Introduction to derivatives
Miloš Kopa
based on
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 1
What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options,
exotics…
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 2
Why Derivatives Are Important
Derivatives play a key role in transferring risks in the
economy
The underlying assets include 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 has become widely accepted
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 3
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
Options, Futures, and Other Derivatives, 8th Edition,
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How Derivatives are Used
To hedge risks
To speculate (take a view on the
future direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment
without incurring the costs of selling
one portfolio and buying another
Options, Futures, and Other Derivatives, 8th Edition,
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Forward Price
The forward price for a contract is the
delivery price that would be applicable to
the contract if were negotiated today
(i.e., it is the delivery price that would
make the contract worth exactly zero)
The forward price may be different for
contracts of different maturities
Options, Futures, and Other Derivatives, 8th Edition,
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Profit from a Long Forward
Position (K= delivery price=forward price at
time contract is entered into)
Profit
Price of Underlying at Maturity
K ST
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Profit from a Short Forward
Position (K= delivery price=forward price at time
contract is entered into)
Profit
Price of Underlying at Maturity
K ST
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Futures Contracts
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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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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1. Gold: An Arbitrage
Opportunity?
Suppose that:
The spot price of gold is US$1,400
The 1-year forward price of gold is US$1,500
The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?
To give an answer, we need to price the contract.
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The Forward Price of Gold
(ignores the gold lease rate)
If the spot price of gold is S and the forward
price for a contract deliverable in T years is F,
then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
In our examples, S = 1400, T = 1, and r =0.05
so that
F = 1400(1+0.05) = 1470
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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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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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Google Call Option Prices (June 15, 2010; Stock Price is
bid 497.07, offer 497.25); See Table 1.2 page 8; Source: CBOE
Strike Jul 2010 Jul 2010 Sep 2010 Sep 2010 Dec 2010 Dec 2010
Price Bid Offer Bid Offer Bid Offer
460 43.30 44.00 51.90 53.90 63.40 64.80
480 28.60 29.00 39.70 40.40 50.80 52.30
500 17.00 17.40 28.30 29.30 40.60 41.30
520 9.00 9.30 19.10 19.90 31.40 32.00
540 4.20 4.40 12.70 13.00 23.10 24.00
560 1.75 2.10 7.40 8.40 16.80 17.70
Options, Futures, and Other Derivatives, 8th Edition,
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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
Speculators
Arbitrageurs
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Hedging Examples (pages 10-12)
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 Microsoft shares
currently worth $28 per share. A two-month
put with a strike price of $27.50 costs $1.
The investor decides to hedge by buying 10
contracts
Options, Futures, and Other Derivatives, 8th Edition,
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Value of Microsoft Shares with and
without Hedging (Fig 1.4, page 12)
40 000 Value of Holding
($)
35 000
No Hedging
30 000 Hedging
25 000
Stock Price ($)
20 000
20 25 30 35 40
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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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Arbitrage Example
A stock price is quoted as £100 in London
and $140 in New York
The current exchange rate is 1.4300
What is the arbitrage opportunity?
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Short Selling (Page 102-103)
Short selling involves selling securities
you do not own
Your broker borrows the securities
from another client and sells them in
the market in the usual way
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Short Selling (continued)
At some stage you must buy the
securities so they can be replaced in the
account of the client
You must pay dividends and other
benefits the owner of the securities
receives
There may be a small fee for borrowing
the securities
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Example
You short 100 shares when the price is $100
and close out the short position three months
later when the price is $90
During the three months a dividend of $3 per
share is paid
What is your profit?
What would be your loss if you had bought
100 shares?
Options, Futures, and Other Derivatives, 8th Edition,
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Notation for Valuing Futures and
Forward Contracts
S0: Spot price today
F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for
maturity T
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The Forward Price
If the spot price of an investment asset is S0 and
the futures price for a contract deliverable in T
years is F0, then
F0 = S0erT
where r is the T-year risk-free rate of interest.
Options, Futures, and Other Derivatives, 8th Edition,
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When an Investment Asset
Provides a Known Income (page 107,
equation 5.2)
F0 = (S0 – I )erT
where I is the present value of the income
during life of forward contract
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When an Investment Asset Provides
a Known Yield (Page 109, equation 5.3)
F0 = S0 e(r–q )T
where q is the average yield during the life
of the contract (expressed with continuous
compounding)
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Valuing a Forward Contract
A forward contract is worth zero (except for
bid-offer spread effects) when it is first
negotiated
Later it may have a positive or negative value
Suppose that K is the delivery price and F0 is
the forward price for a contract that would be
negotiated today
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 30
Valuing a Forward Contract
Page 109-11
By considering the difference between a
contract with delivery price K and a contract
with delivery price F0 we can deduce that:
the value of a long forward contract, ƒ, is
(F0 – K )e–rT
the value of a short forward contract is
(K – F0 )e–rT
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Forward vs Futures Prices
When the maturity and asset price are the same, forward
and futures prices are usually assumed to be equal.
(Eurodollar futures are an exception)
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Futures and Forwards on
Currencies (Page 112-115)
A foreign currency is analogous to a
security providing a yield
The yield is the foreign risk-free interest
rate
It follows that if rf is the foreign risk-free
interest rate
( r rf ) T
F0 S0e
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Explanation of the Relationship
Between Spot and Forward (Figure 5.1)
1000 units of
foreign currency
(time zero)
r T
1000 e f units of
1000S0 dollars
foreign currency
at time zero
at time T
1000 F0 e f
r T
1000S0erT
dollars at time T dollars at time T
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Review of Option Types
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
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Option Positions
Long call
Long put
Short call
Short put
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Long Call (Figure 9.1, Page 195)
Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months
30 Profit ($)
20
10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130
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Short Call (Figure 9.3, page 197)
Profit from writing one European call option: option
price = $5, strike price = $100
Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)
-20
-30
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Long Put (Figure 9.2, page 196)
Profit from buying a European put option: option
price = $7, strike price = $70
30 Profit ($)
20
10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7
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Short Put (Figure 9.4, page 197)
Profit from writing a European put option: option price
= $7, strike price = $70
Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10
-20
-30
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Payoffs from Options
What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
Payoff Payoff
K
K ST ST
Payoff
Payoff
K
K ST ST
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Assets Underlying
Exchange-Traded Options
Page 198-199
Stocks
Foreign Currency
Stock Indices
Futures
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Specification of
Exchange-Traded Options
Expiration date
Strike price
European or American
Call or Put (option class)
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Warrants
Warrants are options that are issued by a
corporation or a financial institution
The number of warrants outstanding is
determined by the size of the original issue
and changes only when they are exercised
or when they expire
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Notation
c: European call option C: American call option
price price
p: European put option P: American put option
price price
S0: Stock price today ST: Stock price at option
maturity
K: Strike price
D: PV of dividends paid
T: Life of option
during life of option
s: Volatility of stock
price r Risk-free rate for
maturity T with cont.
comp.
Options, Futures, and Other Derivatives, 8th Edition, Copyright ©
John C. Hull 2012 45
Put-Call Parity: No Dividends
Consider the following 2 portfolios:
Portfolio A: European call on a stock + zero-
coupon bond that pays K at time T
Portfolio C: European put on the stock + the stock
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Values of Portfolios
ST > K ST < K
Portfolio A Call option ST − K 0
Zero-coupon bond K K
Total ST K
Portfolio C Put Option 0 K− ST
Share ST ST
Total ST K
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The Put-Call Parity Result (Equation
10.6, page 222)
Both are worth max(ST , K ) at the maturity of
the options
They must therefore be worth the same
today. This means that
c + Ke -rT = p + S0
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Positions in an Option & the Underlying
(Figure 11.1, page 237)
Profit Profit
K
K ST ST
(a)
(b)
Profit Profit
K
ST K ST
(c) (d)
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Bull Spread Using Calls
(Figure 11.2, page 238)
Profit
ST
K1 K2
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Bull Spread Using Puts
Figure 11.3, page 239
Profit
K1 K2 ST
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Bear Spread Using Puts
Figure 11.4, page 240
Profit
K1 K2 ST
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Bear Spread Using Calls
Figure 11.5, page 241
Profit
K1 K2 ST
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Box Spread
A combination of a bull call spread and a bear
put spread
If all options are European a box spread is
worth the present value of the difference
between the strike prices
If they are American this is not necessarily so
(see Business Snapshot 11.1)
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Butterfly Spread Using Calls
Figure 11.6, page 242
Profit
K1 K2 K3 ST
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Butterfly Spread Using Puts
Figure 11.7, page 243
Profit
K1 K2 K3 ST
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A Straddle Combination
Figure 11.10, page 246
Profit
K ST
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A Strangle Combination
Figure 11.12, page 249
Profit
K1 K2
ST
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