1

Topic 1
Introduction To Derivatives
2
This first lecture has four main goals:
1. Introduce you to the notion of risk and the role of derivatives in
managing risk.
Discuss some of the general terms such as short/long positions,
bid-ask spread from finance that we need.

2. Introduce you to three major classes of derivative securities.
Forwards
Futures
Options

3. Introduce you to the basic viewpoint needed to analyze these
securities.

4. Introduce you to the major traders of these instruments.
Basics
3
Basics
Finance is the study of risk.
How to measure it
How to reduce it
How to allocate it

All finance problems ultimately boil down to three main
questions:
What are the cash flows, and when do they occur?
Who gets the cash flows?
What is the appropriate discount rate for those cash flows?

The difficulty, of course, is that normally none of those
questions have an easy answer.
4
Basics
As you know from other classes, we can generally classify risk as
being diversifiable or non-diversifiable:
Diversifiable risk that is specific to a specific investment i.e. the risk
that a single companys stock may go down (i.e. Enron). This is
frequently called idiosyncratic risk.
Non-diversifiable risk that is common to all investing in general and
that cannot be reduced i.e. the risk that the entire stock market (or
bond market, or real estate market) will crash. This is frequently called
systematic risk.
The market pays you for bearing non-diversifiable risk only not
for bearing diversifiable risk.
In general the more non-diversifiable risk that you bear, the greater the
expected return to your investment(s).
Many investors fail to properly diversify, and as a result bear more risk
than they have to in order to earn a given level of expected return.
5
Basics
In this sense, we can view the field of finance as being
about two issues:
The elimination of diversifiable risk in portfolios;
The allocation of systematic (non-diversifiable) risk to those
members of society that are most willing to bear it.

Indeed, it is really this second function the allocation
of systematic risk that drives rates of return.
The expected rate of return is the price that the market pays
investors for bearing systematic risk.

6
Basics
A derivative (or derivative security) is a financial
instrument whose value depends upon the value of
other, more basic, underlying variables.

Some common examples include things such as stock
options, futures, and forwards.

It can also extend to something like a reimbursement
program for college credit. Consider that if your firm
reimburses 100% of costs for an A, 75% of costs for
a B, 50% for a C and 0% for anything less.
7
Your right to claim this reimbursement, then is tied to
the grade you earn. The value of that reimbursement
plan, therefore, is derived from the grade you earn.

We also say that the value is contingent upon the grade
you earn. Thus, your claim for reimbursement is a
contingent claim.

The terms contingent claims and derivatives are used
interchangeably.

Basics
8
Basics
So why do we have derivatives and derivatives markets?
Because they somehow allow investors to better control the
level of risk that they bear.
They can help eliminate idiosyncratic risk.
They can decrease or increase the level of systematic risk.
9
A First Example
There is a neat example from the bond-world of a
derivative that is used to move non-diversifiable risk
from one set of investors to another set that are,
presumably, more willing to bear that risk.

Disney wanted to open a theme park in Tokyo, but did
not want to have the shareholders bear the risk of an
earthquake destroying the park.
They financed the park through the issuance of earthquake
bonds.
If an earthquake of at least 7.5 hit within 10 km of the park, the
bonds did not have to be repaid, and there was a sliding scale
for smaller quakes and for larger ones that were located further
away from the park.
10
A First Example
Normally this could have been handled in the insurance
(and re-insurance) markets, but there would have been
transaction costs involved. By placing the risk directly
upon the bondholders Disney was able to avoid those
transactions costs.
Presumably the bondholders of the Disney bonds are basically
the same investors that would have been holding the stock or
bonds of the insurance/reinsurance companies.
Although the risk of earthquake is not diversifiable to the park, it
could be to Disney shareholders, so this does beg the question
of why buy the insurance at all.
This was not a free insurance. Disney paid LIBOR+310
on the bond. If the earthquake provision was not it
there, they would have paid a lower rate.
11
A First Example
This example illustrates an interesting notion that
insurance contracts (for property insurance) are really
derivatives!
They allow the owner of the asset to sell the insured
asset to the insurer in the event of a disaster.
They are like put options (more on this later.)

12
Basics
Positions In general if you are buying an asset be it
a physical stock or bond, or the right to determine
whether or not you will acquire the asset in the future
(such as through an option or futures contract) you are
said to be LONG the instrument.
If you are giving up the asset, or giving up the right to
determine whether or not you will own the asset in the
future, you are said to be SHORT the instrument.
In the stock and bond markets, if you short an asset, it means
that you borrow it, sell the asset, and then later buy it back.
In derivatives markets you generally do not have to borrow the
instrument you can simply take a position (such as writing an
option) that will require you to give up the asset or
determination of ownership of the asset.
Usually in derivatives markets the short is just the negative of
the long position
13
Basics
Commissions Virtually all transactions in the financial
markets requires some form of commission payment.
The size of the commission depends upon the relative position of
the trader: retail traders pay the most, institutional traders pay
less, market makers pay the least (but still pay to the
exchanges.)
The larger the trade, the smaller the commission is in
percentage terms.
Bid-Ask spread Depending upon whether you are
buying or selling an instrument, you will get different
prices. If you wish to sell, you will get a BID quote,
and if you wish to buy you will get an ASK quote.
14
Basics
The difference between the bid and the ask can vary
depending upon whether you are a retail, institutional, or
broker trader; it can also vary if you are placing very
large trades.
In general, however, the bid-ask spread is relatively
constant for a given customer/position.
The spread is roughly a constant percentage of the
transaction, regardless of the scale unlike the
commission.
Especially in options trading, the bid-ask spread is a
much bigger transaction cost than the commission.
15
Basics
Here are some example stock bid-ask spreads from
8/22/2006:
IBM: Bid 78.77 Ask 78.79 0.025%
ATT: Bid 30.59 Ask 30.60 0.033%
Microsoft: Bid 25.73 Ask 25.74 0.039%
Here are some example option bid-ask spreads (All with
good volume)
IBM Oct 85 Call: Bid 2.05 Ask 2.20 7.3171%
ATT Oct 15 Call: Bid 0.50 Ask 0.55 10.000%
MSFT Oct 27.5 : Bid 0.70 Ask 0.80. 14.285%

16
Basics
The point of the preceding slide is to demonstrate that
the bid-ask spread can be a huge factor in determining
the profitability of a trade.
Many of those option positions require at least a 10% price
movement before the trade is profitable.
Many trading strategies that you see people propose
(and that are frequently demonstrated using real data)
are based upon using the average of the bid-ask spread.
They usually lose their effectiveness when the bid-ask
spread is considered.

17
Basics
Market Efficiency We normally talk about financial markets as
being efficient information processors.
Markets efficiently incorporate all publicly available information into
financial asset prices.
The mechanism through which this is done is by investors
buying/selling based upon their discovery and analysis of new
information.
The limiting factor in this is the transaction costs associated with the
market.
For this reason, it is better to say that financial markets are efficient to
within transactions costs. Some financial economists say that
financial markets are efficient to within the bid-ask spread.
Now, to a large degree for this class we can ignore the bid-ask spread,
but there are some points where it will be particularly relevant, and we
will consider it then.
18
Basics
Before we begin to examine specific contracts, we need
to consider two additional risks in the market:
Credit risk the risk that your trading partner might not honor
their obligations.
Familiar risk to anybody that has traded on ebay!
Generally exchanges serve to mitigate this risk.
Can also be mitigated by escrow accounts.
Margin requirements are a form of escrow account.
Liquidity risk the risk that when you need to buy or sell an
instrument you may not be able to find a counterparty.
Can be very common for outsiders in commodities markets.
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Basics
So now we are going to begin examining the basic
instruments of derivatives. In particular we will look at
(tonight):
Forwards
Futures
Options
The purpose of our discussion tonight is to simply
provide a basic understanding of the structure of the
instruments and the basic reasons they might exist.
We will have a more in-detail examination of their properties,
and their pricing, in the weeks to come.
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A forward contract is an agreement between two parties to
buy or sell an asset at a certain future time for a certain
future price.
Forward contracts are normally not exchange traded.
The party that agrees to buy the asset in the future is said to
have the long position.
The party that agrees to sell the asset in the future is said to
have the short position.
The specified future date for the exchange is known as the
delivery (maturity) date.

Forward Contracts
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The specified price for the sale is known as the delivery
price, we will denote this as K.
Note that K is set such that at initiation of the contract the value
of the forward contract is 0. Thus, by design, no cash changes
hands at time 0. The mechanics of how to do this we cover in
later lectures.
As time progresses the delivery price doesnt change, but
the current spot (market) rate does. Thus, the contract
gains (or loses) value over time.
Consider the situation at the maturity date of the contract. If
the spot price is higher than the delivery price, the long party
can buy at K and immediately sell at the spot price S
T
, making a
profit of (S
T
-K), whereas the short position could have sold the
asset for S
T
, but is obligated to sell for K, earning a profit
(negative) of (K-S
T
).

Forward Contracts
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Example:
Lets say that you entered into a forward contract to buy wheat
at $4.00/bushel, with delivery in December (thus K=$3.64.)
Lets say that the delivery date was December 14 and that on
December 14
th
the market price of wheat is unlikely to be
exactly $4.00/bushel, but that is the price at which you have
agreed (via the forward contract) to buy your wheat.
If the market price is greater than $4.00/bushel, you are
pleased, because you are able to buy an asset for less than its
market price.
If, however, the market price is less than $4.00/bushel, you are
not pleased because you are paying more than the market price
for the wheat.
Indeed, we can determine your net payoff to the trade by
applying the formula: payoff = S
T
K, since you gain an asset
worth S
T
, but you have to pay $K for it.
We can graph the payoff function:
Forward Contracts
23
Forward Contracts
Payoff to Futures Position on Wheat
Where the Delivery Price (K) is $4.00/Bushel
-4
-3
-2
-1
0
1
2
3
4
0 1 2 3 4 5 6 7 8
Wheat Market (Spot) Price, December 14
P
a
y
o
f
f

t
o

F
o
r
w
a
r
d
s
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Example:
In this example you were the long party, but what about the
short party?
They have agreed to sell wheat to you for $4.00/bushel on
December 14.
Their payoff is positive if the market price of wheat is less than
$4.00/bushel they force you to pay more for the wheat than
they could sell it for on the open market.
Indeed, you could assume that what they do is buy it on the open
market and then immediately deliver it to you in the forward
contract.
Their payoff is negative, however, if the market price of wheat is
greater than $4.00/bushel.
They could have sold the wheat for more than $4.00/bushel had
they not agreed to sell it to you.
So their payoff function is the mirror image of your payoff
function:
Forward Contracts
25
Forward Contracts
Payoff to Short Futures Position on Wheat
Where the Delivery Price (K) is $4.00/Bushel
-4
-3
-2
-1
0
1
2
3
4
0 1 2 3 4 5 6 7 8
Wheat Market (Spot) Price, December 14
P
a
y
o
f
f

t
o

F
o
r
w
a
r
d
s
26
Forward Contracts
Clearly the short position is just the mirror image of the
long position, and, taken together the two positions
cancel each other out:
27
Forward Contracts
Long and Short Positions in a Forward Contract
For Wheat at $4.00/Bushel
-4
-3
-2
-1
0
1
2
3
4
0 1 2 3 4 5 6 7 8
Wheat Price
P
a
y
o
f
f Long Position
Net
Position
Short Position
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Futures Contracts
A 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 for a certain price. Futures,
however, are usually exchange traded and, to facilitate
trading, are usually standardized contracts. This results in
more institutional detail than is the case with forwards.

The long and short party usually do not deal with each
other directly or even know each other for that matter.
The exchange acts as a clearinghouse. As far as the two
sides are concerned they are entering into contracts with
the exchange. In fact, the exchange guarantees
performance of the contract regardless of whether the
other party fails.

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Futures Contracts
The largest futures exchanges are the Chicago Board of
Trade (CBOT) and the Chicago Mercantile Exchange
(CME).

Futures are traded on a wide range of commodities and
financial assets.

Usually an exact delivery date is not specified, but rather
a delivery range is specified. The short position has the
option to choose when delivery is made. This is done to
accommodate physical delivery issues.
Harvest dates vary from year to year, transportation schedules
change, etc.
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Futures Contracts
The exchange will usually place restrictions and conditions
on futures. These include:
Daily price (change) limits.
For commodities, grade requirements.
Delivery method and place.
How the contract is quoted.

Note however, that the basic payoffs are the same as for a
forward contract.
31
Options Contracts
Options on stocks were first traded in 1973. That was
the year the famous Black-Scholes formula was
published, along with Mertons paper - a set of
academic papers that literally started an industry.
Options exist on virtually anything. Tonight we are
going to focus on general options terminology for
stocks. We will get into other types of options later in
the class.
There are two basic types of options:
A Call option is the right, but not the obligation, to buy the
underlying asset by a certain date for a certain price.
A Put option is the right, but not the obligation, to sell the
underlying asset by a certain date for a certain price.
Note that unlike a forward or futures contract, the holder of the
options contract does not have to do anything - they have the
option to do it or not.
32
Options Contracts
The date when the option expires is known as the
exercise date, the expiration date, or the maturity date.
The price at which the asset can be purchased or sold is
known as the strike price.
If an option is said to be European, it means that the
holder of the option can buy or sell (depending on if it is
a call or a put) only on the maturity date. If the option is
said to be an American style option, the holder can
exercise on any date up to and including the exercise
date.
An options contract is always costly to enter as the long
party. The short party always is always paid to enter into
the contract
Looking at the payoff diagrams you can see why
33
Options Contracts
Lets say that you entered into a call option on IBM
stock:
Today IBM is selling for roughly $78.80/share, so lets say you
entered into a call option that would let you buy IBM stock in
December at a price of $80/share.
If in December the market price of IBM were greater than $80,
you would exercise your option, and purchase the IBM share for
$80.
If, in December IBM stock were selling for less than $80/share,
you could buy the stock for less by buying it in the open market,
so you would not exercise your option.
Thus your payoff to the option is $0 if the IBM stock is less than $80
It is (S
T
-K) if IBM stock is worth more than $80
Thus, your payoff diagram is:
34
Options Contracts
Long Call on IBM
with Strike Price (K) = $80
-20
0
20
40
60
80
0 20 40 60 80 100 120 140 160
IBM Terminal Stock Price
P
a
y
o
f
f
K =
T
35
Options Contracts
What if you had the short position?
Well, after you enter into the contract, you have granted the
option to the long-party.
If they want to exercise the option, you have to do so.
Of course, they will only exercise the option when it is in there
best interest to do so that is, when the strike price is lower
than the market price of the stock.
So if the stock price is less than the strike price (S
T
<K), then the
long party will just buy the stock in the market, and so the option
will expire, and you will receive $0 at maturity.
If the stock price is more than the strike price (S
T
>K), however,
then the long party will exercise their option and you will have to
sell them an asset that is worth S
T
for $K.
We can thus write your payoff as:
payoff = min(0,S
T
-K),
which has a graph that looks like:
36
Options Contracts
Short Call Position on IBM Stock
with Strike Price (K) = $80
-85
-63.75
-42.5
-21.25
0
21.25
0 20 40 60 80 100 120 140 160
Ending Stock Price
P
a
y
o
f
f

t
o

S
h
o
r
t

P
o
s
i
t
i
o
n
37
Options Contracts
This is obviously the mirror image of the long position.
Notice, however, that at maturity, the short option
position can NEVER have a positive payout the best
that can happen is that they get $0.
This is why the short option party always demands an up-front
payment its the only payment they are going to receive. This
payment is called the option premium or price.

Once again, the two positions net out to zero:
38
Options Contracts
Long and Short Call Options on IBM
with Strike Prices of $80
-100
-80
-60
-40
-20
0
20
40
60
80
100
0 20 40 60 80 100 120 140 160
Ending Stock Price
P
a
y
o
f
f
Long Call
Short Call
Net Position
39
Options Contracts
Recall that a put option grants the long party the right to
sell the underlying at price K.
Returning to our IBM example, if K=80, the long party
will only elect to exercise the option if the price of the
stock in the market is less than $80, otherwise they
would just sell it in the market.
The payoff to the holder of the long put position,
therefore is simply
payoff = max(0, K-S
T
)

40
Options Contracts
Payoff to Long Put Option on IBM
with Strike Price of $80
-10
0
10
20
30
40
50
60
70
80
0 20 40 60 80 100 120 140 160
Ending Stock Price
P
a
y
o
f
f
41
Options Contracts
The short position again has granted the option to the
long position. The short has to buy the stock at price K,
when the long party wants them to do so. Of course the
long party will only do this when the stock price is less
than the strike price.
Thus, the payoff function for the short put position is:
payoff = min(0, S
T
-K)

And the payoff diagram looks like:
42
Options Contracts
Short Put Option on IBM
with Strike Price of $80
-85
-63.75
-42.5
-21.25
0
0 20 40 60 80 100 120 140 160
Ending Stock Price
P
a
y
o
f
f
43
Options Contracts
Since the short put party can never receive a positive
payout at maturity, they demand a payment up-front
from the long party that is, they demand that the long
party pay a premium to induce them to enter into the
contract.

Once again, the short and long positions net out to zero:
when one party wins, the other loses.
44
Options Contracts
Long and Short Put Options on IBM
with Strike Prices of $80
-100
-80
-60
-40
-20
0
20
40
60
80
100
0 20 40 60 80 100 120 140 160
Ending Stock Price
P
a
y
o
f
f
Long Position
Short Position
Net Position
45
Options Contracts
The standard options contract is for 100 units of the
underlying. Thus if the option is selling for $5, you
would have to enter into a contract for 100 of the
underlying stock, and thus the cost of entering would
be $500.
For a European call, the payoff to the option is:
Max(0,S
T
-K)
For a European put it is
Max(0,K-S
T
)
The short positions are just the negative of these:
Short call: -Max(0,S
T
-K) = Min(0,K-S
T
)
Short put: -Max(0,K-S
T
) = Min(0,S
T
-K)

46
Options Contracts
Traders frequently refer to an option as being in the
money, out of the money or at the money.
An in the money option means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would receive a payout.
For a call option this means that S
t
>K
For a put option this means that S
t
<K
An at the money option means one where the strike and
exercise prices are the same.
An out of the money option means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would NOT receive a payout.
For a call option this means that S
t
<K
For a put option this means that S
t
>K.

47
Options Contracts
Long Call on IBM
with Strike Price (K) = $80
-20
0
20
40
60
80
0 20 40 60 80 100 120 140 160
IBM Terminal Stock Price
P
a
y
o
f
f
K =
T
Out of the money
In the money
At the money
48
Options Contracts
One interesting notion is to look at the payoff from just
owning the stock its value is simply the value of the
stock:
49
Options Contracts
Payout Diagram for a Long Position in IBM Stock
0
20
40
60
80
100
120
140
160
180
0 20 40 60 80 100 120 140 160
Ending Stock Price
P
a
y
o
f
f
50
Options Contracts
What is interesting is if we compare the payout from a
portfolio containing a short put and a long call with the
payout from just owning the stock:
51
Options Contracts
Payout Diagram for a Long Position in IBM Stock
-100
-50
0
50
100
150
200
0 20 40 60 80 100 120 140 160
Ending Stock Price
P
a
y
o
f
f
Long Call
Short Put
Stock
52
Options Contracts
Notice how the payoff to the options portfolio has the
same shape and slope as the stock position just offset
by some amount?

This is hinting at one of the most important relationships
in options theory Put-Call parity.

It may be easier to see this if we examine the aggregate
position of the options portfolio:
53
Options Contracts
Payout Diagram for a Long Position in IBM Stock
-100
-50
0
50
100
150
200
0 20 40 60 80 100 120 140 160
Ending Stock Price
P
a
y
o
f
f
54
Options Contracts
We will come back to put-call parity in a few weeks, but
it is well worth keeping this diagram in mind.

So who trades options contracts? Generally there are
three types of options traders:
Hedgers - these are firms that face a business risk. They wish
to get rid of this uncertainty using a derivative. For example, an
airline might use a derivatives contract to hedge the risk that jet
fuel prices might change.
Speculators - They want to take a bet (position) in the market
and simply want to be in place to capture expected up or down
movements.
Arbitrageurs - They are looking for imperfections in the capital
market.
55
Financial Engineering
When we start examining the actual pricing of
derivatives (next week), one of the fundamental ideas
that we will use is the law of one price.
Basically this says that if two portfolios offer the same
cash flows in all potential states of the world, then the
two portfolios must sell for the same price in the market
regardless of the instruments contained in the
portfolios.
This is only true to within transactions costs, i.e. the bid-ask
spread on each individual instrument.
Sometimes one portfolio will have such lower transactions costs
that the law will only approximately hold.
56
Financial Engineering
Financial engineering is the notion that you can use a
combination of assets and financial derivatives to
construct cash flow streams that would otherwise be
difficult or impossible to obtain.
Financial engineering can be used to break apart a set
of cash flows into component pieces that each have
different risks and that can be sold to different investors.
Collateralized Bond Obligations do this for junk bonds.
Collateralized Mortgage Obligations do this for residential
mortgages.
Financial engineering can also be used to create cash
flows streams that would otherwise be difficult to obtain.
57
Financial Engineering
The Schwab/First Union equity-linked CD is a good
example of financial engineering.
When it was issued (in 1999), the stock market was
(and had been) incredibly hot for several years.
Many investors wanted to be in the market, but did not want to
risk the market going down in value.
The equity-linked CD was designed to meet this need.
As we will demonstrate, an investor could roll their own
version of this, but in doing so would have incurred significant
transaction costs.
Plus, many small investors (to whom this was targeted) probably
could not get approval to trade options.
58
Financial Engineering
The Contract:
An investor buys the CD (Certificate of Deposit) today, and then earns
70% of the simple rate of return on S&P 500 index over the next 5.5
years.
If the S&P index ended up below the initial index level (so that the
appreciation was negative), then the investor received their full initial
investment back, but nothing else.
Thus, the payoff to the CD was simply:




So lets say that you invested $10,000, and that in June of 1999 the
index was 1300 (so that you were, in essence, buying $10,000/1,300 or
7.69 units of the index).
5.5
0
* 1 max 0, 1
Maturity
Index
CD Investment
Index
| |
(
= +
|
(
|

\ .
59
Financial Engineering
In 5.5 years your payoff will be based upon the index
level. Potential index levels and payoffs include:
Index Simple Rate of Return Cash Received
1000 - 23.07% $10,000
1200 - 7.69% $10,000
1300 0.00% $10,000
1400 7.69% $10,538
1500 15.38% $11,076
2000 53.85% $13,769
(Note that on 12/30/2004 the S&P 500 was at 1211.92!)
The following chart demonstrates the payouts.
60
Financial Engineering
Payoff to Equity Linked Swap
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
0 500 1000 1500 2000 2500
S&P 500 Level
P
a
y
o
f
f
61
Financial Engineering
Now, the first thing about that chart that you should
notice is that it looks an awful lot like the shape of a call
option, although the slope of the upward-sloping part is
not as steep.
This is our first indication that we may be able to
decompose this into two simpler securities.
Indeed, one way of decomposing this security would be
to assume that we bought a bond that paid $10,000 at
time 5.5, and that we bought 5.38 call options with a
strike of 1300 (70% of 10,000/1300.)
The next graph demonstrates this positions payoff.
62
Financial Engineering
Bond Plus Call Payoff
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
0 500 1000 1500 2000 2500 3000
Index Value
P
a
y
o
f
f Option Payoff
Bond Payoff
Net
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Financial Engineering
This position is ALSO identical to a position consisting of:
$10,000/1300 = 7.692 units of the index.
$10,000/1300 = 7.692 put options on the index (K=1300)
(-(1-.7)*$10,000/1300 = -2.30769) CALL options on the index.

The reason for the short call options is because the CD
only gives us 70% of the return on the index, so we
have to sell back some of that return via the call option
(note that we will earn a premium for this.)

The following chart shows this:
64
Financial Engineering
Long Index, Long Put, Short Call
-5000
0
5000
10000
15000
20000
25000
0 500 1000 1500 2000 2500 3000
Index
P
a
y
o
f
f
Index Payoff
Put Position
Call Position
Net
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Financial Engineering
Now, all three of these should sell for the same price but there
will be some differences because of transactions costs.
Really, this is why the Schwab equity-linked CD can work: investors
(retail investors) are willing to turn to the prepackaged asset to
avoid transaction costs (and to avoid timing difficulties with
unwinding their position.)
Lets just think of this as a bond and .7 long call options for a
moment.
Clearly the call cannot be free, since the investor holds this
option they must pay something for it. How much do they pay?
The interest that they could have earned on this money had they
invested in a traditional CD.
At that time 5.5 year CDs were yielding 6%, so the investor gives
up $3,777 dollars in year 5.5 dollars.
5.5
($10, 000*1.06 ) 10, 000 3, 777 =
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Financial Engineering
The equity-linked CD is just one example of financial
engineering the notion that investors are really just
purchasing potential future cash flows and that any two
sets of identical potential future cash flows must sell for
the same price.

This has led to a real revolution in finance, and we will
discuss this idea throughout the semester.

We will return to options pricing later in the semester.
Next, we turn our attention to the futures/forwards
markets and pricing.