05 Derivatives

FINANCE II – SPRING 2024
Session 5: Forwards, Futures, Options
© Urs Wälchli Finance II, p. 1 Session 5

STRUCTURE
– Types of Derivatives
– Forwards
– Futures
– Options
– Applications
– Participants in Derivatives Markets

INTRODUCTION
A Derivative is a security whose value depends on the value of other, more basic, underlying
assets.
Hence the term “derivative.” Derivatives derive their value from other assets.
There are many different types of derivatives, including:
– Forward contracts
– Futures
– Options
The key participants in derivatives markets are:

– Hedgers (risk management)
– Speculators
– Arbitrageurs

FORWARD CONTRACT
– A forward is a contract to buy or sell an asset at a certain future time T

for a certain price K
– One of the parties takes a long position and agrees to buy the underlying asset on a
certain specified future date for a certain specified price
– The other party assumes a short position and agrees to sell the asset on the same
date for the same price.
– Usually between two financial institutions or between a financial institution and its client
– Very flexible and, therefore, typically not traded on an exchange
– Common underlying assets

– Currencies (e.g., EUR)
– Commodities (e.g., gold)
– Interest rates
– Etc.

EXAMPLE
A British company (reference currency GBP) expects to receive a payment of USD 5 million in
6 month. The current exchange rate (S0) is 1 USD = 0.8 GBP.
This transaction has currency risk: The exchange rate could fluctuate between now and the
payment date (ST). So it is not clear how many GBP the company will ultimately recover.
GBP-Value of USD-Payment in 6 months

9
7
GBP-value of USD 5M
2
1
0
0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60
Exchange Rate in 6 months (ST)

EXAMPLE (CONT’D)
To protect against the currency risk, the firm could enter a forward contract to sell USD 5
million (the underlying asset) at a fixed delivery price K (the forward price) in 6 months (T).
At the time the contract is entered into, the delivery price is chosen so the value of the
contract to both parties is zero
– The delivery price which makes the contact have zero value is called the forward price
– For our example, let’s assume the 6-month forward price K is 1 USD = GBP 0.79
(forward rates on currencies are defined by the spot rate as well as the interest rates in
the various currencies)
At maturity, the forward contract has the following payoffs:

– The payoff from a LONG position in a forward contract on one unit of an asset is
Payoff long = ST – K
where ST is the (today unknown) spot price of the asset at maturity
– The payoff from a SHORT position in a forward contract on one unit of an asset is
Payoff short = K – ST
FORWARD PAYOFF AT MATURITY
Long Position Short Position
ST – K K – ST
Payoff at Maturity
Payoff at Maturity
ST
ST
K
K

EXAMPLE
Let’s assume the firm enters into a short forward contract for USD 5 million at K = 0.79 GBP in
6 months. Because 0.79 GBP is the forward price (fair price), this contract is free of charge.
What happens at maturity?
Original Business Forward Short

GBP-Value of USD-Payment in 6 months Payoff of the Forward Short at Maturity
9 5
8 4
3
7
2
BGP-Payoff
GBP-value of USD 5M
6
1
5
4
+ 0
-10.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60
3 -2
2 -3
1 -4
0 -5
0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60
Total Payoff at Maturity

4.5
By selling the USD 5M
4 forward, the firm can
3.5
completely eliminate the
GBP Payoff
3
2.5 currency risk and lock in a
payment of GBP 3.95M
2
1.5
1
0.5
0
© Urs Wälchli 0.00 0.20 0.40 Finance
0.60 0.80II, p.1.00
8 1.20 1.40 1.60 Session 5
THE BALANCE SHEET VIEW
Accounts Obligation from

receivable USD 5.00 Forward Short USD 5.00
Receivable from
Forward Long GBP 3.95

WHY ENGAGE IN A FORWARD CONTRACT?
It permits each party to lock-in, or fix the purchase or sale price in advance – GBP 0.79 per
USD in our example – a convenience in cash planning
This is relevant not only for currency transactions.

– Purchase of materials for production (e.g., steel)
– Purchase of merchandise
– Purchase of energy (e.g., electricity)
– Sale of goods and services
– Etc.
Fundamentally, forward contracts are a very cheap way of hedging market risks (i.e.,
risks that arise from fluctuations in market prices).

STRUCTURE
– Forwards
– Futures
– Options
– Applications

FUTURES CONTRACTS
Futures contract is similar to a forward contract in that it is an agreement between two parties
to buy or sell an asset at a certain time in the future for a certain price
As with forward contracts, both financial assets and commodities constitute the underlying
assets of futures contracts
Unlike a forward, the precise delivery date is usually not specified

– Instead, the exchange specifies a delivery period, such as a particular month
– The holder of the short position has the right to decide the exact delivery date within the
delivery period
Unlike a forward, futures contracts are usually exchange traded

– The Chicago Board of Trade and the Chicago Mercantile Exchange are two exchanges
with very high volumes of futures trading
– To facilitate exchange trading, the terms of futures contracts are usually standardized
– Often, for a particular underlying asset (e.g. crude oil) the exchange will specify the quality
(e.g. West Texas Intermediate) and delivery location (e.g. Cushing, Oklahoma).

EXAMPLE
Live Cattle futures on the CME
– One contract is on 40,000 pounds

– Price quotation is US cents per pound ($1.806)
– Delivery: on any Business day of the contract month and the first eleven business days in
the succeeding calendar month
– Delivery points:
– Colorado
– Iowa/Minnesota/South Dakota
– Kansas
– Etc.
STRUCTURE
– Forwards
– Futures
– Options
– Applications

OPTION CONTRACTS
Two basic types of option contracts:

– Call option: gives the holder the right to buy the underlying asset by a certain date T for a
certain price K
– Put option: gives the holder the right to sell the underlying asset by a certain date T for a
certain price K
An option contract gives the holder the right, but not the obligation, to take a specified
action, such as buy or sell the underlying asset
Price in the contract, K: exercise price or strike price (often also denoted with the letter X)
Date in the contract, T: expiration date, exercise date, or maturity

OPTION CONTRACTS
Two main types of option contracts:

– American options: can be exercised at any time up to the expiration date
– European options: can only be exercised on the expiration date itself
The terms American and European refer to contract terms, not the location of the option or the
exchange on which it is traded!
– For example, some European options trade on North American exchanges
– An American option cannot be less valuable than its European counterpart

EXAMPLE
– You have been offered the right to buy a piece of land for $1.1 million in a year. The cost
of this right is $50,000, payable today.
– According to your research, the current value of the land is $1 million, and the expected
return is 20%. This return is uncertain, however and the associated risk (return standard
deviation, “volatility”) is 15%. The risk-free rate of return is 10%.
– Should you buy the right to buy the land?

NPV-APPROACH
– From today’s perspective, the value of the offer is as follows:

– Present value of the land: 1 million
– The purchase price in 1 year (X) is fixed at 1.1 million (contractually guaranteed à no
uncertainty). Because there is no uncertainty, the appropriate discount rate is the risk-
free rate (R):
PV of purchase price = X/(1+R) = 1.1/1.1 = 1 million.
– The right to buy the land costs 50’000 today
– The NPV is -50’000. It’s not a good deal:
NPV = –Cost of right to buy land – PV purchase price + PV land value

= – 50’000 – 1’100’000/1.1 + 1’000’000 = – 50’000.

CAN WE DO BETTER?
– We have assumed that we will buy the land in 1 year…

– But we don’t have to! We have the RIGHT to buy the land, not the OBLIGATION! (The
counterparty has the OBLIGATION to sell it to us if we exercise our right). Why is this
relevant?
– We have flexibility:
– We can wait for 1 year and see how the land price develops.
– In 1 year, we only buy the land @1.1 million if its market value is higher!
Otherwise, we do not exercise the right to buy and simply walk away.
– Our flexibility: Postpone the investment decision and learn in the meantime.
– For what follows, remember that the expected return of 20% is uncertain (15% standard
deviation).

ILLUSTRATION
Value of Land (millions)
Value in 1 year = 1.6 Mio.

Possible development
Return >> 20%
Value of the right to buy (in
1 year): 500,000
(Buy @ 1.1 something with a
value of 1.6 à NPV1 = 0.5M)
Exercise
Price (K)
Current
Value (S)
Time (days)

ILLUSTRATION (2)
«In the Money»

If value at year end (ST) >
purchase price (K)
à «exercise» the right
and buy the land
Exercise à PayoffT = ST – K
Price (X)
Current «Out of the Money»
Value (S) If value at year end (ST) <
purchase price (K)
à Don’t «exercise»
à Don’t buy the land
à PayoffT = 0
Time (days)

CALL OPTION PAYOFF AT MATURITY
For the option owner (LONG position): For the option writer (SHORT position):
• Don’t exercise the right if the land value is • Opposite payoffs.
below 1.1 million at maturity. PayoffT = 0 • Obligation to sell the land at 1.1 million if value
• Exercise the right if the value is above 1.1 goes up. PayoffT = 1’100 – value of land.
million. PayoffT = Value of land – 1’100 • Can’t sell the land at 1.1 million if value goes down.
• Option payoff at maturity = max(0, ST – K) PayoffT = 0
• Option payoff at maturity = min(0, K – ST)
Payoff call option long Payoff call option short
1'400 0
Thousands
Thousands
0 500 1'000 1'500 2'000 2'500

Thousands
1'200 -200
1'000 -400
Option payoff
800
Option payoff
-600
600
-800
400
-1'000
200
-1'200
0
0 500 1'000 1'500 2'000 2'500 -1'400
Thousands
Future Value of Asset at Maturity Future Value of Asset at Maturity
At maturity, the worst thing that can happen to a At maturity, the best thing that can happen to a call
call long is nothing. Else, the owner makes money. short is nothing. Else, the writer loses money.
Because of these asymmetric payoffs at maturity (owner of option can’t lose money, writer of option can’t make money), options
are clearly valuable. In other words, no option writer in his right mind will give away an option for free. Long positions in call
options are valuable (and short positions have a corresponding negative value). The question is how to determine that value…
RELEVANT VALUE DRIVERS
– Related to the Underlying Asset

– S = Current value of the underlying asset (i.e., where we start)
– 𝛔 = Volatility / Uncertainty (How volatile the return is)
– y = Expected Dividends of the asset during the lifetime of the option (value
depreciation over time)
– Variables related to the Option

– K = Exercise price (required future investment; dashed line)
– T-t = Time to maturity of the Option (How long we canwait)
– R = Risk-free return (trend): as the risk-free rate increases, the right to buy something in
the future become more attractive

BLACK-SCHOLES-MERTON MODEL: CALL OPTION
– Under VERY strict assumptions, there is a closed-form solution to the valuation

problem. The value of the right to buy one unit of the underlying asset, a
so-called call option, is determined as:
𝐜 = 𝐒×𝐞"𝐲 𝐓"𝐭 ×𝐍 𝐝𝟏 − 𝐊×𝐞"𝐫 𝐓"𝐭 ×𝐍 𝐝𝟐
Buy fraction of asset Risk-free borrowing of expected K
with: ln S⁄K + r − y + σ" ⁄2 × T − t

d! =
S = Current value of the asset σ× T − t
K = Exercise price
𝛔 = Return volatility of underlying d2 = d1 - s ´ T - t.
T-t = Time to maturity
y = dividend yield (continuous comp.) N(d.) = probability that a normal
r = risk-free rate (continuous comp.) (0,1) variable is less than d.

BLACK-SCHOLES-MERTON MODE: PUT OPTION
– The right to sell one unit of the underlying asset is called put option. We can value a put
option as follows:
𝐩 = 𝐊×𝐞"𝐫 𝐓"𝐭 ×𝐍 −𝐝𝟐 − 𝐒×𝐞"𝐲 𝐓"𝐭 ×𝐍 −𝐝𝟏
Invest risk-free Sell a fraction of the underlying
– Don’t worry (too much) about the formulas. There is a calculator on my website
(https://www.teju-finance.com/bs)
– NOTE THAT ON THIS WEBSITE (AS WELL AS IN MANY OTHER RESOURCES), THE
EXERCISE PRICE IS DENOTED WITH THE LETTER X (NOT K)

LAND EXAMPLE
– From our assumptions from before, we know:

– S = 1,000,000; X = 1,100,000; T-t = 1 year; y = 0; R = 10%; σ = 15%
Variable Description Value

S Current Value of the Asset 1'000'000
X Exercise price 1'100'000 From today’s
T-t Time to maturity 1.00 perspective, the right
R Risk-free return (discrete compounding) 10.00%
Y Dividend yield (discrete compounding) 0.00%
to buy the land in 1
σ Volatility (Standard deviation of return) 15.00% year has a value of
approximately $60,000
c Value of a right to buy (call option) 59'785.29
– The value of the right to buy the land is 60,000. The asking price for that right is 50,000.
Consequently, it is a GOOD deal. It’s NPV is 10,000.

EXAMPLE FOR RIGHT TO SELL (PUT OPTION)
The Meta stock is trading at USD 393.

– You want to guarantee a minimum sales price of $350 (K, X) in 2 years (T-t).
– The risk-free rate of return (discrete compounding) is 4%, the stock pays no dividends (y
= 0), and its return volatility is 40%.
Based on this information, how much will the insurance cost you today?
This is a so-called “protective put.” You buy a PUT option to lock in the minimum price at
which you can sell in the future. Using the online calculator, the value of such an option is:
The right to sell one Meta stock at 350

in 2 years has a value of approx. $49.6
today. This is how much the
“insurance” against higher losses
would cost you today.

PUT OPTION PAYOFF AT MATURITY
For the put option owner (LONG position): For the put option writer (SHORT position):
• Don’t exercise the option if the stock price is • Opposite payoffs.
above 350. PayoffT = 0 • Obligation to buy at 350 if the price is low.
• Exercise if it is below 350. • Can’t buy at 350 if the price is
• PayoffT = max(0, X – ST) • PayoffT = min(0, ST – X)
Payoff put option long Payoff put option short

400 0
0 50 100 150 200 250 300 350 400 450 500 550 600 650 700
350 -50
300 -100
250 -150
Option payoff
Option payoff
200
-200
150
-250
100
-300
50
-350
0
0 50 100 150 200 250 300 350 400 450 500 550 600 650 700 -400
Future Value of Asset at Maturity Future Value of Asset at Maturity
At maturity, the worst thing that can happen to a At maturity, the best thing that can happen to a call
call long is nothing. Else, the owner makes money. short is nothing. Else, the writer loses money.

Illustration (2)
WHAT MAKES OPTIONS VALUABLE?

«In the Money»
If value at year end >
purchase price
à «exercise»
à Buy the land
Remember the main questions behind option valuation:

«Out of the Money»
If value at year end <
purchase price
à Don’t «exercise»
à Don’t buy the land
à Option is worthless
• How likely is it, that the option ends up «in the money?» Time (days)
© Urs Wälchli BRN 482: Corporate Financial Policy 7
• And, if so, how deep in the money will it be?
Keeping all else the same, the sensitivities of calls an puts can be described as:
Parameter CALL option sensitivity PUT option sensitivity
S (+) With a higher starting point, it is more (–) With a higher starting point, it is less likely
likely to end up in the money (above X). to end up in the money (below X).
X (–) With a higher hurdle (dashed line), it is (+) With a higher hurdle, it is more likely to
less likely to end up in the money (above X). end up in the money (below X)
T-t (+) As time passes, options lose value (+) As time passes, options lose value
R (+) The steeper the trend, the easier it is to (–) The steeper the trend, the harder it is to
get in the money (above X) get in the money (below X).
Y (–) If the asset loses a lot of value over time, (+) If the asset loses a lot of value over time,
it is harder to get in the money (above X) it is easier to get in the money (below X)
σ (+) Uncertainty is good. With high volatility, (+) Uncertainty is good. With high volatility,
the option can go deep in the money. the option can go deep in the money.

WAIT A SECOND...
In Finance I, you have learned that risk is bad. Higher risk means higher discount rates and
lower NPV.
Now I am telling you that risk is good… Who is right???
Both are!
– In Finance I, you have looked at investment decisions in a relatively static way. Once
you have made your investment, you prefer certainty and predictability to “milk the cow.”
(You don’t want your new technology to be obsolete in a year…)
– With options, we look at rights to make investment decisions in the future! The (full)
capital has not yet been invested. If the product or the market environment develop
favorably, we invest. If not, we do something else. Such managerial flexibility is more
valuable in dynamic (volatile) environments!
– As we have seen throughout Finance II, these considerations around options are
CRUCIAL when analyzing the capital structure, implementing projects (“agility”), and
financing companies (“financing rounds”).
• In management (and life), it’s all about options…

STRUCTURE
– Forwards
– Futures
– Options
– Applications

OPTIONS IN VALUATION
Remember the way we value assets:

– Understand the asset payoff over time or at maturity
– Build a replicating portfolio with identical payoffs
In this context, options play a crucial role.
Why?
– Whenever there is a “kink” in a payoff chart, there is an option.
Let’s look at a few examples:

– Straight debt
– Convertible bonds
– Other option strategies

The ingredients for the
replicating portfolios

OPTIONS IN THE FINANCING OF PROJECTS AND FIRMS
– Options play a crucial role when financing and implementing projects?

Why?
• When implementing projects, not all investment decisions must be taken

upfront… For example:
– If things go well, we keep investing and expand (Option to expand)
– If things don’t go well, we stop the project (Option to abandon)
– Over time, we learn about the project and the market. We can tie our
investment decisions to these learnings.
– Milestone financing, agility, lean management, etc.
• These (real) options make projects more valuable. And it’s no rocket
science.

OPTIONS IN THE CAPITAL STRUCTURE
– Options also play an important role when analyzing the capital structure of a
firm. Why?
• Unless a company is fully equity financed (i.e., all providers of capital have the
exact same claim), the various sources of capital (i.e., debt and equity) share
the downside risk and the upside potential non-proportionately.
• Whenever there is a “kink” in the payoff line, there is an option!
• Most financing instruments have implied options

EXAMPLE
Let’s assume a firm currently has an enterprise value of 2,000. It is

financed with 1,400 of debt (zero-coupon bond) with maturity 5 years. The
current risk-free rate of return is 3% p.a., and the volatility of the firm’s
return is 35%.
Distribution of Payoffs at Maturity

4'000
Total payoff Debt payoff
3'500
3'000
2'500 Equity Payoff

Payoff
2'000
1'500
1'000
500
0
0 700 1'400 2'100 2'800 3'500
Future Value of Firm (in 5 years)

REPLICATING PORTFOLIO
Risk-free investment with
Face Value 1,400 and Put Short with Exercise Price
Maturity 5 years = 1,400
Distribution of Payoffs at Maturity Distribution of Payoffs at Maturity Distribution of Payoffs at Maturity
2'000 2000 2'000
Debt payoff Risk -free bond Put short
1'500 1500 1'500
1'000 1000 1'000
500 500 500
= +
Payoff
Payoff
Payoff
0 0 0
0 700 1'400 2'100 2'800 3'500 0 700 1'400 2'100 2'800 3'500 0 700 1'400 2'100 2'800 3'500
-500 -500 -500
-1'000 -1000 -1'000
-1'500 -1500 -1'500
-2'000 -2000 -2'000

Future Value of Firm (in 5 years) Future Value of Firm (in 5 years) Future Value of Firm (in 5 years)
1,400
Value? = 1,207.65 −182.85
1.03#
Debt value = 1,207.65 – 182.85 = 1,024.80

ANOTHER REPLICATING PORTFOLIO
Asset long
(the firm) Call Short with Exercise Price
= 1,400
3,500 3,500
2'000 Total firm payoff Call Short
Debt payoff 3,000 3,000
1'500 2,500
2,500
1'000 2,000 2,000
1,500 1,500
500
1,000 1,000
= +
Payoff
Payoff
Payoff
0 500 500
0 700 1'400 2'100 2'800 3'500
-500 0 0
-500 0 500 1,000 1,500 2,000 2,500 3,000 3,500 -500 0 500 1,000 1,500 2,000 2,500 3,000 3,500
-1'000
-1,000 -1,000
-1'500 -1,500 -1,500
-2,000 -2,000
-2'000 Future Value of Firm (in 5 years) Future Value of Firm (in 5 years)
Future Value of Firm (in 5 years)
S = 2,000
Value? −975.20
Debt value = 2,000 – 975.2 = 1,024.80

ANOTHER APPLICATION... CONVERTIBLE BOND
Let’s assume an investor holds a convertible bond with the following characteristics:
– The notional value is CHF 5 million (zero-coupon)
– At the discretion of the investor, this bond can be converted into 25% of the firm’s
equity (hence, «convertible» bond)
The current value of the firm is CHF 18 million, the maturity date of the bond is 3 years from
now (this is also when the conversion option expires), the risk-free rate of return is 3% and the
volatility of the firm’s return is 40%.
Based on this information, what’s the value of the convertible bond?

THE PAYOFF CHART (AT MATURITY)
At maturity (in 3 years), the investor can choose between the bond (cash payment
of max. 5M) OR 25% of the firm’s equity.
– The investor will choose the bond repayment up to a firm value of 20M.
– Above 20M (=5/0.25) , 25% of the equity is more valuable than a fixed payment
of 5M. Hence, at firm value above 20M in 3 years, the investor will exercise the
conversion option...
Distribution of Payoffs at Maturity Distribution of Payoffs at Maturity

15 15
Convertible bond
Bond 25% Equi ty
10 10
Payoff
Payoff
5 5
0 0
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
Future Value of Firm (in 3 years) Future Value of Firm (in 3 years)

REPLICATING PORTFOLIO...

15 15 15.0
Convertible bond
Bond 0.25*Call long (X = 20)
10 10 10.0
= +
Payoff
Payoff
Payoff
5 5 5.0
0 0 0.0
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
Future Value of Firm (in 3 years) Future Value of Firm (in 3 years) Future Value of Firm (in 3 years)
! 0.25 Call options with X = 20

Risk-free bond: ".$%! = 4.576
Value of convertible bond?
- Put(S=18, X = 5,T-t=3, R=3%, s=40%) = -0.0542
0.25 x Call(S=18, X = 20,T-t=3, R=3%, s=40%)
5.7136 = 4.5215 =0.25 x 4.7684 = 1.1921
Using option pricing and the idea of a replicating

portfolio, we conclude that the value of the
convertible bond is 5.7136 million.

OTHER OPTION STRATEGIES… THE SKY IS THE LIMIT

EXAM RELEVANCE OF DERIVATIVES
What do you need to know from all of this for the final
exam?
1. I do NOT expect you to value options (Black-Scholes

Model).
2. I expect you to be able to build replicating portfolios

of the payoffs at maturity, using the various
“ingredients” from the formula sheet (Asset long/short;
Forward long/short; Call/Put long/short)
3. I will NOT ask for any payoff profiles that we have not
discussed carefully in class.

STRUCTURE
– Forwards
– Futures
– Options
– Applications

PARTICIPANTS IN DERIVATIVES MARKETS
Hedgers
– Goal: Reduce risk exposure by taking perfectly negatively correlated position (insurance)
– Example: The British company in the introductory example with a FX risk
Speculators
– Goal: Take a position in the market. With derivatives, speculators can do so with high
leverage.
– Example: Suppose you think the stock of AstraZeneca is currently undervalued. à Buy
call options on AstraZeneca
Arbitrageurs
– Goal: Obtain a riskless profit by simultaneously entering transactions in 2 or more markets
– Example: A stock trades in both New York and London. Suppose the price is $120 in New
York and $110 in London. à Buy call option in London and put option in New York

SUMMARY
We have studied derivatives (forward, futures, options).

– Valuation
– Payoffs at maturity
We have seen that volatility is very important to the value of options.
We have used various assets to build replicating portfolios and to value other complex assets
(debt, convertible bond, etc.).
Options can among other things be used to hedge, bet, value corporate debt, and value
growth options.
The derivatives markets play a very important role, in particular because the facilitate the
trading (transfer) of risk!

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FINANCE II – SPRING 2024

Session 5: Forwards, Futures, Options

© Urs Wälchli Finance II, p. 1 Session 5

– Participants in Derivatives Markets

© Urs Wälchli Finance II, p. 2 Session 5

There are many different types of derivatives, including:

The key participants in derivatives markets are:

© Urs Wälchli Finance II, p. 3 Session 5

– A forward is a contract to buy or sell an asset at a certain future time T

– Very flexible and, therefore, typically not traded on an exchange

– Common underlying assets

© Urs Wälchli Finance II, p. 4 Session 5

GBP-Value of USD-Payment in 6 months

© Urs Wälchli Finance II, p. 5 Session 5

At maturity, the forward contract has the following payoffs:

where ST is the (today unknown) spot price of the asset at maturity

Long Position Short Position

© Urs Wälchli Finance II, p. 7 Session 5

Original Business Forward Short

Total Payoff at Maturity

Accounts Obligation from

© Urs Wälchli Finance II, p. 9 Session 5

This is relevant not only for currency transactions.

© Urs Wälchli Finance II, p. 10 Session 5

– Participants in Derivatives Markets

© Urs Wälchli Finance II, p. 11 Session 5

Unlike a forward, the precise delivery date is usually not specified

Unlike a forward, futures contracts are usually exchange traded

© Urs Wälchli Finance II, p. 12 Session 5

Live Cattle futures on the CME

– One contract is on 40,000 pounds

– Participants in Derivatives Markets

© Urs Wälchli Finance II, p. 14 Session 5

Two basic types of option contracts:

Date in the contract, T: expiration date, exercise date, or maturity

© Urs Wälchli Finance II, p. 15 Session 5

Two main types of option contracts:

© Urs Wälchli Finance II, p. 16 Session 5

– Should you buy the right to buy the land?

© Urs Wälchli Finance II, p. 17 Session 5

– From today’s perspective, the value of the offer is as follows:

PV of purchase price = X/(1+R) = 1.1/1.1 = 1 million.

– The right to buy the land costs 50’000 today

– The NPV is -50’000. It’s not a good deal:

NPV = –Cost of right to buy land – PV purchase price + PV land value

© Urs Wälchli Finance II, p. 18 Session 5

– We have assumed that we will buy the land in 1 year…

© Urs Wälchli Finance II, p. 19 Session 5

Value in 1 year = 1.6 Mio.

© Urs Wälchli Finance II, p. 20 Session 5

«In the Money»

© Urs Wälchli Finance II, p. 21 Session 5

0 500 1'000 1'500 2'000 2'500

Future Value of Asset at Maturity Future Value of Asset at Maturity

– Related to the Underlying Asset

– Variables related to the Option

© Urs Wälchli Finance II, p. 23 Session 5

– Under VERY strict assumptions, there is a closed-form solution to the valuation