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Lecture 1
OVERVIEW
Chapters 1, 2 and 9
Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 1
The Nature of Derivatives
 A derivative is an instrument whose value depends on the values of other more
basic underlying variables.
 Used by:
 Hedgers (to protect against existing exposure)
 Speculators (to capitalise on anticipated price movements)
 Arbitrageurs (to exploit mispricing)
 What are the different types of derivative contracts?
Role of Derivatives
 Derivatives play a key role in transferring risks in the economy
 There are many underlying assets: stocks, currencies, interest rates, commodities,
debt instruments, electricity, insurance payouts, the weather, etc.
 Many financial transactions have embedded derivatives
 The real options approach to assessing capital investment decisions, which values
the options embedded in investments using derivatives theory, has become widely
accepted
Examples of Derivatives
 Futures Contracts
 Forward Contracts
 Swaps contract
 Options contract
Exchange Traded vs Over the Counter Markets
Exchange OTC
 Standardised contracts are  The over-the counter market is an
exchanged and “traded” important alternative to exchanges
 Includes the use of an intermediary  Trades are usually between
between buyer and seller financial institutions, corporate
 Electronic trading and high treasurers, and fund managers
frequency algorithmic trading is  Transactions are much larger than
becoming an increasingly important in the exchange-traded market
part of the market  Becoming increasingly more
regulated due to GFC (central
clearing parties)
Market Size OTC and Exchange Traded
Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
Futures Contracts
 A futures contract is an agreement to buy or sell an asset at a certain time in the
future for a certain price.
 Specification need to be identified
 Terminology: Buy (Long) a Sell (short) position
 Traditional vs Electronic traded (Exchange traded - CME Group (i.e. NYSE
Euronext, Eurex etc.))
 Settled daily, meet Margin
 How is price determined?
 Most contracts are closed out before maturity – Why?
Delivery
 If a futures contract is not closed out before maturity, it is usually settled by
delivering the assets underlying the contract. When there are alternatives about
what is delivered, where it is delivered, and when it is delivered, the party with the
short position chooses.
 A few contracts (for example, those on stock indices and Eurodollars) are settled in
cash
 When there is cash settlement contracts are traded until a predetermined time. All
are then declared to be closed out.
Margins
 A margin is cash or marketable securities deposited by an investor with his or her
broker
 The balance in the margin account is adjusted to reflect daily settlement
 Margin minimizes the possibility of a loss through a default on a contract
Margins
 A margin is required as collateral (protects against default risk) for all traders of
financial futures contracts.
 Margin requirements can be posted in the following forms:
 Cash (local currency or USD dollar)
 Government Securities
 Clearing Corporation Stock and approved stock
 Letter of credit from an approved bank
 If there is insufficient margin, the trade cannot be executed. Customer either reduce
trade size or top up (increase) margin.
Margin Cash Flows When Futures Price
Increases
Margin Cash Flows When Futures
Price Decreases
Example
 January: an investor enters into a long futures contract to buy 100 oz of gold @
$1,750 per oz in April.
 April: the price of gold is $1,825 per oz
 What is the investor’s profit or loss?
 Profit = ($1825 - $1750)*100 = $7500.
Forward Contract
Over-the Counter Markets
 Customised, long (buy) short (sell) positions
 A forward contract is an OTC agreement to buy or sell an asset at a certain time in the
future for a certain price
 There is no daily settlement (but collateral may have to be posted). At the end of the life
of the contract one party buys the asset for the agreed price from the other party
 Popular with financial institutions and fund managers; especially on currencies and
interest rates.
 Can you see a potential risk problem here?
 What are the potential benefits?
The Lehman Bankruptcy (Business Snapshot
1.1, page 4)
 Lehman’s filed for bankruptcy on September 15, 2008. This was the biggest
bankruptcy in US history
 Lehman was an active participant in the OTC derivatives markets and got into
financial difficulties because it took high risks and found it was unable to roll over its
short term funding
 It had hundreds of thousands of transactions outstanding with about 8,000
counterparties
 Unwinding these transactions has been challenging for both the Lehman liquidators
and their counterparties
New Regulations for OTC Market
 The OTC market is becoming more like the exchange-traded market. New
regulations introduced since the crisis mean that
 Standard OTC products must be traded on swap execution facilities
 A central clearing party must be used as an intermediary for standard products
 Trades must be reported to a central registry
Foreign Exchange Quotes for USD/GBP
exchange rate on June 22, 2012 (See Table 1.1,
page 7)
Bid Offer
Spot 1.5585 1.5589
1-month forward 1.5582 1.5587
Example (page 5)
 On June 22, 2012 the treasurer of a corporation might enter into a long forward
contract to sell £100 million in six months at an exchange rate of 1.5573
 This obligates the corporation to pay £1 million and receive $155.73 million on
December 22, 2012
 What are the possible outcomes for settlement at maturity?
Options - Recall
 Terminology
 Puts, Calls
 Long, Short
 Premium, Strike/Exercise Price
 European, American
 In-the-money, Out-of-the-money
 Intrinsic value, Time value
 Vanilla, exotic
Options
 A call option is an option to buy a certain asset by a certain date for a certain price
(the strike price)
 A put option is an option to sell a certain asset by a certain date for a certain price
(the strike price)
 Exchange traded options: Chicago Board Options Exchange, International
Securities Exchange, NYSE, Eurex (Europe) etc.
 What influences option price?
American vs European Options
 An American option can be exercised at any time during its life
 A European option can be exercised only at maturity
 Which option will be worth more for dividend paying stocks?
Google Call Option Prices (June 25, 2012
Stock Price: bid 561.32, offer 561.51; See page
8)

Strike July July Sept Sept Dec Dec
Price ($) Bid Offer Bid Offer Bid Offer
520 46.50 47.20 55.40 56.80 67.70 70.00
540 31.70 32.30 41.60 42.50 55.30 56.20
560 20.00 20.40 30.20 30.70 44.20 45.00
580 11.30 11.60 20.70 21.20 34.50 35.30
600 5.60 5.90 13.50 13.90 26.30 27.10
Example
 Suppose investor instructs broker to buy Dec call option on Google with XP
$580.The sell/ask price= $35.30
 Option contract to buy or sell is 100 shares
 Cost to investor = $35.30*100 =$3,530 to have the right to buy Google shares at
$580.
 If stock price increases to $650, what is the intrinsic value?
Exchanges Trading Options
 Chicago Board Options Exchange
 International Securities Exchange
 NYSE Euronext
 Eurex (Europe)
 and many more (see list at end of book)
WHY Trade using Derivatives?
 To Hedge, Speculate, and make Arbitrage profit
 Hedge funds trade derivatives for all three reasons
 When a trader has a mandate to use derivatives for hedging or arbitrage, but then
switches to speculation, large losses can result. (See SocGen, Business Snapshot
1.4, page 19)
Hedging Examples (Example 1.1 and 1.2, page
13)
 A US company will pay £10 million for imports from Britain in 3 months and decides
to hedge using a long position in a forward contract
 An investor owns 1,000 shares currently worth $28 per share. A two-month put with
a strike price of $27.50 costs $1. The investor decides to hedge by buying 10
contracts
Speculation Example (pages 15)
 An investor with $2,000 to invest feels that a stock price will increase over the next 2
months. The current stock price is $20 and the price of a 2-month call option with a
strike of $22.50 is $1
 What are the alternative strategies?
Speculation Example (cont.)
 If price increases to $27, what happens?
 Stock: Buy 100 ($2000/$20) shares so profit = 100($27-$20) = $700
 Option: Purchase 2000 calls (100*20), intrinsic value = (27-22.50)=$4.50.
 Total payoff: (2000*4.5)-cost of investment (2000) =$7000.
 Any risk if Speculation is wrong? Say price$15?
 100($15-$20)= -500
 Will option be exercised? What is the maximum loss?
Arbitrage Example (page 17)
 A stock price is quoted as £100 in London and $152 in New York = $USD/UK =
$152/UK
 The current exchange rate is 1.5500
 What is the arbitrage opportunity?

 -Buy 100 shares in NY
 -Sell the Shares in UK
 Convert the sale proceeds from UK to Dollars
 Profit: 100[(1.55*100)-$152]=$300
1. Gold: An Arbitrage Opportunity?
 Example: Suppose that
 The spot price of gold is US$1,700 per ounce
 The quoted 1-year futures price of gold is US$1,800
 The 1-year US$ interest rate is 5% per annum
 No income or storage costs for gold
 Is there an arbitrage opportunity?
 F = $1800
 S(1+r)^t = $1785
 Strategy buy low and sell high!
 Arbitrage Profit = $1800-$1785 = $15
1. Oil: An Arbitrage Opportunity?
 Suppose that:
 The spot price of oil is US$80
 The quoted 1-year futures price of oil is US$90
 The storage costs of oil are 2% per annum
 Is there an arbitrage opportunity?
1. Oil: An Arbitrage Opportunity?
 What is the future price of Gold?
 If the spot price of gold is S & the futures price is for a contract deliverable in T
years is F, then
 F = S (1+r )T
 Storage cost = 2%*$80=$1.60
 F = $80(1+0.05) +1.60
 = $85.60
2. Gold: Another Arbitrage Opportunity?
 Example: Suppose that
 The spot price of gold is US$1,700
 The quoted 1-year futures price of gold is US$1,680
 No income or storage costs for gold
 Is there an arbitrage opportunity? - DIY
Convergence of Futures to Spot (Figure 2.1,
page 28)
Example of a Futures Trade (page 29-30)
 An investor takes a long position in 2 December gold futures contracts on June 5
 contract size is 100 oz.
 futures price is US$1650
 initial margin requirement is US$6,000/contract (US$12,000 in total)
 maintenance margin is US$4,500/contract (US$9,000 in total)
A Possible Outcome (Table 2.1, page 30)
Types of Orders
 Limit
 Stop-loss
 Stop-limit
 Market-if touched
 Discretionary
 Time of day
 Open
 Fill or kill
Profit from a Long and Short Forward or
Futures Position
Forward Contracts vs Futures Contracts
(Table 2.3, page 43)
Types of Options
 A call is an option to buy
 A put is an option to sell
 A European option can be exercised only at the end of its life
 An American option can be exercised at any time
 Option Positions
- Long call (Right to buy); Short call (obligation to sell)
- Long put (right to sell); Short put (obligation to buy)
 Note: A futures/forward contract gives the holder the obligation to buy or sell at a
certain price but Option give the holder the right.
Explanation: Long Call
(Figure 9.1, Page 212)
Intrinsic value = Max [St-XP,0]
Explanation: Short Call
(Figure 9.3, page 213)
 Profit from writing one European call option: option price = $5, strike price = $100
Intrinsic value = -Max [St-XP,0]
Explanation: Long Put
 Profit from buying a European put option: option price = $7, strike price = $70
Intrinsic value = Max [XP-St,0]
Explanation: Short Put
 Profit from writing a European put option: option price = $7, strike price = $70
Intrinsic value = -Max [XP-St,0]
Option Terminology
 Option Moneyness :
 At-the-money option
 In-the-money option
 Out-of-the-money option
 Market Makers:
 - Most exchanges use market makers to facilitate options trading
 - A market maker quotes both bid and ask prices when requested
 - The market maker does not know whether the individual requesting the quotes
wants to buy or sell
FOLLOWING SLIDES NOT EXAMINABLE
(FOR EXTRA KNOWLEDGE)
Introduction to Exotic Options
 An exotic option is something that has a different payoff structure than typical
European or American options
 This can either be in terms of what the underlying asset is, or could be in terms of
when and how a payment is received
 Typically traded OTC due to complex nature of payoff structures
Examples
 Asian or average option – Cash settled, payoff depends on the average price of the
underlying over a period of time.
 Binary or Digital – fixed payoff “all or nothing"
 Barrier – payoff depends on whether an underlying asset has reached or exceeded
a set “price”
 Chooser – can flip between a put or a call
 Lookback – options strike is floating and determined at maturity
Vanilla options: Non – linear payoffs Exotic options: Discontinuous payoffs
Expiry
Payoff One Touch
Expiry
Payoff Call Option
St
Expiry
St Payoff
Call Option +
Knock – Out
Expiry
Payoff Barrier
Put Option
St
Expiry
St
Payoff Double No
Touch
St
Further Information You might Find
Interesting…
 Bloomberg Derivatives Blog
 https://www.bloomberg.com/professional/blog/category/derivative/
 Bank of International Settlements on Derivatives
 http://www.bis.org/statistics/derstats.htm

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Lecture 1

 What are the different types of derivative contracts?

 Many financial transactions have embedded derivatives

 Profit = ($1825 - $1750)*100 = $7500.

1-month forward 1.5582 1.5587

3-month forward 1.5579 1.5585

6-month forward 1.5573 1.5580

 What are the possible outcomes for settlement at maturity?

 What influences option price?

 Which option will be worth more for dividend paying stocks?

520 46.50 47.20 55.40 56.80 67.70 70.00

540 31.70 32.30 41.60 42.50 55.30 56.20

560 20.00 20.40 30.20 30.70 44.20 45.00

580 11.30 11.60 20.70 21.20 34.50 35.30

600 5.60 5.90 13.50 13.90 26.30 27.10

 If stock price increases to $650, what is the intrinsic value?

 What is the arbitrage opportunity?

 Is there an arbitrage opportunity?

 Is there an arbitrage opportunity? - DIY

Intrinsic value = Max [St-XP,0]

Intrinsic value = -Max [St-XP,0]

Intrinsic value = Max [XP-St,0]

Intrinsic value = -Max [XP-St,0]

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