no-arbitrage price of the right is given by the equation:
$R = $41.70 − $28 = $13.70

▶ Interestingly, the market price of the right was $13.20 at the close of
the session on March 24th , 2009.
▶ The difference of $0.50 can be explained by the presence of various
market factors such as transaction costs, the time value of money, or
simply by the fact that asset prices are fluctuating over time.
▶ It may also represent a small arbitrage opportunity, which cannot be
always excluded.
▶ Nevertheless, the no-arbitrage argument prices the right at $13.70,
close to its market value.
▶ In general, the absence of arbitrage hypothesis is widely recognised as
an accurate tool for pricing.

2. Bank Interest Rates
▶ More interesting settings are obtained once we also consider the time
value of money. (Interest rates/inflation.)
▶ Assumptions:
▶ We assume the existence of a risk-free bank account with known
interest rate r (per annum).
▶ Often, the interest rate r is assumed constant during the time interval of
interest [0, T ], so that an initial deposit of 1 unit will increase – at time
point t – to:
▶ ert , for a continuously compounded case;
▶ (1 + r)t , for a discretely compounded case.

2.1 Arbitrage Opportunities and Pricing
▶ Definition: Arbitrage opportunity is guaranteed profit on a transaction

without being exposed to any risk of incurring a loss.
▶ As stated in the definition, an arbitrage opportunity is the possibility to
make a strictly positive amount of money starting from 0 or even from
a negative amount. In a sense, an arbitrage opportunity can be seen as
a way to beat the market.
▶ There are many real-life examples of situations where arbitrage
opportunities can occur, such as:
▶ assets with different returns (finance);
▶ servers with different speeds (queueing, networking, computing).

▶ Basic rule of arbitrage opportunity: Buy underpriced assets and sell

overpriced assets.

▶ Basic rule of arbitrage opportunity: Buy underpriced assets and sell

overpriced assets.
▶ Example: Consider a share that is traded on both the New York Stock
Exchange and the London Stock Exchange. Suppose that the share
price is $189 in New York and £100 in London at a time when the
exchange rate is 1.87 $/£.
▶ Arbitrage opportunity:
▶ Buy 100 shares in London.
▶ Sell all shares in New York.
▶ Change Dollars into Pounds.
▶ Riskless profit is £106.95 (in the absence of transaction costs).

▶ This arbitrage opportunity cannot last for long – the forces of supply
and demand will increase the sterling price of the stock in London and
decrease the dollar price in New York.
▶ Look on pages 28-29 in the Old Lecture Notes on Moodle for additional
examples of arbitrage opportunities.

▶ This arbitrage opportunity cannot last for long – the forces of supply
and demand will increase the sterling price of the stock in London and
decrease the dollar price in New York.
▶ Look on pages 28-29 in the Old Lecture Notes on Moodle for additional
examples of arbitrage opportunities.
▶ Remarkably, we can determine the price of many derivatives, only by
applying the no-arbitrage principle.
▶ Assumption:
▶ No-arbitrage principle.
▶ When determining the price of a derivative we assume an idealized
market without arbitrage opportunities.

2.2 Arbitrage and Put-Call Parity
▶ Theorem (Put-Call Parity):

▶ Let St be the price of an asset at time point t and Ct and Pt the prices of
European call and put options at time t, both based on the same asset
with an exercise price of K and expiry date T .
▶ Then:
St + Pt − Ct = Ke−r(T −t)
▶ The equality of these cash flows is independent of the future behaviour

of the stock and is model independent.
▶ Note that the put-call parity does not hold for American options!

▶ Example: Find a lower bound for a 6 months European call option with
a strike price of £35, when the initial underlying share price is £40
and the risk-free interest rate is 5% per annum.

▶ Example: Find a lower bound for a 6 months European call option with
a strike price of £35, when the initial underlying share price is £40
and the risk-free interest rate is 5% per annum.
▶ In this case S0 = 40, K = 35, T = 0.5, and r = 0.05.
▶ The lower bound for the call option price is S0 − K exp(−rT ), which is
equal to:
40 − 35 exp(−0.05 × 0.5) = £5.864

2.2 Arbitrage Opportunity by Put-Call Parity
▶ Example: 3 months European call and put options of exercise price £12
are trading at £3 and £6 respectively. The stock price is £8, the
interest rate is 5%.
▶ Show that there exists an arbitrage opportunity.

▶ Example: 3 months European call and put options of exercise price £12
are trading at £3 and £6 respectively. The stock price is £8, the
interest rate is 5%.
▶ Show that there exists an arbitrage opportunity.
▶ Solution: The put-call parity P0 = C0 − S0 + Ke−rT is violated, since:

1
6 < 3 − 8 + 12e−0.05× 4 = 6.851
▶ To produce arbitrage, we act as follows:

▶ Buy a put option for £6. Sell a call option for £3. Buy a share for £8.
Borrow £11 at the interest rate 5%.
▶ Our net position at time t = 0 is precisely zero.

▶ Example (continued): We know that the payoff from buying a put

option (long position in a put option) is max(K − ST , 0) and the
payoff from selling a call option (short position in a call option) is
− max(ST − K, 0), which is min(K − ST , 0).
▶ To value the portfolio π = P + S − C − B at maturity time T = 14 , we
need to know the value from P + S − C at maturity time T .
▶ There are 2 cases to consider:
▶ K ≥ ST . The value is K − ST + ST − 0 = K.
▶ K ≤ ST . The value is 0 + ST + (K − ST ) = K.
▶ Therefore the value of P + S − C at time T is always K.

▶ Example (continued): We thus have:

1
πT = K − B0 erT = 12 − 11e0.05× 4 ≈ 0.862
1
▶ We repay the loan £11e0.05× 4 .
1
▶ The balance 12 − 11e0.05× 4 is an arbitrage profit of £0.862.

2.2 Proof of Put-Call Parity Formula
▶ Proof:
▶ The payoff of the call is C = max(ST − K, 0) and the payoff of the put
is P = max(K − ST , 0).

▶ Proof:
▶ The payoff of the call is C = max(ST − K, 0) and the payoff of the put
is P = max(K − ST , 0).
▶ Now consider the two portfolios:
▶ 1st combination: underlying asset and European put.
▶ 2nd combination: European call and Ke−rT invested in bank at time 0.
▶ The value of 1st combination at time point T is:
VT = ST + max(K − ST , 0) = max{ST , K}.
▶ The value of the 2nd combination at time T is:
WT = K + max(ST − K, 0) = max{ST , K}.

▶ Proof (continued):
▶ Consider two combinations of financial derivatives that both have the
same value VT = WT at time point T. Then their prices Vt and Wt at
any time point t must also coincide.

▶ To prove this, we will use no-arbitrage and assume that Vt > Wt . At
time t we:
▶ sell (short) the 1st combination for Vt , then buy the 2nd combination for
Wt , and invest the difference (Vt − Wt ).
▶ At time point T we:
▶ sell the 2nd combination for WT , and re-buy the 1st combination for VT .

▶ To prove this, we will use no-arbitrage and assume that Vt > Wt . At
time t we:
▶ sell (short) the 1st combination for Vt , then buy the 2nd combination for
Wt , and invest the difference (Vt − Wt ).
▶ At time point T we:
▶ sell the 2nd combination for WT , and re-buy the 1st combination for VT .
▶ Risk-free profit is (Vt − Wt )er(T −t) assuming an interest rate of r.

▶ This means that Vt and Wt must have the same value for all t.

Further Reading for Arbitrage
▶ To see some real examples of arbitrage in the financial markets, as

opposed to the textbook idealized notion of ‘no arbitrage’:
▶ See the following link:
http://www.math.bme.hu/matolcsi/szjrt8.pdf
course.
▶ For further reading on put-call parity for the interested students,
please see:
▶ Paul Wilmott (2007). Paul Wilmott Introduces Quantitative Finance.
Section 2.12.
course.

Forward Contract & Option Pricing.
Alexandros Beskos
Department of Statistical Science, University College London

(a.beskos@ucl.ac.uk)
October 21, 2022, STAT0013

Outline
1 Value of Forward Contract

Value of Long Forward Contract
Forward Contract on Fixed Income Security
Forward Contract under Fixed Dividend Yield
2 Binomial Model
Replicating Portfolio
Risk-Neutral Portfolio

1. Value of Forward Contract
▶ There are two main questions regarding forward contracts.
Q1 What is a fair strike price?
Q2 At a time after the contract is written – but before the expiration date –
what is the contract worth?

▶ Motivation:

▶ Motivation:
▶ Suppose that today (time 0) you know you will need to do a
transaction at a future date (time T ). There are two possibilities:
▶ Wait until time T and then do the transaction at prevailing market
prices, i.e. do a spot transaction in the future.
▶ Alternatively, you can lock in the terms of the transaction today,
i.e. arrange a forward transaction at time 0.

▶ Motivation:
▶ Suppose that today (time 0) you know you will need to do a
transaction at a future date (time T ). There are two possibilities:
▶ Wait until time T and then do the transaction at prevailing market
prices, i.e. do a spot transaction in the future.
▶ Alternatively, you can lock in the terms of the transaction today,
i.e. arrange a forward transaction at time 0.
▶ Valuation of such instruments is important for financial statements or

internal reports.
▶ Negotiating an early termination:
▶ Speculator - wants to lock in gains, or cut losses.
▶ Hedger - underlying hedged position is gone.
▶ Default - file claim for damages.
1. Notation
▶ T : denotes the time (maturity) of the contract in years from inception

until delivery.
▶ K: delivery (strike) price.
▶ F (t, T ), 0 ≤ t ≤ T : the forward price at time t, i.e. the agreed delivery

price of the asset in a forward contract that would apply if the contract
were entered in at time t.
▶ The delivery price K is paid at maturity – that is, the time at which the
asset changes hands – and there is no payment by either party when
the contract is first entered into.
▶ St , 0 ≤ t ≤ T – the value of the asset at time t.
▶ f (t, T ), 0 ≤ t ≤ T : the value of an existing forward contract, to the

holder, at time t after inception.

1. Notation (Continued)
▶ It is important to realize that there are two prices or values associated

with a forward contract at time t: f (t, T ) and F (t, T ).
▶ For simplicity, we often shorten F (t, T ) to Ft and f (t, T ) to ft .
▶ When we use the term contract value or forward value we will always
refer to f (t, T ), whereas when we use the term contract price or
forward price we will always refer to F (t, T ). The particular quantity
in question will be clear from the context.

1. Notation (Continued)
▶ It is important to realize that there are two prices or values associated

with a forward contract at time t: f (t, T ) and F (t, T ).
▶ For simplicity, we often shorten F (t, T ) to Ft and f (t, T ) to ft .
▶ When we use the term contract value or forward value we will always
refer to f (t, T ), whereas when we use the term contract price or
forward price we will always refer to F (t, T ). The particular quantity
in question will be clear from the context.
▶ For example, we have that f (0, T ) = 0 and F (0, T ) = K.
▶ Note that f (t, T ) need not be (and typically will not be) equal to 0 for
t > 0.
▶ We consider only non-wasting securities, which can be kept
indefinitely with no storage costs.

1. Examples of Forward Contracts
▶ Examples of forward contracts:
▶ A forward contract for delivery of a non-dividend paying stock with

maturity 6 months.
▶ A forward contract for delivery of a 9-month Treasury Bill with
maturity 3 months (i.e., upon delivery, the Treasury Bill has 9 months
to maturity).
▶ A forward contract for the sale of gold with maturity 1 year.
▶ A forward contract for delivery of 10m Euros with maturity 6 months.

1. Forward Price via No-Arbitrage Principle
▶ We now price a forward contract by making use of the no-arbitrage
principle.
▶ Assumptions:
(a) No transaction costs.
(b) The market participants can borrow or lend money at the same
continuously compounded risk-free rate r.

▶ We now price a forward contract by making use of the no-arbitrage
principle.
▶ Assumptions:
(a) No transaction costs.
(b) The market participants can borrow or lend money at the same
continuously compounded risk-free rate r.
▶ Theorem: Consider a forward contract on an asset with current price

S0 . The delivery date of the forward contract is T . Then, the forward
price of the contract at time t = 0 is:
F (0, T ) = K = S0 erT
If the price of the asset at time t is St then:
F (t, T ) = Ft = St er(T −t)

▶ Example: If the stock price is £40 with no dividends, and the interest
rate is 5%, then a forward contract after 3 months should have delivery
price equal to:
F (0, T ) = K = 40 e0.05×0.25 = £40.50
▶ This is the correct price so that the initial value f0 of the contract is
zero, and the contract is a fair one.

1. Proof of Theorem
▶ Proof:
▶ We use the no-arbitrage principle to prove the given statement.
▶ We distinguish between cases K > S0 exp(rT ) and K < S0 exp(rT )
and describe in each case how we can construct an explicit arbitrage
strategy.
▶ This would contradict our main assumption of no arbitrage.
▶ Therefore, using the no-arbitrage principle we will conclude that,
necessarily, K = S0 exp(rT ).

1. Proof of Theorem
▶ Proof (Continued):
▶ If K > S0 exp(rT ) a simple arbitrage strategy is:

1. Borrow S0 at an interest rate of r.
2. Buy the underlying asset.
3. Short the forward contract – agree to deliver the asset at time T .
▶ At time T sell the asset for K and repay the loan. The riskless profit is
K − S0 exp(rT ) > 0
irrespectively of the price of the asset.

1. Proof of Theorem
▶ If K < S0 exp(rT ) an arbitrage strategy is:
1. Short the underlying asset.
2. Invest the proceeds of S0 at the risk-free interest rate of r.
3. Go long on the forward contract – agree to buy the asset at time T .
▶ At time T buy the asset for K and make a riskless profit of
S0 exp(rT ) − K > 0

1.1 Value of Long Forward Contract
▶ The no-arbitrage principle requires that the value of a forward contract

at the time of inception is zero, and the delivery price equals the
forward price:
f0 = f (0, T ) = 0, F0 = F (0, T ) = S0 erT = K
▶ However, the value of the contract can change after time t = 0, and
can become positive or negative, because the fair forward price, when
recalculated, can change as the price of the underlying asset changes
over time – while the delivery price K of the contract remains the
same.

1.1 Value of Long Forward Contract
▶ Theorem: Consider a long forward contract on an asset with current

price S0 . The delivery date of the forward contract is T and the strike
price is K. Then the forward value of the long contract at time t is:
f (t, T ) = ft = (Ft − K)e−r(T −t) = St − Ke−r(T −t)
The forward value of a short forward contract at time t is:
ft = (K − Ft )e−r(T −t) = Ke−r(T −t) − St

1.1 Proof of Theorem
▶ Proof:
▶ Portfolio – a collection of assets (such as derivatives, cash, underlying
securities etc.) held by an institution or a private individual.
▶ At any time t between the beginning of the contract and the delivery
date, the value ft of a long forward contract with delivery price K can
be found by considering the following two portfolios:
▶ Portofolio A: One long forward contract + cash of amount Ke−r(T −t) .
▶ Portofolio B: One underlying security.

▶ Proof:
▶ After time T , Ke−r(T −t) will become K and I will use this money to buy
1 unit of the security.
▶ Thus, at time T the two portfolios have the same value (independently
of the security price), which means that they must have the same value
at any time t, otherwise there is arbitrage.
▶ (See also the argument on page 40 of presentation our 2nd Meeting for a
similar reasoning involving no arbitrage.)
▶ The value of portfolio A at time t is: ft + Ke−r(T −t) .
▶ The value of portfolio B at time t is: St .
▶ Since the value of the 2 portfolios is the same, ft + Ke−r(T −t) = St ,

and the value of the contract is:
ft = St − Ke−r(T −t)
▶ So, f0 is zero if and only if K = S0 erT = F0 .
▶ Notice that St = Ft e−r(T −t) (from Theorem on page 8) , and ST = FT .
▶ Therefore, we can rewrite the above as
ft = (Ft − K)e−r(T −t) = St − Ke−r(T −t)
▶ This equation shows that we can value a long forward contract on an

asset by assuming that the cash value of the asset at the maturity of the
forward contract is the forward price Ft .

1.1 Example
▶ Example: Consider a 6-month long forward contract on an 1-year bill

with principal of $1, 000.
▶ The delivery price is $950, and the 6-month interest rate is 6% (with
continuous compounding). Assume S0.5 = $930.
▶ Then, the value of the contract at 6 months is:
f0.5 = S0.5 − Ke−r(T −t) = 930 − 950 e−0.06×0 = −$20

1.1 Example
▶ Example: Consider a long forward contract on a non-dividend paying

stock that matures in 6 months.
▶ The spot price is £1 and the risk-free interest rate is 10%.
6
▶ Therefore, the forward price is F0 = S0 erT = 1 · e0.1× 12 = 1.05127,
and f0 = 0.
▶ After three months the spot price is £1.05, and the interest rate
remains the same. What is the value of the contract at this time?
▶ We obtain:
6 3
f0.25 = 1.05 − 1.05127e−0.1×( 12 − 12 ) = £0.02469

1.2 Forward Contract on Fixed Income Security
▶ Consider now a (non-wasting) security that provides known cash

incomes of ci at time ti for a number of time points in the future.
▶ Let I0 be the present value of the future income.
▶ Let S0 be the present value (spot price) of the asset.
▶ The forward price is:

F0 = (S0 − I0 )erT
▶ Intuition:
▶ Let T = 0, then F0 is the spot price minus income.
▶ At time T , I will receive the asset minus the income.
▶ See also the example in Section 4.5, page 33, in the Old Lecture Notes on
the Moodle page of the course.

1.3 Fixed Dividend Yield
▶ We can price forward contracts even when the underlying asset
provides a dividend.
▶ Definition:
▶ Dividend: one-off payment made by a corporation to its shareholders at
a certain time, usually as a distribution of profits.
▶ Dividend yield: the company’s total annual dividend payments divided
by its market capitalization.
▶ Consider the case where the underlying asset provides a known
dividend yield which is paid continuously at an annual rate q.
▶ T : the delivery date of the forward contract.
▶ S0 : current asset price.
▶ Then the forward price is:
F0 = S0 e−qT × erT = S0 e(r−q)T


1.3 Example
▶ Example: Consider a forward contract with maturity at 18 months,

where the underlying asset gives a continuous dividend yield at 5%.
▶ The interest rate is 8% and the spot price is £1.20.

1.3 Example
▶ Example: Consider a forward contract with maturity at 18 months,

where the underlying asset gives a continuous dividend yield at 5%.
▶ The interest rate is 8% and the spot price is £1.20.
▶ The price of the contract is therefore:

18
F0 = 1.20e(0.08−0.05)× 12 = £1.25523
▶ If the delivery price is K, then the value of the contract at time t is:
ft = St e−q(T −t) − Ke−r(T −t)

2. Asset Price Models
▶ We need something random for the stock and something to represent

the time-value of money.
▶ In order to model the value of a variable that changes over time we will
develop models based on stochastic processes.
▶ We can use discrete time, where the variable changes only at certain
fixed points in time, or we can use continuous time, where the variable
changes at any time.
▶ Also, the variable can be continuous (can take any value within a
range), or it can be discrete (takes only certain values).
▶ We will start now with discrete time and discrete variables.

2. Binomial Model
▶ The most accessible approach to option pricing is the Binomial model.
▶ To introduce the basic logic behind option pricing we start from a

simple model, the one-step Binomial Tree.
▶ This model has the following features:
▶ Basic arithmetic and no complicated stochastic calculus.
▶ Ideas of hedging and no arbitrage are present.
▶ A simple algorithm for determining the correct value for an option.

2. Binomial Model
▶ In the binomial model we assume that the asset, which initially has the
value S, can, during a time step T , either move up or down:
▶ Rise to a value u × S.
▶ Or fall to a value d × S.
▶ With 0 < d < 1 < u.
▶ The probability of a rise is p, so the probability of a fall is 1 − p.
▶ The three constants u, d and p are chosen to give the Binomial walk
the same drift and standard deviation as the asset we are trying to
model. (More on this at one of our next Meetings.)

2. Binomial Model
▶ Assumptions:
▶ The Binomial model makes the assumption that the underlying asset
(from now on referred to as a stock), takes on one of only two possible
values at each period. While this may seem unrealistic, the assumption
leads to a formula that can accurately price options.
▶ The model also assumes the absence of arbitrage opportunities.

2. Binomial Model
▶ Assumptions:
▶ The Binomial model makes the assumption that the underlying asset
(from now on referred to as a stock), takes on one of only two possible
values at each period. While this may seem unrealistic, the assumption
leads to a formula that can accurately price options.
▶ The model also assumes the absence of arbitrage opportunities.
▶ The Binomial option pricing technique is often applied by Wall Street

practitioners to numerically compute the prices of complex options.
▶ Once we make the Binomial assumption, it will turn out that the
probability of reaching either node (up or down) no longer matters.
▶ We will first learn to price an European call option, and then move on
to pricing other derivatives.

2. Binomial Model
▶ We have enough information (we have made enough assumptions) to

price options.
▶ Remember: For derivative pricing, it will turn out that what matters is
the list of possible scenarios, but not the actual probability of each
scenario happening.
▶ The Binomial model is also called the Cox-Ross-Rubinstein option
pricing model.
▶ Two angles (two possible approaches):
▶ Replicating: Replicating portfolio approach.
▶ Hedging: Risk-free (riskless) portfolio approach.

2.1 Replicating Portfolio
▶ Definition:
▶ A replicating portfolio is a portfolio of assets, consisting of:
▶ Real assets with liquid market prices (i.e., assets which can be sold quickly
without reducing their price much).
▶ Real illiquid assets (i.e., assets which cannot be sold quickly).
▶ Theoretical assets.
▶ It reproduces (replicates; has the same properties) the cash flows or

market values of a pool of liabilities or assets across a large number of
stochastic (i.e. random) scenarios.

2.1 Motivating Toy Example
▶ Example: Consider a share which trades on 1st January at £10.

Suppose we know that on 1st July with probability p = 2/3 it will be
worth £25, and with probability 1/3 it will be worth £5.
▶ On 1st January, the following contract is freely traded (bought and
sold) on the market:
▶ If the share goes up, I will pay you £4. If the share goes down, I pay you
nothing.
▶ You also have a bank account that pays no interest, which you can pay
into or borrow from.
▶ What is the contract worth on 1st January?

▶ Example: Consider a share which trades on 1st January at £10.

Suppose we know that on 1st July with probability p = 2/3 it will be
worth £25, and with probability 1/3 it will be worth £5.
▶ On 1st January, the following contract is freely traded (bought and
sold) on the market:
▶ If the share goes up, I will pay you £4. If the share goes down, I pay you
nothing.
▶ You also have a bank account that pays no interest, which you can pay
into or borrow from.
▶ What is the contract worth on 1st January?
▶ It might appear that it depends on the probability that the share goes
up or down. You might argue it should be 2/3 × 4 + 1/3 × 0 = £8/3,
i.e. the expected value.

▶ Example (Continued):
▶ Surprisingly the contract is worth £1 – for any value of p.

▶ Example (Continued):
▶ Surprisingly the contract is worth £1 – for any value of p.
▶ Create a replicating portfolio as follows: suppose we buy x units of the
stock and borrow y amount of money from the bank. Then there are 2
possibilities:
▶ If the stock goes up, my portfolio will be worth 25x − y.
▶ if the stock goes down, my portfolio will be worth 5x − y.
▶ Since my portfolio is replicating, it must have the same value as the

contract at the terminal time and also at all intermediate times
including at initial time 0 (otherwise there will be arbitrage
opportunities).
▶ That means, if the stock goes up, my portfolio has to be worth £4, and
if the stock goes down, my portfolio has to be worth £0.
▶ Example (Continued): Therefore, we have the following system of

equations:
25x − y = 4, 5x − y = 0
▶ Solving this system, we obtain the solution x = 1/5 and y = 1.
▶ Thus, we buy 1/5 unit of the stock, and borrow £1 from the bank
(‘put −£1 in the bank’).
▶ If the stock goes up, the portfolio is now worth 1/5 × 25 − 1 = £4,
exactly the same as the contract.
▶ If the stock goes down, the portfolio is now worth 1/5 × 5 − 1 = £0,
exactly the same as the contract.

▶ Example (Continued): Key insight: whatever happens, this replicating

portfolio pays exactly the same as the contract, so it must be worth
exactly the same.
▶ The portfolio costs 1/5 × 10 − 1 = £1, that is
x × (current stock price) − y, and therefore so must the contract.

▶ Example (Continued): Key insight: whatever happens, this replicating

portfolio pays exactly the same as the contract, so it must be worth
exactly the same.
▶ The portfolio costs 1/5 × 10 − 1 = £1, that is
x × (current stock price) − y, and therefore so must the contract.
▶ If the contract trades for more – say £1.05 – then sell the contract for
that much, and buy the portfolio for £1.
▶ On 1st July, whatever happens, the portfolio pays out the same as the
contract, so we can cover our promise. However, we have £0.05 left –
guaranteed profit!

▶ Example (Continued): If the contract trades for less – say £0.95 – then
buy the contract for that amount, and sell the portfolio for £1. Again,
contract and portfolio match, so we make £0.05 guaranteed.
▶ Later in our course, we will see how to create replicating portfolios in
general.

▶ Example (Continued): If the contract trades for less – say £0.95 – then
buy the contract for that amount, and sell the portfolio for £1. Again,
contract and portfolio match, so we make £0.05 guaranteed.
▶ Later in our course, we will see how to create replicating portfolios in
general.
▶ The ‘true probability’ of going up does not affect the argument above.
▶ However, there exists a ‘phantom probability’ q = 1/4 that does make

things interesting.
▶ The price of the contract is the expected value as if the probability of
going up is 1/4 – that expectation is (1/4) × 4 + (3/4) × 0 = £1.

▶ Example (Continued): Interestingly, under this phantom probability,

the expected value of the stock on 1st July is:
(1/4) × 25 + (3/4) × 5 = £10
i.e. exactly what it was on 1st January.

▶ In fact, this is how to find q: it is chosen to make the average value of
the stock constant.
▶ We will learn how to find the probability q later in the course.

2.2 Risk-Neutral Portfolio
▶ Definition: A risk-neutral (risk-free; riskless) portfolio is one in which

the value of the portfolio does not change regardless of the behaviour
of the underlying assets.

▶ Example: Assume that the price of a stock S is £100 and that there is a
55% chance that the stock price will next be £101 and a 45% chance it
will be £99.
▶ Assume that we hold a call option on this asset that is going to expire
tomorrow (T = 1 day). This option has a strike price of £100.

▶ Example: Assume that the price of a stock S is £100 and that there is a
55% chance that the stock price will next be £101 and a 45% chance it
will be £99.
▶ Assume that we hold a call option on this asset that is going to expire
tomorrow (T = 1 day). This option has a strike price of £100.
▶ The payoff of the call option will be as follows:
▶ If the stock price goes up to £101, the option will provide a payoff of
max(101 − 100, 0) = £1.
▶ If the stock price goes down to £99, the option will provide a payoff of
max(99 − 100, 0) = £0.
▶ We can see this as a game where with 55% probability you get £1 and
with 45% probability you get £0. We assume discrete compounding.

▶ Example (Continued): The classical decision theory says that the game
is fair when the expected payoff of the game is £0. This means that in
this case:
E [ Payoff at T − Call Option value ] = 0
▶ Therefore, we should compute the option value as:
Call Option value = E [ Payoff at T ]

= 0.55 × 1 + 0.45 × 0 = £0.55
▶ In this case, we would conclude that a fair or correct price for the
option would be £0.55.

▶ Example (Continued): The classical decision theory says that the game
is fair when the expected payoff of the game is £0. This means that in
this case:
E [ Payoff at T − Call Option value ] = 0
▶ Therefore, we should compute the option value as:
Call Option value = E [ Payoff at T ]

= 0.55 × 1 + 0.45 × 0 = £0.55
▶ In this case, we would conclude that a fair or correct price for the
option would be £0.55.
▶ But is this indeed the correct price? We have learnt that the correct
price is such that there are no arbitrage opportunities in the market, so
we can check if a price of £0.55 allows for arbitrage.

▶ Example (Continued): Let us sell short a quantity, ∆, of the underlying

asset so that now we have a portfolio consisting of a long option
position and ∆ short stock position.
▶ Up: If the asset rises to 101 we have a portfolio worth:
max(101 − 100, 0) − (∆ × 101) = 1 − 101∆
▶ Down: If the asset falls we have:
max(99 − 100, 0) − (∆ × 99) = −99∆

▶ Example (Continued): Let us sell short a quantity, ∆, of the underlying

asset so that now we have a portfolio consisting of a long option
position and ∆ short stock position.
▶ Up: If the asset rises to 101 we have a portfolio worth:
max(101 − 100, 0) − (∆ × 101) = 1 − 101∆
▶ Down: If the asset falls we have:
max(99 − 100, 0) − (∆ × 99) = −99∆
▶ This portfolio is risky in the sense that there are two values that it can
take, we do not know what the portfolio will be worth. Or, can it be
made riskless?

▶ Example (Continued): Step 1: Construct a risk-free portfolio:

▶ Suppose we choose ∆ such that
1
1 − 101∆ = −99∆, i.e. ∆ = 2
▶ Then whether the asset rises or falls our portfolio has a value of:
1 − 101∆ = −99∆ = − 99
2
▶ There is no risk, we are guaranteed this amount of money irrespective of

the behaviour of the underlying securities. This is a case of hedging.

▶ Example (Continued): Step 2: Apply no arbitrage rule:

▶ We are now half-way to valuing this option today, 1 day before expiry.
▶ The 2nd and final step, is to say that if the portfolio has a guaranteed
value then the return must be the same as the risk-free rate applied over
the 1 day.


▶ We are now half-way to valuing this option today, 1 day before expiry.
▶ The 2nd and final step, is to say that if the portfolio has a guaranteed
value then the return must be the same as the risk-free rate applied over
the 1 day.
▶ If V is the option price today, then our portfolio’s value today is:
V − 100∆
for some V to be found.

▶ The present value of tomorrow’s portfolio, after discounting at an
interest rate of r, is:
1 99
−
1 + rδt 2


▶ This must be the same as the portfolio’s value today so:
1 99
V − 100∆ = V − 12 100 = V − 50 = − r
1 + 252 2
▶ Put in the relevant r and calculate V from this:

1 99
V = 50 − r
1 + 252 2
▶ Note that I have assumed 252 business days in a year so that:
1
δt =
252
▶ If r = 10% then V = 0.5196.

2.2 Factors Affecting Option Value
▶ The conclusion is that the option value depends on the interest rate,
the payoff, the size of the up move, the size of the down move and the
time step.
▶ The probabilities of going up/down are irrelevant!
▶ The option price does not depend on the probability of the up/down
move. Probability p was never involved into the calculation.

2.2 Factors Affecting Option Value
▶ The conclusion is that the option value depends on the interest rate,
the payoff, the size of the up move, the size of the down move and the
time step.
▶ The probabilities of going up/down are irrelevant!
▶ The option price does not depend on the probability of the up/down
move. Probability p was never involved into the calculation.
▶ This is quite counter-intuitive. Surely the value of an option depends
on whether the asset is likely to go up or down.
▶ It turns out that this is not the case. We will expand on this idea
further in our next Meeting.

2.2 Further Reading for Binomial Model
▶ For further examples and explanations regarding the Binomial model,

see the suggested reading below.
▶ See Sections 5.1-5.2 from the Old Lecture Notes on the Moodle page of
the course for extra examples.
▶ Paul Wilmott (2007). Paul Wilmott Introduces Quantitative Finance.
Sections 3.1 to 3.6.
▶ Martin Baxter & Andrew Rennie (1996). Financial Calculus. Section 2.1.

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Introduction to Derivatives

Department of Statistical Science, University College London

October 14, 2022, STAT0013

A Beskos (a.beskos@ucl.ac.uk) Meeting 2 Oct 14, 2022, STAT0013 1 / 41

A Beskos (a.beskos@ucl.ac.uk) Meeting 2 Oct 14, 2022, STAT0013 2 / 41

▶ Our course distinguishes between two types of financial objects:

A Beskos (a.beskos@ucl.ac.uk) Meeting 2 Oct 14, 2022, STAT0013 3 / 41

▶ Our course distinguishes between two types of financial objects:

▶ Answer comes in two parts: modelling and arbitrage.

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▶ For example, I could sell you such a contract for£1, 000.

▶ What I am selling you is a piece of paper promising to pay you £1

▶ Financial institutions are selling extremely complex financial

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▶ Definition: A derivative is an instrument whose value depends on the

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▶ Definition: A derivative is an instrument whose value depends on the

▶ Where can we buy a derivative?

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▶ Why are derivatives useful?

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▶ Why are derivatives useful?

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▶ Definition: A forward contract is a customized agreement between two

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▶ Definition: A forward contract is a customized agreement between two

▶ Delivery Price: the specified price K.

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▶ Forward contracts are designed to neutralize risk by fixing the price

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▶ Forward contracts are designed to neutralize risk by fixing the price

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▶ Forward contracts are designed to neutralize risk by fixing the price

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▶ Example: An American trader expects to buy £1m in 6 months and

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▶ Example: An American trader expects to buy £1m in 6 months and

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▶ Definition: A futures contract is similar to a forward one, but has

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▶ Definition: A futures contract is similar to a forward one, but has

(a) It is traded on an exchange. Everything about the contract and the

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▶ Example: It is October and you enter into a futures contract to be given

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▶ A very common form of derivative studied in this course is an option.

▶ Definition: Option is a financial instrument giving you the right – but

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▶ A very common form of derivative studied in this course is an option.

▶ Definition: Option is a financial instrument giving you the right – but

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▶ A very common form of derivative studied in this course is an option.

▶ Definition: Option is a financial instrument giving you the right – but

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▶ A (long) European call option will be exercised if the asset price is

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▶ A (long) European call option will be exercised if the asset price is

▶ Similarly, the payoff function for a long put option is max[K − ST , 0]

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