Introduction

Chapter 1

Geng Niu
Riem Building
(Guanghua campus) 403
g.niu@swufe.edu.cn

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https://riem.swufe.edu.cn/info/1052/1550.htm

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Course evaluation (tentative)

 Assignments + participation (30%)

 Midterm exam (30%)
 Final exam (40%)

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Textbook (main)

 Options, Futures, and Other Derivatives,

8th edition (John C. Hull)
 Classical textbook; many editions (very
similar across editions though).
 Used wildly in Master of Finance programs
and MBA programs with finance tracks
around the world.
 Less on math, more on intuitions

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Textbook (main)

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Textbook (main)

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Supplementary materials:
 Fixed Income Markets and Their Derivatives, 2th edition
(Suresh M. Sundaresan)
 Bond Markets, Analysis and Strategies, 5th edition (Frank

J. Fabozz)
 FRM (Financial Risk Management) Exam notes.

 Mark Meldrum lectures

https://www.youtube.com/watch?v=84Up9kFVl4A&list=PLM
9WI-4yn8BIROK_B1HCsdAlFGvAMdSJr

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Some useful online resources
 http://www.cmegroup.com/ (Chicago Mercantile
Exchange & Chicago Board of Trade)
 http://finance.yahoo.com/
 http://www.cffex.com.cn/en_new/ (China Finance Futures
Exchange)
 http://www.shfe.com.cn/en/ (Shanghai Futures
Exchange)
 http://www.dce.com.cn/portal/cate?cid=1114494099100
(Dalian Commodity Exchange)
 http://english.czce.com.cn/ (Zhengzhou Commodity
Exchange)
 http://eng.cfachina.org/ (China Futures Association)
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Dynamics of some assets: what’s in common?

Glod Price Oil Price

2000.000 120.00
1600.000 100.00
80.00
1200.000
60.00
800.000
40.00
400.000 20.00
0.000 0.00
1 0 1 9 9 7 8 6 7 5 4 5 3 4 2 2 1 1 0 0 9
-0 -3 -3 -2 -2 -2 -2 -2 -2 -2 -0 -0 -0 -0 -0 -0 -3 -0 -3 -3 -2
-04 -09 -03 -09 -03 -09 -03 -09 -03 -09 -01 -07 -01 -07 -01 -07 -12 -07 -12 -06 -12
10 10 11 11 12 12 13 13 14 14 10 10 11 11 12 12 12 13 13 14 14
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20

U.S. / Euro
Exchange Rate S&P 500
2500.00
1.6000 2000.00
1.2000 1500.00
0.8000 1000.00
0.4000 500.00
0.0000 0.00
4 6 8 7 8 8 9 1 1 1 3 8 0 3 5 0 2 6 9
1 -0 8-1 3-2 1-0 6-1 1-2 9-0 4-2 2-0 3 -0 9-1 3-2 0-1 4-2 1-0 5-2 2-0 6-1 2-2
-0 -0 -0 -1 -0 -0 -0 -0 -1 -0 -0 -0 -1 -0 -1 -0 -1 -0 -1
010 010 011 011 012 013 013 014 014 010 010 011 011 012 012 013 013 014 014
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

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How Derivatives are Used
 To hedge risks: risk management
 To speculate (bet on the future
direction of the market)
 To lock in an arbitrage (riskless)
profit

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Derivatives are relevant to many
sectors
 Financial sector (banks, hedge funds, mutual
funds, asset management company, etc):
provide competitive financial products
 Other companies: interest rates, exchange
rates, commodity prices (grain, oil, gold,
copper…)
 Government: how to regulate financial market
properly?

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Why Study Derivatives Pricing

 Learn the language of modern finance

 Foundation of financial engineering and risk
management
 Prepare for graduate studies in finance
 Prepare for professional certificates:

 Prepare for job interviews

 Understand financial news

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 The derivatives pricing literature is very huge.
 Mathematical techniques involved can be
quite challenging
 Advanced computational skills are also
needed.
 Derivatives pricing is
considered “rocket science”.

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 What you will learn in this course are still the
basics.
 They are mostly “toy models”.
 However, this course prepares you for future
learning.
 Intuitions are often more importpont and
useful.
 So, be confident and have fun !

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What is a Derivative?

 A derivative is an instrument whose value

depends on, or is derived from, the value of
another asset (the underlying asset).
 Examples: futures, forwards, swaps, options,
exotics…

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Examples

 Forward & Future: an agreement to buy or

sell an asset at a certain time for a certain
price.
 Call Option: the holder has the right to buy
the underlying asset by a certain date for a
certain price.
 Put Option: the holder has the right to sell the
underlying asset by a certain date for a
certain price.

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How Derivatives Are Traded

 On exchanges such as the Chicago Board

Options Exchange
 In the over-the-counter (OTC) market where
traders working for banks, fund managers
and corporate treasurers contact each other
directly

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Size of OTC and Exchange-Traded Markets
(Figure 1.1, Page 3)

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market

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A motivating example: Apple farmer
and pie chain
 Khan Academy course: Forward contract
introduction
 https://www.khanacademy.org/economics-fin
ance-domain/core-finance/derivative-securitie
s/forward-futures-contracts/v/forward-contract
-introduction?modal=1

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A motivating example: Apple farmer
and pie chain
 Suppose in a village there is an apple farmer.
 Every year this farmer produces 2,000
pounds.
 The apple price fluctuates over time.
 In some years it is over $0.3/pound, in other
years it is below $0.1/pound.

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A motivating example: Apple farmer
and pie chain
 There is also an pie chain near the village
that specializes in making apple pies.
 When apple price increases, the factory loses
money. When apple price decrease, the
factory’s profit increases.
 The farmer and the factory both face price
risk.
 They don’t like the unpredictability.
 What can they do?
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A motivating example: Apple farmer
and pie chain
 They can make an agreement before harvest.
 They can set up a contract: the factor agrees
to buy 2,000 pounds apple from the farmer at
a specified time, i.e., after the harvest, for
$0.2 per pound.
 The farmer also agrees to sell.
 Such an agreement is an forward contract.
 Both parties get rid of the uncertainty and can
concentrate on their main jobs.
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Terminology: forward Price
 The forward price for a contract is the
delivery price that would be applicable
to the contract if were negotiated
today
 The forward price may be different for
contracts of different maturities

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Terminology: long and short

 The party that has agreed to buy

has what is termed a long
position
 The party that has agreed to sell
has what is termed a short
position

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Example

 On May 24, 2010 the treasurer of a US

corporation enters into a long forward
contract to buy £1 million in six months at an
exchange rate of 1.4422
 This obligates the corporation to pay
$1,442,200 for £1 million on November 24,
2010
 What are the possible outcomes?

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Profit from a Long Forward Position (K=
delivery price=forward price at time contract is entered into)

Profit

K Price of Underlying at
Maturity, ST: USD/GPB

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Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into)

Profit

K Price of Underlying
at Maturity, ST: USD/GPB

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Futures contract

 Khan Academy course: Futures introduction

 https://www.khanacademy.org/economics-fin
ance-domain/core-finance/derivative-securitie
s/forward-futures-contracts/v/futures-introduct
ion?modal=1

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Apple farmer and pie chian again

 After the contract being made, there are still

some problems.
 What if one of the party does not want to fulfill
his or her obligation?—— counterparty risk
 What if there is a second farmer in the
village, who produces 2000 pounds a year,
also want to set up a forward contract with
the pie chain, but the pie chain only needs
another 1000 pounds?

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Apple farmer and apple juice factory
again
 Suppose there is a rich guy in the village.
 The guy is willing to serve as the
intermediary.
 The guy proposes this contract to any farmer:
agree to buy 1,000 pounds of apple on Nov
15 for 0.2$/pound per contract.
 He also proposes another contract to any pie
chain: agree to sell 1,000 pounds of apple on
Nov 15 for 0.2$/pound per contract.
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Apple farmer and apple juice factory
again
 Therefore, instead of negotiating contract
terms every year with each other, farmers
and pie chains can easily set up
standardized contracts with the rich guy.
 This saves everyone’s time!
 This kind of contract is called futures
contract.
 The rich guy is essentially serving as the
exchange.
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Futures Contracts (page 7)

 Agreement to buy or sell an asset for a

certain price at a certain time
 Similar to forward contract
 Whereas a forward contract is traded
OTC, a futures contract is traded on an
exchange

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Why exchanges exist?

 Khan Academy course: Motivation for the

futures exchange
 https://www.khanacademy.org/economics-fin
ance-domain/core-finance/derivative-securitie
s/forward-futures-contracts/v/motivation-for-th
e-futures-exchange?modal=1

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Apple farmer and pie chain again
again
 The rich guy is not doing charity.
 Because he takes the (counterparty) risk and
provide convenience, he can get some
rewards.
 The actual term he would offer to the farmer
may be: agree to buy apples at $0.19/pound;
and to the pie chain may be: agree to sell
apples at $0.21/pound.

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Foreign Exchange Quotes for USD/GBP,
May 24, 2010

Bid Offer
Spot 1.4407 1.4411

1-month forward 1.4408 1.4413

3-month forward 1.4410 1.4415

6-month forward 1.4416 1.4422

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Exchanges Trading Futures

 CME Group (formerly Chicago Mercantile

Exchange and Chicago Board of Trade)
 NYSE Euronext
 BM&F (Sao Paulo, Brazil)
 TIFFE (Tokyo)
 and many more (see list at end of book)

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Examples of Futures Contracts

Agreement to:
 Buy 100 oz. of gold @ US$1400/oz. in
December
 Sell £62,500 @ 1.4500 US$/£ in March
 Sell 1,000 bbl. of oil @ US$90/bbl. in April

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 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)

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Long Call
Profit from buying one European call option: option price =
$5, strike price = $100, option life = 2 months
A: long position trader; B: short position trader

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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

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Options vs Futures/Forwards

 A futures/forward contract gives the holder

the obligation to buy or sell at a certain price
 An option gives the holder the right to buy or
sell at a certain price

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Types of Traders

 Hedgers: to reduce risk

 Speculators: to make profit from taking the
risk
 Arbitrageurs: look for riskless profit

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 Hedging Examples
 An investor owns 1,000 Microsoft 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

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Value of Microsoft Shares with and without
Hedging (Fig 1.4, page 12)

40,000 Value of Holding ($)

35,000

No Hedging
30,000 Hedging

25,000

Stock Price ($)

20,000
20 22 24 26 28 30 32 34 36 38

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Speculation Example

 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?

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 Strategy A: purchase 100 shares today:-$2000
 Strategy B: long 2000 call options today:-$2000
 c=$1/option; K=$22.5/share

 The right to buy stock at $22.5/share after 2 month

 What are the profits after 2 months, if

 St=27

 St=15

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Arbitrage Example

 A stock price is quoted as £100 in

London and $140 in New York
 A: The current exchange rate ($/ £ )is
1.4300
 What is the arbitrage opportunity?
 B: What if the exchange rate ($/ £ ) is
1.3700

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£100 in London and $140 in New
York
 A: exchange rate ($/ £ )is 1.4300
 Buy 100 shares in New York: - $140
 Sell 100 shares in London: + £100
 Change £100 to $143 in the FX market
 Profit $143-$140
 B: the exchange rate ($/ £ ) is 1.3700
 Buy 100 shares in London: -£100
 Sell 100 shares in New York: + $140
 Chang $140 to £ (140/1.37) > -£100

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No Arbitrage Theory and Efficient
Market Hypothesis
 No Arbitrage: Two assets with the same
future payoffs must have the same price
today.
 Otherwise, you can earn a positive profit for
certain.
 How? Buy the cheap asset and sell the
expensive one.
 Result: Demand for the cheap asset
increases and so is its price.
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Assumption

 The market is efficient.

 If there were arbitrage opportunities, some
investors would have taken these
opportunities already.
 Thus, these opportunities will be eliminated
immediately.

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An old joke

 An economist will not pick up a twenty-dollar

bill on the ground.
 Why?
 If it were really there, someone would have
picked it up already.
 Arbitrage opportunities (free money) cannot
exist.

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