Introduction To Derivatives

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

2. Introduce you to three major classes of derivative securities.

O Forwards
O Futures
O Options

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

securities.

4. Introduce you to the major traders of these instruments.


 Basics
O Finance is the study of risk.
O How to measure it
O How to reduce it
O How to allocate it

O All finance problems ultimately boil down to three main

questions:
O What are the cash flows, and when do they occur?
O Who gets the cash flows?
O What is the appropriate discount rate for those cash flows?

O The difficulty, of course, is that normally none of those

questions have an easy answer.
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 Basics
O As you know from other classes, we can generally classify risk as
being diversifiable or non-
non-diversifiable:
O Diversifiable ƛ risk that is specific to a specific investment ƛ i.e. the risk
that a single companyƞs stock may go down (i.e. Enron). This is
frequently called m m
m m

O Ñon--diversifiable ƛ risk that is common to all investing in general and
Ñon
that cannot be reduced ƛ i.e. the risk that the entire stock market (or
bond market, or real estate market) will crash. This is frequently called
 m m
..
 m m

O The market Ơpaysơ you for bearing non-

non-diversifiable risk only ƛ not
for bearing diversifiable risk.
O In general the more non-
non-diversifiable risk that you bear, the greater the
expected return to your investment(s).
O 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.

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 Basics
O In this sense, we can view the field of finance as being
about two issues:
O The elimination of diversifiable risk in portfolios;
O The 
m
 of systematic (non-
(non-diversifiable) risk to those
members of society that are most willing to bear it.

O Indeed, it is really this second function ƛ the allocation

of systematic risk ƛ that drives rates of return.
O The expected rate of return is the Ơpriceơ that the market pays
investors for bearing systematic risk.

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

O Some common examples include things such as stock

options, futures, and forwards.

O It can also extend to something like a reimbursement

program for college credit. Consider that if your firm
reimburses 100% of costs for an ƠAơ, 75% of costs for
a ƠBơ, 50% for a ƠCơ and 0% for anything less.

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 Basics
O oour Ơrightơ 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.

O We also say that the value is contingent upon the grade

you earn. Thus, your claim for reimbursement is a
Ơcontingentơ claim.

O The terms contingent claims and derivatives are used

interchangeably.

X
 Basics
O So why do we have derivatives and derivatives markets?
O Because they somehow allow investors to better control the level
of risk that they bear.
O They can help eliminate idiosyncratic risk.
O They can decrease or increase the level of systematic risk.

†
 A First Example
O There is a neat example from the bond-
bond-world of a
derivative that is used to move non-
non-diversifiable risk
from one set of investors to another set that are,
presumably, more willing to bear that risk.

O 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.
O They financed the park through the issuance of earthquake
bonds.
O 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.

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 A First Example
O Ñormally this could have been handled in the insurance
(and re-
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.
O 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.
O 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.
O This was not a Ơfreeơ insurance. Disney paid LIBOR+310
on the bond. If the earthquake provision was not it
there, they would have paid a lower rate.

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 A First Example
O This example illustrates an interesting notion ƛ that
insurance contracts (for property insurance) are really
derivatives!
O They allow the owner of the asset to Ơsellơ the insured
asset to the insurer in the event of a disaster.
O They are like put options (more on this later.)

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 Basics
O Positions ƛ In general if you are buying an asset ƛ 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 ƠLOÑ ơ the instrument.
O 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 ƠSHORTơ the instrument.
O In the stock and bond markets, if you Ơshortơ an asset, it means
that you borrow it, sell the asset, and then later buy it back.
O In derivatives markets you generally do not have to borrow the
instrument ƛ 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.
O Usually in derivatives markets the Ơshortơ is just the negative of
the Ơlongơ position
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 Basics
O Commissions ƛ Virtually all transactions in the financial
markets requires some form of commission payment.
O 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.)
O The larger the trade, the smaller the commission is in
percentage terms.
O Bid-Ask spread ƛ Depending upon whether you are
Bid-
buying or selling an instrument, you will get different
prices. If you wish to sell, you will get a ƠBIDơ quote,
and if you wish to buy you will get an ƠASKơ quote.

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 Basics
O 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.
O In general, however, the bid-
bid-ask spread is relatively
constant for a given customer/position.
O The spread is roughly a constant percentage of the
transaction, regardless of the scale ƛ unlike the
commission.
O Especially in options trading, the bid-
bid-ask spread is a
much bigger transaction cost than the commission.

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 Basics
O Here are some example stock bid-
bid-ask spreads from
8/22/2006:
O IBM: Bid ƛ 78.77 Ask ƛ 78.79 0.025%
O ATT: Bid ƛ 30.59 Ask ƛ 30.60 0.033%
O Microsoft: Bid ƛ 25.73 Ask ƛ 25.74 0.039%
O Here are some example option bid-
bid-ask spreads (All with
good volume)
O IBM Oct 85 Call: Bid ƛ 2.05 Ask ƛ 2.20 7.3171%
O ATT Oct 15 Call: Bid ƛ 0.50 Ask ƛ0.55 10.000%
O MSFT Oct 27.5 : Bid ƛ 0.70 Ask ƛ0.80. 14.285%

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

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 Basics
O Market Efficiency ƛ We normally talk about financial markets as
being efficient information processors.
O Markets efficiently incorporate all publicly available information into
financial asset prices.
O The mechanism through which this is done is by investors
buying/selling based upon their discovery and analysis of new
information.
O The limiting factor in this is the transaction costs associated with the
market.
O For this reason, it is better to say that financial markets are efficient 
m
 

     .. Some financial economists say that
financial markets are efficient to within the bid-
bid-ask spread.
O Ñow, to a large degree for this class we can ignore the bid-bid-ask spread,
but there are some points where it will be particularly relevant, and we
will consider it then.

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 Basics
O Before we begin to examine specific contracts, we need
to consider two additional risks in the market:
O Credit risk ƛ the risk that your trading partner might not honor
their obligations.
O Familiar risk to anybody that has traded on ebay!
O enerally exchanges serve to mitigate this risk.
O Can also be mitigated by escrow accounts.
O Margin requirements are a form of escrow account.
O Liquidity risk ƛ the risk that when you need to buy or sell an
instrument you may not be able to find a counterparty.
O Can be very common for Ơoutsidersơ in commodities markets.

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 Basics
O So now we are going to begin examining the basic
instruments of derivatives. In particular we will look at
(tonight):
O Forwards
O Futures
O Options
O The purpose of our discussion today is to simply provide
a basic understanding of the structure of the instruments
and the basic reasons they might exist.
O We will have a more in-in-detail examination of their properties,
and their pricing, in the weeks to come.

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 Forward Contracts
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.
O Forward contracts are normally not exchange traded.
O The party that agrees to buy the asset in the future is said to
have the long position.
O The party that agrees to sell the asset in the future is said to
have the short position.
O The specified future date for the exchange is known as the
delivery (maturity
(maturity)) date.


 Forward Contracts
The specified price for the sale is known as the delivery
price, we will denote this as K.
O Ñote 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 doesnƞt change, but
the current spot (market) rate does. Thus, the contract
gains (or loses) value over time.
O 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 ST, making a
profit of (ST-K), whereas the short position could have sold the
asset for ST, but is obligated to sell for K, earning a profit
(negative) of (K-
(K-ST).

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 Forward Contracts
O Example:
O Letƞs say that you entered into a forward contract to buy wheat
at $4.00/bushel, with delivery in December (thus K=$4.00.)
O Letƞs say that the delivery date was December 14 and that on
December 14th 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.
O 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.
O 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.
O Indeed, we can determine your net payoff to the trade by
applying the formula: payoff = ST ƛ K, since you gain an asset
worth ST, but you have to pay $K for it.
O We can graph the payoff function:

 Forward Contracts
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2
´
$ %

0
0 1 2 3 4 5 6 7 8
-1

-2

-3

-4
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 Forward Contracts
O Example:
O In this example you were the long party, but what about the
short party?
O They have agreed to sell wheat to you for $4.00/bushel on
December 14.
O Their payoff is positive if the market price of wheat is less than
$4.00/bushel ƛ they force you to pay more for the wheat than
they could sell it for on the open market.
O 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.
O Their payoff is negative, however, if the market price of wheat is
greater than $4.00/bushel.
O They could have sold the wheat for more than $4.00/bushel had
they not agreed to sell it to you.
O So their payoff function is the mirror image of your payoff
function:
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 Forward Contracts
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 Forward Contracts
O Clearly the short position is just the mirror image of the
long position, and, taken together the two positions
cancel each other out:

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 Forward Contracts
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3
Short Position
2

1
Long Position


0


0 1 2 3 4 5 6 7 8
1

2
Ñet
Position


4
 

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 Futures Contracts
O 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.

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

O Futures are traded on a wide range of commodities and

financial assets.

O 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.
O Harvest dates vary from year to year, transportation schedules
change, etc.

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 Futures Contracts
O The exchange will usually place restrictions and conditions
on futures. These include:
O Daily price (change) limits.
O For commodities, grade requirements.
O Delivery method and place.
O How the contract is quoted.

O Ñote however, that the basic payoffs are the same as for a
forward contract.

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 Options Contracts
O Options on stocks were first traded in 1973. That was
the year the famous Black-
Black-Scholes formula was
published, along with Mertonƞs paper - a set of
academic papers that literally started an industry.
O 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.
O There are two basic types of options:
O A Call option is the right, but not the obligation, to buy the
underlying asset by a certain date for a certain price.
O A Put option is the right, but not the obligation, to sell the
underlying asset by a certain date for a certain price.
O Ñote 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.

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 Options Contracts
O The date when the option expires is known as the
exercise date, the expiration date, or the maturity date.
O The price at which the asset can be purchased or sold is
known as the strike price.
O 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.
O An options contract is always costly to enter as the long
party. The short party always is always paid to enter into
the contract
O Looking at the payoff diagrams you can see whyƦ

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 Options Contracts
O Letƞs say that you entered into a call option on IBM
stock:
O Today IBM is selling for roughly $78.80/share, so letƞs say you
entered into a call option that would let you buy IBM stock in
December at a price of $80/share.
O If in December the market price of IBM were greater than $80,
you would exercise your option, and purchase the IBM share for
$80.
O 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.
O Thus your payoff to the option is $0 if the IBM stock is less than $80
O It is (ST-K) if IBM stock is worth more than $80
O Thus, your payoff diagram is:

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 Options Contracts
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 Options Contracts
O What if you had the short position?
O Well, after you enter into the contract, you have 6 the
option to the long-
long-party.
O If they want to exercise the option, you have to do so.
O Of course, they will only exercise the option when it is in there
best interest to do so ƛ that is, when the strike price is lower
than the market price of the stock.
O So if the stock price is less than the strike price (ST<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.
O If the stock price is more than the strike price (ST>K), however,
then the long party will exercise their option and you will have to
sell them an asset that is worth ST for $K.
O We can thus write your payoff as:
payoff = min(0,ST-K),
which has a graph that looks like:

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 Options Contracts
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*% & ´

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 Options Contracts
O This is obviously the mirror image of the long position.
O Ñotice, however, that at maturity, the short option
position can ÑEVER have a positive payout ƛ the best
that can happen is that they get $0.
O This is why the short option party always demands an up-
up-front
payment ƛ itƞs the only payment they are going to receive. This
payment is called the option × m or price.

O Once again, the two positions Ơnet outơ to zero:

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 Options Contracts
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Long Call


 

Ñet Position


















Short Call







 
 


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 Options Contracts
O Recall that a put option grants the long party the right to
sell the underlying at price K.
O 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.
O The payoff to the holder of the long put position,
therefore is simply
payoff = max(0, K-K-ST)

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 Options Contracts
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 Options Contracts
O 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.
O Thus, the payoff function for the short put position is:
payoff = min(0, ST-K)

O And the payoff diagram looks like:

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 Options Contracts
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 Options Contracts
O Since the short put party can never receive a positive
payout at maturity, they demand a payment up-up-front
from the long party ƛ that is, they demand that the long
party pay a × m to induce them to enter into the
contract.

O Once again, the short and long positions net out to zero:
when one party wins, the other loses.

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 Options Contracts
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 Options Contracts
O 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.
O For a European call, the payoff to the option is:
O Max(0,ST-K)
O For a European put it is
O Max(0,K--ST)
Max(0,K
O The short positions are just the negative of these:
O Short call: -Max(0,ST-K) = Min(0,K-
Min(0,K-ST)
O Short put: -Max(0,K-
Max(0,K-ST) = Min(0,ST-K)

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 Options Contracts
O Traders frequently refer to an option as being Ơin the
moneyơ, Ơout of the moneyơ or Ơat the moneyơ.
O An Ơin the moneyơ 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.
O For a call option this means that St>K
O For a put option this means that St<K
O An Ơat the moneyơ option means one where the strike and
exercise prices are the same.
O An Ơout of the moneyơ option means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would ÑOT receive a payout.
O For a call option this means that St<K
O For a put option this means that St>K.

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 Options Contracts
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 Options Contracts
O One interesting notion is to look at the payoff from just
owning the stock ƛ its value is simply the value of the
stock:

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 Options Contracts
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 Options Contracts
O 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:

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200

150
Stock
100
Long Call


50
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0
0 20 40 60 80 100 120 140 160
-50
Short Put

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 Options Contracts
O Ñotice how the payoff to the options portfolio has the
same shape and slope as the stock position ƛ just offset
by some amount?

O This is hinting at one of the most important relationships

in options theory ƛ Put-
Put-Call parity.

O It may be easier to see this if we examine the aggregate

position of the options portfolio:

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 Options Contracts
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 Options Contracts
O We will come back to put-
put-call parity in a few weeks, but
it is well worth keeping this diagram in mind.

O So who trades options contracts? enerally there are

three types of options traders:
O 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.
O 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.
O Arbitrageurs - They are looking for imperfections in the capital
market.

D½
 Financial Engineering
O When we start examining the actual pricing of
derivatives (next week), one of the fundamental ideas
that we will use is the Ơlaw of one priceơ.
O 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
ƛ regardless of the instruments contained in the
portfolios.
O This is only true to Ơwithin transactions costsơ, i.e. the bid-
bid-ask
spread on each individual instrument.
O Sometimes one portfolio will have such lower transactions costs
that the law will only approximately hold.

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 Financial Engineering
O 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.
O Financial engineering can be used to Ơbreak apartơ a set
of cash flows into component pieces that each have
different risks and that can be sold to different investors.
O Collateralized Bond Obligations do this for Ơjunkơ bonds.
O Collateralized Mortgage Obligations do this for residential
mortgages.
O Financial engineering can also be used to create cash
flows streams that would otherwise be difficult to obtain.

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 Financial Engineering
O The Schwab/First Union equity-
equity-linked CD is a good
example of financial engineering.
O When it was issued (in 1999), the stock market was
(and had been) incredibly Ơhotơ for several years.
O Many investors wanted to be in the market, but did not want to
risk the market going down in value.
O The equity-
equity-linked CD was designed to meet this need.
O As we will demonstrate, an investor could Ơroll their ownơ
version of this, but in doing so would have incurred significant
transaction costs.
O Plus, many small investors (to whom this was targeted) probably
could not get approval to trade options.

D†
 Financial Engineering
O The Contract:
O 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.
O 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.
O Thus, the payoff to the CD was simply:

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D D 
-

   
 
    
   





O So letƞs 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).

D
 Financial Engineering
O 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
(Ñote that on 12/30/2004 the S&P 500 was at 1211.92!)
O The following chart demonstrates the payouts.

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 Financial Engineering
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 Financial Engineering
O Ñow, 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-
upward-sloping part is
not as steep.
O This is our first indication that we may be able to
decompose this into two simpler securities.
O 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.)
O The next graph demonstrates this positionƞs payoff.

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 Financial Engineering
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18***

16***

14***

12***
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Bond ayoff
8***
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6***

4***

2***

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 Financial Engineering
O This position is ALSO identical to a position consisting of:
O $10,000/1300 = 7.692 units of the index.
O $10,000/1300 = 7.692 put options on the index (K=1300)
O (-(1
(1--.7)*$10,000/1300 = -2.30769) CALL options on the index.

O 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.)

O The following chart shows this:

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 Financial Engineering
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5***

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15***
ndex a off


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 Financial Engineering
O Ñow, all three of these 
 sell for the same price ƛ but there
will be some differences because of transactions costs.
O Really, this is why the Schwab equity-
equity-linked CD can work: investors
(retail investors) are willing to turn to the Ơprepackagedơ asset to
avoid transaction costs (and to avoid timing difficulties with
unwinding their position.)
O Letƞs just think of this as a bond and .7 long call options for a
moment.
O Clearly the call cannot be free, since the investor holds this
option they must pay something for it. How much do they pay?
O The interest that they could have earned on this money had they
invested in a traditional CD.
O At that time 5.5 year CDs were yielding 6%, so the investor Ơgives
upơ $3,777 dollars in year 5.5 dollars.

 





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rr
 Financial Engineering
O The equity-
equity-linked CD is just one example of financial
engineering ƛ 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.

O This has led to a real revolution in finance, and we will

discuss this idea throughout the semester.

O We will return to options pricing later in the semester.

Ñext, we turn our attention to the futures/forwards
markets and pricing.

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