Financial Derivatives

• Definition
• Options
• Futures
• Options Vs Futures

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 I. Options: Definition
• A call (put) option is the right, but not the obligation,
to buy (sell) a specific asset at a specific price within
a specific period of time.
– The specific asset, that underlies an option contract, is also
called the underlying asset of the option
– The specific price is called the strike (or exercise) price (of
the option contract)
– When the owner of an option exercises his right to buy or
sell the underlying asset, the option is said to be exercised
– The right expires on the expiration day
– The market price of an option is termed the option
premium
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 Option Exercise: Call Options
• When exercised, holder/buyer of a physically
(cash) settled call option will receive the
actual underlying asset (cash value of the
asset at the exercise time) from the option
seller and pay the strike price to the seller

Asset (physically settled)

Option Cash value (cash settled) Option
Buyer Seller
(Call) (Call)
Strike price (in cash)

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 Exercise Style of Options
• When the owner of an option can exercise the option
depends on its exercise style
• European (style) options: Options which can be
exercised only on the expiration date
• American (style) options: Options which can be
exercised anytime during the life of the option
• Bermudan (style) options: Options which can be
exercised only on prespecified days during the life of
the option
– For instance, some OTC options are exercisable once a
month
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 Option Exercise: Put Options
• When exercised, holder/buyer of a physically
(cash) settled put option will deliver the actual
underlying asset (cash value of the asset at
the exercise time) to the option buyer and
receive the strike price
Asset (physically settled)
Option Cash value (cash settled) Option
Buyer Seller
(Put) (put)
Strike price (in cash)
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 Buyers/Holders of Options
• A buyer will buy the option from another
person (an investor or a dealer)
– Not buying the underlying asset
– Just buying a right to acquire the asset
• A buyer will pay the option premium (to the
option seller) plus the broker’s commission (to
the broker)
• A buyer of an option is called an option holder
and has a long position in the option
– To create such a long position, the buyer can place
a “Buy to Open” order
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 Buyer’s Simple Strategies
• During the life of the option, the buyer can sell
(at any time) the option at its market price
(thus closing out his long position)
– To do this, the buyer can place an offsetting order,
namely, a “Sell to Close” order (closing an existing
long position)
• can exercise the option (on exercisable dates),
or
• can keep the option and do nothing
– On the expiration date, this strategy is equivalent
to letting the option expire
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 Sellers/Writers of Options
• A seller of an option is called an option writer and
has a short position in the option
– To establish such a position, investor needs to place an
order “Sell to Open” (a short position)
– E.g. an investor who has sold an SPX Feb 1900 call to an
option buyer is said to have written the call option and is
short selling the call
• The seller will sell the option to another investor (or
a dealer)
• The seller of an option will collect the option
premium from the buyer
– The seller will need to pay the broker’s commission also
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 Contract Size for Options
• Minimal transaction size is one contract
• The standard contract size for options on stocks and
ETFs is 100 shares
– Namely, the underlying asset of each option contract is
actually 100 shares of the underlying stock or ETF
– E.g. the buyer of two FB Feb 115 Call contracts has the
right to buy 200 shares of the stock at $115/share
• The standard contract size for index options is $100
(called the multiplier) times the index value (one
unit) at the exercise time
– E.g. the buyer of one SPX Feb 19th 1900 Call contract has
the right to receive cash equal to ($100*the index level) in
exchange for $100*1900 = $190,000
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 Convention on Premium Quotes
• Option premium is quoted on a per “share/unit” basis
so each point in the premium represents $100
• Consider the FB Feb 115 call quoted at $2.88 on
2/1/2016.
– Two contracts of this option would cost
2*($2.88 * 100) = $576
(plus the broker’s commission)
• Consider the SPX Feb 19th 1900 call closed at $52.60 on
2/1/2016
– 3 contracts of this option would cost
3*($52.60 * 100) = $15,780
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 Payoff of Calls at Expiration
• The call holder exercises the option only if ST (the
inflow) > X (the outflow). Otherwise, the holder
will simply let the option expire worthless.
• Let CT denote a (long) call option’s payoff (per
share) at T. Then we have
– CT = ST – X, if ST > X (and option exercised);
– CT = 0, otherwise (and option expired).
– Equivalently, CT = max[(ST -X),0]
– Holder’s P/L (i.e., Profit/Loss) = Payoff – Call Premium

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 Ex 1: A Long FB Call
• Consider the FB Feb 115 Call that is traded at
$2.88 today. The stock’s price is $114.86.
Analyze this call option’s cash flow on the
expiration day T
• This FB call’s payoff at expiration T is
▪ CT = ST -$115, if (ST - $115) > 0;
▪ CT = 0 if (ST - $115) ≤ 0.
▪ Or equivalently, CT = max[(ST - $115),0]
• The holder’s P/L (per share) at T is
P/L = max(ST - $115,0) - $2.88
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 Ex 1. (cont’d)
• Analyze the (per share) payoff and profit of a holder
of the FB Feb 115 call option at T.
ST Exercise? Payoff at T -Premium P/L
$0 No $0 -$2.88 -$2.88
$50 No $0 -$2.88 -$2.88
$100 No $0 -$2.88 -$2.88
$110 No $0 -$2.88 -$2.88
$115 No $0 -$2.88 -$2.88
$120 Yes $120-$115 -$2.88 $2.12
$130 Yes $130-$115 -$2.88 $12.12
$140 Yes $140-$115 -$2.88 $22.12
• We can then plot the payoff and (P/L) vs. the stock
price at T and generate a so called payoff diagram 13
 Ex 1 (cont’d): Payoff Diagram
Payoff/Profit Payoff of a long call
= max (ST-115,0)

P/L

OTM Region,
Call expires ITM Region,
worthless Exercise

0 X=$115 ST (stock
-$2.88 price at T)
Break even price
Payoff and P/L of the FB Feb 115 call vs. the FB stock price at expiration
OTM: Out of the money. ITM: In the money.
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 Ex 2. A Short FB Call
• Consider the FB Feb 115 Call examined earlier.
Analyze the payoff and P/L of a writer of this call on
the expiration day T
• If the option is not exercised and expires worthless,
the writer’s payoff is zero
• If the option is exercised, then the writer receives the
strike ($115 here) and pays the stock (worth ST). So
– Writer’s payoff at T = $115 – ST < 0
• The option premium ($2.88 here) is collected up
front and not taken into account in the calculation of
the payoff at expiration
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 Ex 2. A Short FB Call (cont’d)
• So, this short call’s payoff at expiration T is
▪ Payoff = $115 - ST if (ST - $115) > 0
▪ Payoff = 0 if (ST - $115) ≤ 0
• Or, Payoff = -max[(ST - $115),0] = - CT
• Namely, a short call’s payoff at T = -CT
• An option writer’s P/L at T is given by
Writer’s P/L = payoff + option premium
• Here, P/L = -max(ST - $115,0) + $2.88
• Notice that
▪ Holder’s Payoff + Writer’s Payoff = 0
▪ Holder’s P/L + Writer’s P/L = 0
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 Ex 2. (cont’d)
• Analyze the (per share) payoff and profit of the
writer of the FB Feb 115 call option at T.
ST Exercise? Payoff at T Premium P/L
$0 No $0 $2.88 $2.88
$50 No $0 $2.88 $2.88
$100 No $0 $2.88 $2.88
$110 No $0 $2.88 $2.88
$115 No $0 $2.88 $2.88
$120 Yes -$5 $2.88 -$2.12
$130 Yes -$15 $2.88 -$12.12
$140 Yes -$25 $2.88 -$22.12
• We can then plot the payoff and (P/L) vs. the stock price at T
and generate the writer’s option payoff diagram 17
 Ex 2 (cont’d): Payoff Diagram
Payoff/Profit

ITM Region,
$2.88 Exercise
X=$115
0
ST (stock
OTM Region, price at T)
Call expires
worthless
Profit and Loss
of a short call
Payoff of a
short call
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 Option Payoffs and P/L: Calls
• Fix notation
▪ X: an option’s strike price
▪ St:the underlying asset’s price at time t
▪ Ct: a (long) call option’s payoff at t
• The call holder’s
▪ Payoff = Ct = max[(St – X),0]
▪ P/L = max(St – X,0) – call premium
• The call writer’s P/L
▪ Payoff = – Ct = – max[(St – X),0]
▪ P/L = call premium - max(St – X,0)
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 II. Moneyness of Options
• Let St denote the underlying asset’s value at
time t, and X denote the strike.
– If St > X, a call (put) option is said to be in the
money (out of the money) at time t
– If St = X, a call/put option is said to be at the
money at time t
– If St < X, a call (put) option is said to be out of the
money (in the money) at time t
• Notice that an option’s moneyness can change
due to changes in St
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 Ex 3. Moneyness of FB Options
• Suppose the FB stock’s price is $114.86.
Determine the moneyness of the following FB
options
▪ Feb 120 call
▪ Feb 110 call
▪ Feb 110 put
▪ Feb 120 put

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 IV. Payoff and P/L of Puts
• Example 5: Consider the FB Feb 115 Put that is
traded at $3.35 today. The stock’s price is
$114.86. Analyze this put option’s payoff and
P/L on the expiration day T
• This FB put’s payoff at expiration T is
▪ PT = $115 – ST , if (ST < $115);
▪ PT = 0, otherwise.
▪ Or equivalently, PT = max[(115 – ST),0]
• The holder’s P/L (per share) at T is
P/L = max(115 – ST,0) – $3.35
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 Ex 5 (cont’d): the Put Buyer
Payoff/Profit

Payoff of a long
$115 FB Feb 115 put

$115-3.35

X=$115 ST
0
P&L of a
-$3.35
long put

Option premium = $3.35

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 Ex 5 (cont’d): the Put Writer
Payoff/Profit
P&L of a
short put
$3.35

X=$115 ST
0

Payoff of a short
FB Feb 115 put
-$111.65

-$115
Option premium = $3.35
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 Option Payoffs and P/L: Puts
• A put option’s payoff at time t
(usually denoted Pt) = max(X – St,0)
• A put holder’s
▪ Payoff = Pt = max(X – St,0)
▪ P/L = max(X – St,0) – put premium
• A put writer’s
▪ Payoff = – Pt = – max(X – St,0)
▪ P/L = – max(X-St,0) + put premium

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