Advanced Financial Mathematics

Chapter 2
Introduction to forwards and options
These notes are greatly inspired from the book Derivatives Markets
 Forward contracts
Descriptions and characteristics
• Definition: A forward contract is an agreement between two parties for the purchase of an
asset (or a quantity of an asset) with an initial value 𝑆𝑆0 at a predetermined delivery date T
and at a predetermined price 𝑭𝑭𝟎𝟎,𝑻𝑻 .

• This type of contract is traded in the over-the-counter (OTC) market. A forward contract is
also referred: an over-the-counter (OTC) forward contract

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 Long/short Position

• Long position:

• Short position:

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Example
Buying Selling
Spot 1,2422 1,2438
Forward 1 mois 1,2446 1,2462
Forward 3 mois 1,2516 1,2527

Forward 6 mois 1,2795 1,2805

Spot and forward exchange rate quotations for the USD/EUR in 2018.

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Futures contracts on certain organized markets

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 Forward contract price
• At t = 0:

• At the delivery date T:

• Remark:
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 Forward contract transactions

Buyer (long position) Seller (short position)

At t=0
(position taking)

At t=T
(contract maturity)

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 Value at maturity - Payoff
• The value at maturity for the buyer (long position) at t = T is:

• The value at maturity for the seller (short position) at t = T is:

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Payoff (and profit) of the forward contract
Payoff

𝑆𝑆𝑇𝑇

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Example 2.1 in DM
Suppose that the price of the index is $1050 in 6 months.
• The buyer who entered into a long position at a forward price of $1020 is
obligated to pay $1020 to acquire the index:

• Observation:

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Prepaid forward, outright purchase set capitalization

• The buyer (long position) would like to pay in advance at t = 0 instead

of doing so at the delivery date T.
• The price paid at t = 0 for their long position in the contract (spot
price) is:
• Remarks:

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Transactions of the prepaid forward contract

Buyer (long position) Seller (short position)

At t=0
(position taking)

At t=T
(Contract maturity)

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Outright Purchase vs Forward Contract

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 Payoff and profit diagram

Payoff

𝑆𝑆𝑇𝑇

−𝐹𝐹0,𝑇𝑇
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How to recreate a forward with an outright
purchase and vice versa?

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 Replicating a forward contract with a outright
purchase and a loan
Outright purchase loan The outcome of Forward (long
the position position)

At t=0
(position taking)

At t=T
(contract maturity)

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 Replicating an outright purchase with a forward
contract and a deposit
Forward (long deposit The outcome of the Outright Purchase
position) position
At t=0
(position taking)

At t=T
(contrat maturity)

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 Use of Zero-Coupon Bonds
Any investment at the risk-free rate or any borrowing at the same risk-
free rate can be compared to a risk-free zero-coupon bond that pays no
coupons whose gain and/or profit is independent of the underlying
asset's value at the forward's maturity.

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 Graphs for Zero-Coupon Bonds
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝑆𝑆𝑇𝑇 𝑆𝑆𝑇𝑇

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Net payoff or profit
Definition: The net payoff or profit associated with a derivative product is defined as
the value at maturity of the derivative product minus the accumulated initial cost:
𝑁𝑁𝑒𝑒𝑒𝑒 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝/𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑎𝑎𝑎𝑎 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 − (1 + 𝑟𝑟𝑓𝑓 )𝑇𝑇 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑠𝑠𝑠𝑠

• For a forward:
𝑁𝑁𝑒𝑒𝑒𝑒 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝/𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 =

• For a prepaid forward:

𝑁𝑁𝑒𝑒𝑒𝑒 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝/𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 =

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 Cash payment and delivery
• The buyer receives the underlying asset on the delivery date, and the seller
receives the money (the forward price) in exchange at that same moment.

• In practice, the underlying asset is never actually traded, and payment

occurs solely in cash (a cash payment).
• To illustrate the profit of each party:

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 Credit risk/default risk
• Each party bears the risk that the other party may not fulfill its
commitments as stipulated in the contract.

• The risks of standardized contracts traded on regulated markets are

generally lower.

• Different risks and uncertainties that can impact the profits for each
party.

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 Call option
Definition and characteristics

Definition: A call option is a contract that gives the buyer of the option
the right to purchase the underlying asset or a certain quantity of the
underlying asset (𝑆𝑆):
• at a predetermined price (𝐾𝐾)
• at a maturity date (expiration date) T or by a maturity date T
(according to the terms of the option), regardless of the market
value of the underlying asset at that date.

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Remark
• The underlying asset in question is often a financial security (e.g.,
stocks).
• 𝐾𝐾: strike price
• The decision to use the option is called exercise.
• There are different types of exercises :
• European (at the maturity T only).
• American (by the maturity T).
• Bermudan (at certain specific times before the maturity T).

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Remarks
• The holder of the option:

• The seller/issuer of the option:

• The price at t = 0 of a call option (European by default) with maturity

T and a strike price K is denoted by C(𝑲𝑲, 𝑻𝑻).

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 Examples 2.3-2.4 in DM
Suppose the buyer agrees to pay $1020 for the S&R index in six
months but is not obligated to do so. What type of contract will
they sign?

• What happens if in 6 months the S&R price is $1100?

• The same question if the S&R price is $900?

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Remarks

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Questions
• Why would someone choose to be on the selling side?

• How can we determine the contract's value (payoff) for the buyer and the
seller of the option at maturity?

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 Option payoff and profit
• Case 1: 𝑺𝑺𝑻𝑻 < 𝑲𝑲:

• The profit of the option buyer is:

• The profit of the option seller is:

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Option payoff and profit (continued)
• Case 2: 𝑺𝑺𝑻𝑻 > 𝑲𝑲

• The profit of the holder will be:

Profit (long position) =

• The profit of the seller

Profit (short position)=

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Value at maturity
• The value at maturity of the purchased call option (long call payoff)
for the buyer is:

• The profit of the purchased call option (long call profit) for the buyer
is:

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Diagram for a purchased long call option
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝑆𝑆𝑇𝑇 𝑆𝑆𝑇𝑇

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Example
Consider a call option on the S&R index with a strike price K=$100 in 3
months. The option price is C(K, T)=$7.
Determine the value at maturity of the option if, in 3 months, the S&R
price is equal to
a) 110 $
b) 90 $
c) Calculate the buyer's profit in each of the two cases above if the
effective risk-free rate for the next 3 months is 2%.

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Solution

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Payoff of a written call option
• The payoff of a written call option (short call payoff) is :

• The profit of a written call option (short call profit) for the buyer is
therefore :

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Written call option
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾 𝑆𝑆𝑇𝑇 𝐾𝐾 𝑆𝑆𝑇𝑇

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 Put option
Definition et characteristics
A put option is a contract that gives the option buyer the right to sell
the underlying asset
• at a predetermined price 𝑲𝑲 (exercise price, strike price).
• at a maturity date (delivery date, expiration date) T or by a maturity date T
(according to the terms of the option), regardless of the market value of the
asset at that date.
• The same definitions apply to the put option as seen with the call
option (European, American, Bermudian, etc.)

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Remarks
• The option holder (the subscriber):

• The seller/issuer of the option:

• We will assume here once again that only European options are being
dealt with.
• We denote by 𝐏𝐏(𝑲𝑲, 𝑻𝑻) the price at t=0 of a put option (European by
default) with maturity T and strike price 𝐾𝐾

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2.3.2 Payoff and profit
If 𝑆𝑆𝑇𝑇 > 𝐾𝐾 ∶

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Payoff and profit
If 𝑆𝑆𝑇𝑇 < 𝐾𝐾:

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Payoff and profit
• The value at maturity of the purchased put option (long put payoff) is:

• The profit of the purchased put option (long put profit) for the buyer
is therefore:

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Charts for a purchased put option (long put)
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑎𝑎𝑎𝑎 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝑆𝑆𝑇𝑇 𝑆𝑆𝑇𝑇

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Payoff and profit
• Thus, the value at maturity of a written put option (short put payoff)
is:

• The profit of a written put option (short put profit) for the seller is
therefore:

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Diagram of a written put option (short put)
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾 𝑆𝑆𝑇𝑇 𝐾𝐾 𝑆𝑆𝑇𝑇

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Remark
• A call option becomes more profitable when...

• A put option becomes more profitable when...

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Some vocabularies
• An option is called "in-the-money" if its value is strictly positive.
• For a call option:
• For a put option:
• We would say that options are "out-of-the-money" if their value is strictly
negative when the holder exercises them.
• If its value is zero, we would refer to the options as "at-the-money".
• "purchased call/put" is used to describe the buying of an option, and "written
call/put" is used to describe the selling of an option.

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 Summary of Positions
Derivative Product Position Profit Minimum Profit Maximum Profit

Forward Long

Forward Short

Call option Long

Call option Short

Put option Long

Put option Short

48
Chapter2-Advanced Financial Mathematics-UEH-F2023
The basic diagrams

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Table 2.7 in DM

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