ch01 forwrd and futures, options

8/13/2019 Ch01 Forwrd and futures, options

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IntroductionChapter 1

1


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Derivates- Definition

A derivative can be defined as a financialinstrument whose value depends on (orderives from) the values of other, more basic,underlying variables. Very often the variablesunderlying derivatives are the prices of tradedassets. A stock option, for example, is aderivative whose value is dependent on the

price of a stock. Depending on the type ofrelationship they can broadly be classifiedinto two categories:

Linear

Non-Linear instruments 2


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Derivates- Definition

1. Linear Instruments (payoffs): refers toforward contracts, futures and swaps.These are obligations to exchangepayments according to specified schedule.

2. Non-Linear Instruments (payoffs): refers tooptions, their value is non-linear functionof the underlying assets.

Derivates are financial contract traded inprivate over the counter (OTC) markets or onorganized exchanges.

3


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

4

Source: Bank for International Settlements. Chart shows total principal

amounts for OTC market and value of underlying assets for exchange

market

0

50

100

150

200

250

300

350

400

450

500

550

Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

Size ofMarket

($ trillion)

OTCExchange


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Ways Derivatives are Used

To hedge risks

To speculate (take a view on thefuture 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 sellingone portfolio and buying another


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Foreign Exchange Quotes forGBP, July 20, 2007 (See page 4)

Bid Offer

Spot 2.0558 2.0562

1-month forward 2.0547 2.0552




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Forward Price

The forward price for a contract is thedelivery price that would be applicable tothe 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 forcontracts of different maturities


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Terminology

The party that has agreed to buyhas what is termed a long position

The party that has agreed to sellhas what is termed a short position


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Example (page 4)

On July 20, 2007 the treasurer of acorporation enters into a long forwardcontract to buy 1 million in six months atan exchange rate of 2.0489

This obligates the corporation to pay$2,048,900 for 1 million on January 20,2008

What are the possible outcomes?


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Profit from aLong Forward Position

Profit

Price of Underlying

at Maturity, ST

K


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Profit from aShort Forward Position

Profit

Price of Underlying

at Maturity, ST

K


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Futures Contracts (page 6)

Agreement to buy or sell an asset for acertain 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

Chicago Board of Trade Chicago Mercantile Exchange

LIFFE (London)

Eurex (Europe) 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$900/oz. inDecember (NYMEX)

Sell 62,500 @ 2.0500 US$/ in March(CME)

Sell 1,000 bbl. of oil @ US$120/bbl. in

April (NYMEX)


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1. Gold: An Arbitrage

Opportunity?

Suppose that:

The spot price of gold is US$900

The 1-year forward price of gold isUS$1,020

The 1-year US$ interest rate is 5% per

annumIs there an arbitrage opportunity?


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2. Gold: Another ArbitrageOpportunity?

Suppose that:

- The spot price of gold is US$900

- The 1-year forward price of gold isUS$900- The 1-year US$ interest rate is 5%

per annum

Is there an arbitrage opportunity?


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The Forward Price of Gold

If the spot price of gold is Sand theforward price for a contract deliverable in Tyears isF, then

F= S (1+r )Twhere r is the 1-year (domestic currency)risk-free rate of interest.

In our examples,S

= 900,T

= 1, andr

=0.05 so that

F = 900(1+0.05) = 945


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1. Oil: An Arbitrage Opportunity?

Suppose that:

- The spot price of oil is US$95- The quoted 1-year futures price of

oil is US$125

- The 1-year US$ interest rate is5% per annum

- The storage costs of oil are 2%per annumIs there an arbitrage opportunity?


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2. Oil: Another ArbitrageOpportunity?

Suppose that:

- The spot price of oil is US$95- The quoted 1-year futures price of

oil is US$80- The 1-year US$ interest rate is

5% per annum

- The storage costs of oil are 2%per annumIs there an arbitrage opportunity?


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Options

A call option is an option to buy a certainasset by a certain date for a certain price(the strike price)

A put option is an option to sell a certainasset 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 anytime during its life

A European option can be exercised only at

maturity


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Intel Option Prices (Sept 12, 2006; StockPrice=19.56);See Table 1.2 page 7; Source: CBOE

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StrikePrice

OctCall

JanCall

AprCall

OctPut

JanPut

AprPut

15.00 4.650 4.950 5.150 0.025 0.150 0.275

17.50 2.300 2.775 3.150 0.125 0.475 0.725

20.00 0.575 1.175 1.650 0.875 1.375 1.700

22.50 0.075 0.375 0.725 2.950 3.100 3.300

25.00 0.025 0.125 0.275 5.450 5.450 5.450


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Exchanges Trading Options

Chicago Board Options ExchangeAmerican Stock Exchange

Philadelphia Stock Exchange

Pacific Exchange LIFFE (London)

Eurex (Europe)

and many more (see list at end of book)


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Options vs Futures/Forwards

A futures/forward contract gives the holderthe obligation to buy or sell at a certainprice

An option gives the holder the right to buyor sell at a certain price


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Buy one Jan Call option contract at a Strikeprice of $20. What could be the possible

outcomes?

Sell one Oct Put option contract at a Strike

price of $22.50. What could be the possibleoutcomes?

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Four type of participants in the option market:

Buyers of calls

Sellers of calls

Buyers of puts

Sellers of puts

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Types of Traders

Hedgers

Speculators

Arbitrageurs

Some of the largest trading losses in derivatives have

occurred because individuals who had a mandate to be

hedgers or arbitrageurs switched to being speculators


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Hedging Examples (pages 10-11)

A US company will pay 10 million forimports from Britain in 3 months anddecides to hedge using a long position in aforward contract

An investor owns 1,000 Microsoft sharescurrently worth $28 per share. A two-monthput with a strike price of $27.50 costs $1.The investor decides to hedge by buying 10

contracts

H d i b i d i


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Hedging being done usingForwards OR Option contracts- A

Comparison Forward contracts are designed to

neutralize risk by fixing the price that

hedger will pay or receive for the underlyingassets.

Option contract by contrast provideinsurance.

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Value of Microsoft Shares withand without Hedging (Fig 1.4, page 11)

20,000

25,000

30,000

35,000

40,000

20 25 30 35 40

Value of Holding($)

Stock Price ($)

No Hedging

Hedging


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Speculation Example

An investor with $2,000 to invest feels thata stock price will increase over the next 2months. The current stock price is $20 and

the price of a 2-month call option with astrike of 22.50 is $1

What are the alternative strategies?

S l ti b i d i


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Speculation being done usingFuture OR Option contracts- A

ComparisonFuture and options are similar instruments forspeculators in that they both provide a way in

which type of leverage can be obtained. Using future position the potential loss and

potential loss is very large.

When options are used, the speculators

loss is limited to the amount paid forentering the option.

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Arbitrage Example

A stock price is quoted as 100 in Londonand $200 in New York

The current exchange rate is 2.0300 What is the arbitrage opportunity?


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Questions:

It is May and a trader writes a Septembercall option with a strike price of $20. thestock price is $18 and the option price is$2. Describe the traders cash flow if theoption is held until September and thestock price is $25 at that time?

A trader writes a December put option with

a strike of price of $30. the price of optionis $4. under what circumstances does atrader make a gain?

ch01 forwrd and futures, options

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