McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 1. Introduction

Rangarajan K. Sundaram

Stern School of Business

New York University

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 Differences between this class and all other
classes in finance & some reminders
• For the purposes of the class, financial markets are divided into:
- Spot market; and
- Forward market.

• In other finance classes, it was assumed or implied that individuals behave in

risk-averse manner. In this class, individuals can behave in risk-neutral manner.
However, individuals are still rational in the sense that they prefer more wealth to
less (i.e., marginal utility from wealth is positive).

• Remember from your previous class(s) in investment that individuals can hold
one or more of the following positions:
- Long position;
- Short position; and
- Short-sale position.

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 Differences between this class and all other
classes in finance & some reminders
• Remember that risk means the possibility of a change in the value of an asset
whether up or down. This broad definition of risk is convenient because different
directions of change are attached to different types of positions held by
individuals.

• For the purposes of this class, it is important to recognize that risk or any concept
attached to it should be thought of in a dynamic sense not in a static sense in the
sense that it can change with time. For example, firm’s risk and therefore, its stock
price risk changes when the firm changes it assets or the way it is financed.
Individual’s attitude towards risk can also change over time like when the
individuals becomes older.

• Risk premium means the compensation that individuals require for bearing the risk
of a security. Mathematically speaking, it represents the change in marginal utility
from wealth as risk increases. Increasing marginal utility means risk-averse
behavior, constant marginal utility means risk-neutral behavior, and decreasing
marginal utility means risk-seeking behavior.
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Differences between this class and all other
classes in finance & some reminders

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Outline

Introduction

Forward Contracts

Futures Contracts

Options

Derivatives and Risk-Management: Some Comments

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Introduction

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Objectives
This segment
Introduces the major classes of derivative securities
Forwards
Futures
Options
Discusses their broad characteristics and points of distinction.
Discusses their uses at a general level.
The objective is introductory: to lay the foundations for the detailed
analysis of derivative securities.

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Derivatives

A derivative security is a financial security whose value depends on (or

derives from) other, more fundamental, underlying financial variables such
as the price of a stock, an interest rate, an index level, a commodity price or
an exchange rate.

A derivative security can also be defined as a contract that allows a

transaction to be settled in the future.

A derivative security is a risky instrument that can be used to manage

risk.

Whenever you allow for short-selling the portfolio construction decision, you
are implicitly allowing for the existence of derivative instruments.

There are three basic classes of derivative securities:

Futures & forwards.
Options.

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Basic Distinctions - I

 Forward contracts are those where two parties agree to a specified trade
at a specified point in the future.
 Defining characteristic: Both parties commit to taking part in the trade or
exchange specified in the contract.
 Futures are variants on the theme:
 Futures contracts are forward contracts where buyers and sellers
trade through an exchange rather than bilaterally.

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Basic Distinctions – II

 Options: Characterized by optionality concerning the specified trade.

 One party, the option holder, retains the right to enforce or opt out
of the trade.
 The other party, the option writer, has a contingent obligation to
take part in the trade.
 Call option: Option holder has the right, but not the obligation, to buy
the underlying asset at the price specified in the contract.
 Option writer has a contingent obligation to participate in the
specified trade as the seller.
 Put option: Holder has the right, but not the obligation, to sell the
underlying asset at the price specified in the contract.
 Option writer has a contingent obligation to participate in the
specified trade as the buyer.

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Risk-Management Roles - I

These classes of derivatives serve important, but different, purposes.

Futures, forwards and swaps enable investors to lock in cash flows
from future transactions.
Thus, they are instruments for hedging risk.
"Hedging" is the offsetting of an existing cash-flow risk.
Example 1 A company that needs to procure crude oil in one month
can use a one-month crude oil futures contract to lock in a price for the
oil.
Example 2 A company that has borrowed at floating interest rates
and wishes to lock in fixed interest rate payments instead can enter
into a swap where it commits to exchanging fixed interest rate
payments for floating ones.

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Risk-Management Roles - II

 Options provide one-sided protection.

 The option confers a right without an obligation. As a consequence:
 Call  Protection against price increase.
 Put  Protection against price decrease.
 Example Suppose a company needs to procure oil in one month.
 If the company buys a call option, it has the right to buy oil at the "strike
price" specified in the contract.
 If the price of oil in one month is lower than the strike price, the company
can opt out of the contract.
 Thus, the company can take advantage of price decreases but is
protected against price increases.
 In short, options provide financial insurance.

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Outline for Remaining Discussion

The rest of the material defines these classes of instruments more

formally.
Order of coverage:
Forwards
Futures
Options

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Forward Contracts

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Forward Contracts

 The building block of most other derivatives, forwards are thousands of

years old.
 A forward contract is a bilateral agreement
 between two counterparties
 a buyer (or "long position"), and
 a seller (or "short position")
 to trade in a specified quantity
 of a specified good (the "underlying")
 at a specified price (the "delivery price")
 on a specified date (the "maturity date") in the future.
 The delivery price is related to, but not quite the same thing as, the
"forward price." The forward price will be defined shortly.

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Forwards: Characteristics

 Important characteristics of a forward contract:

 Bilateral contract Negotiated directly by seller and buyer.

 Customizable Terms of the contract can be "tailored."
 Credit Risk There is possible default risk for both parties.
 Unllateral Reversal Neither party can unilaterally transfer its
obligations in the contract to a third party.
Futures & forwards differ on precisely these characteristics as we see shortly.

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The Role of Forwards: Hedging

 Forwards enable buyers and sellers to lock-in a price for a future market
transaction.
 Thus, they address a basic economic need: hedging.
 Demand for such hedging arises everywhere. Examples:
 Currency forwards: lock-in an exchange rate for a future transaction to
eliminate exchange-rate risk.
 Notional outstanding in Dec-2008: $24.6 trillion.
 Interest-rate forwards (a.k.a. forward-rate agreements): lock-in an
interest rate today for a future borrowing/investment to eliminate
interest-rate risk.
 Notional outstanding in Dec-2008: $39.3 trillion.
 Commodity forwards: lock-in a price for a future sale or purchase of
commodity to eliminate commodity price risk.
 Notional outstanding in Dec-2008: $2.5 trillion.

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BUT...

 An obvious but important point: The elimination of cash flow uncertainty

using a forward does not come "for free."
 A forward contract involves a trade at a price that may be "off-market," i.e.,
that may differ from the actual spot price of the underlying at maturity.
 Depending on whether the agreed-upon delivery price is higher or lower than
the spot price at maturity, one party will gain and the other party lose from
the transaction.

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An Example

 A US-based exporter anticipates €200 million of exports and hedges

against fluctuations in the exchange rate by selling €200 million forward
at $1.30/€.
 Benefit? Cash-flow certainty: receipts in $ are known.
 Cost? Exchange-rate fluctuations may lead to ex-post regret.
 Exchange rate at maturity is $1.40/€.
 Exporter loses $0.10/€ for a total loss of $20 million on the
hedging strategy.
 Exchange rate at maturity is $1.20/€.
 Exporter gains $0.10/€ for a total gain of $20 million on the
hedging strategy.

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Forward Contracts: Payoffs
 Forward to buy XYZ stock at F = 100 at date T.
 Let ST denote the price of XYZ on date T.

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Forwards are "Linear" Derivatives

ST : Spot price at maturity of forward contract.

F : Delivery price locked-in on forward contract.

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 The Forward Price

 We have seen what is meant by the delivery price in a forward contract.

 What is meant by a forward price?
 The forward price is a breakeven delivery price: it is the delivery price that would make the contract have zero value to both parties at inception.
 Intuitively, it is the price at which neither party would be willing to pay anything to enter into the contract.

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The Forward Price and the Delivery Price

 At inception of the contract, the delivery price is set equal to the forward
price.
 Thus, at inception, the forward price and delivery price are the same.
 As time moves on, the forward price will typically change, but the delivery
price in a contract, of course, remains fixed.
 So while a forward contract necessarily has zero value at inception, the value
of the contract could become positive or negative as time moves on.
 That is, the locked-in delivery price may look favorable or unfavorable
compared to the forward price on a fresh contract with the same
maturity.

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The Forward Price

Is the forward price a well-defined concept?

 Not obvious, a priori.

 It is obvious that
If the delivery price is set too high relative to the spot, the contract
will have positive value to the short (and negative value to the long).
If the delivery price is set too low relative to the spot, the situation is
reversed.
 But it is not obvious that there is only a single breakeven price. It appears
plausible that two people with different information or outlooks about the
market, or with different risk-aversion, can disagree on what is a
breakeven price.
This question is addressed in Chapters 3-4 on forward pricing.

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Futures Contracts

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Futures Contracts

A futures contract is like a forward contract except that it is traded on an

organized exchange.
This results in some important differences. In a futures contract:
 Buyers and sellers deal through the exchange, not directly.
 Contract terms are standardized.
 Default risk is borne by the exchange, and not by the individual parties
to the contract.
 "Margin accounts" (a.k.a "performance bonds") are used to manage
default risk.
 Either party can reverse its position at any time by closing out its
contract.

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Forwards vs. Futures

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The Futures Price

As with a forward contract, there is no up-front payment to enter into a

futures contract.
Thus, the futures price is defined in the same way as a forward price: it is the
delivery price which results in the contract having zero value to both parties.
Futures and forward prices are very closely related but they are not quite
identical.
The relationship between these prices is examined in Chapter 3.

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Options

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Basic Definitions

An option is a financial security that gives the holder the right to buy or sell
a specified quantity of a specified asset at a specified price on or before a
specified date.

 Buy = Call option. Sell = Put option

 On/before: American. Only on: European
 Specified price = Strike or exercise price
 Specified date = Maturity or expiration date
 Specified asset = "underlying"
 Buyer = holder = long position
 Seller = writer = short position

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Broad Categories of Options

 Exchange-traded options:

Stocks (American).
Futures (American).
Indices (European & American)
Currencies (European and American)
 OTC options:

Vanilla (standard calls/puts as defined above).

Exotic (everything else—e.g., Asians, barriers).
 Others (e.g., embedded options such as convertible bonds or
callable bonds).

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Options as Financial Insurance

 As we have noted above, option provides financial insurance.

 The holder of the option has the right, but not the obligation, to take part
in the trade specified in the option.
 This right will be exercised only if it is in the holder's interest to do so.
 This means the holder can profit, but cannot lose, from the exercise
decision.

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Put Options as Insurance: Example
 Cisco stock is currently at $24.75. An investor plans to sell Cisco stock she
holds in a month's time, and is concerned that the price could fall over
that period.
 Buying a one-month put option on Cisco with a strike of K will provide her
with insurance against the price falling below K.
 For example, suppose she buys a one-month put with a strike of K
= 22.50.
 If the price falls below $22.50, the put can be exercised and the
stock sold for $22.50.
 If the price increases beyond $22.50, the put can be allowed to
lapse and the stock sold at the higher price.
 In general, puts provide potential sellers of the underlying with insurance
against declines in the underlying's price.
 The higher the strike (or the longer the maturity), the greater the
amount of insurance provided by the put.

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Call Options as Insurance: Example

 Apple stock is currently trading at $218. An investor is planning to buy the

stock in a month's time, and is concerned that the price could rise sharply
over that period.
 Buying a one-month call on Apple with a strike of K protects the investor
from an increase in Apple's price above K.
 For example, suppose he buys a one-month call with a strike of K = 225.
 If the price increases beyond $225, the call can be exercised and the
stock purchased for $225.
 If the price falls below $225, the option can be allowed to lapse and the
stock purchased at the lower price.
 In general, calls provide potential buyers of the underlying with protection
against increases in the underlying's price.
 The lower the strike (or the longer the maturity), the greater the amount
of insurance provided by the call.

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The Provider of this Insurance

 The writer of the option provides this insurance to the holder: The writer is
obligated to take part in the trade if the holder should so decide.
 In exchange, writer receives a fee called the option price or the option
premium.
 Chapters 9-16 are concerned with various aspects of the option premium
including the principal determinants of this price and models for identifying
fair value of an option.
 Chapter 17 discusses how to measure the risk in an option or a portfolio of
options.
 Chapters 18 and 19 extend the pricing analysis to "exotic" options.
 Chapter 21 studies hybrid securities such as convertible bonds that have
embedded optionalities.

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Derivatives and Risk-Management:
Some Comments

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Derivatives and Risk-Management

 Derivatives can be used to hedge or obtain insurance against existing

risk exposures.
 We examine derivatives use in various contexts throughout the book.
 Here, we use a simple example to make a simple preliminary point:
that derivatives do not offer a panacea in managing risk.
 There are pros and cons to every derivatives strategy (including
to the strategy of using no derivatives).
 That is, there is no dominant alternative that is better in all
conditions.

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A Simple Example

 Suppose it is currently December, and a US-based company learns that

it will be receiving €25 million in March.
 As a US-based organization, the company needs to convert the euros
into dollars upon receipt, so is exposed to changes in the exchange
rate.
 The company has (at least) three choices:
 Do nothing, i.e., retain full exposure to changes in exchange
rates.
 Use a forward/futures contract to lock in an exchange rate
today.
 Buy a put option on the euro that guarantees a floor exchange
rate.

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Comparing the Alternatives

 We compare outcomes under these three alternatives using three

relevant criteria:
1. Cash-flow uncertainty under the strategy.
2. Up-front cost of the strategy.
3. Exercise-time (or lock-in) regret from the strategy.
 Assume the following:
 The company can lock in an exchange rate of $1.0328/€ using CME
March futures contracts.
 The company can buy put options on the euro with a strike of
$1.03/€ and expiring in March at a total cost of $422,500.

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The Alternatives Compared

The table below presents the outcomes (in US$) under the three alternatives
in two scenarios:
A "low" exchange rate (relative to the locked-in rate) of $0.9928/€.
A "high" exchange rate of $1.0728/€.

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The Alternatives Compared

1. Cash flow uncertainty

 Maximal for the do-nothing alternative.
 Intermediate for the option contract.
 Least for the futures contract.
2. Up-Front Cost
 Zero for the do-nothing and futures contract alternatives.
 Substantial ($422,500) for the options contract.
3. Exercise-Time Regret None with the options contract, but possible with the
others:
 If $1.0728/€. The futures contract has ex-post regret (not hedging would
have been better).
 If $0.9928/€. The do-nothing contract has ex-post regret: hedging would
have been better.

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The Best Alternative?

► There is none: Each strategy has its pros and cons .

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