Mathematics of Options, Futures, and Derivative Securities I.

Daniel Spirn, School of Mathematics, University of Minnesota.

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Syllabus

Semester I

Semester II 1. Review of Black-Scholes

1. Mechanics of Futures Markets 2. Hedging Strategies Using Futures 3. Interest Rate Markets 4. Determination of of Forward and Future Prices 5. Interest Rate Futures 6. Swaps 7. Mechanics of Options Markets 8. Properties of Stock Option Prices 9. Trading Strategies Involving Options 10. Binomial Trees 11. Wiener Processes and Itos Lemma 12. The Black-Scholes Model 13. Options on Stock Indices, Currencies and Futures 14. The Greek Letters 15. Volatility Smiles

2. Review of Greeks 3. Volatility Smiles 4. Basic Numerical Procedures 5. Value at Risk 6. Time Series 7. Estimation of Volatilities and Correlations 8. Credit Risk 9. Credit Derivatives 10. Exotic Options 11. Weather, energy, and insurance derivatives 12. More on models and numerical procedures 13. Martingales and measures 14. Interest Rate Derivatives 15. Convexity, timing, and quanto adjustments 16. Models of Short Rate 17. Heath-Jarrow-Morton 18. Swaps revisited 19. Real Options

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Class Information
Lecture: Mondays & Wednesdays 4:30PM6:00PM. Lecture Room: Vincent Hall 20 Oce Hours: Mondays 3:30PM4:30PM & Wednesdays: 2:30PM3:30PM Oce: Vincent Hall 112b Contact: spirn@math.umn.edu & 612-625-1349 Textbook: Options, Futures, and Other Derivatives , 6th Edition, John Hull, Prentice Hall. Grade Information: Homework: Midterm: Final: 50 % 20 % 30 %

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Mathematics Involved
Control Theory

Probability Theory

Partial Dierential Equations

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What is a derivative?

What is a derivative? A nancial instrument whose value derives from the value of underlying variables. or Financial instruments whose price and value derive from the value of assets underlying them. 1 or Financial contracts whose value derive from the value of underlying stocks, bonds, currencies, commodities, etc.

Examples: Future contract for orange juice. Not the orange juice itself. Option to buy/sell a stock. Not the stock itself.

Edmund Parker
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Asset Derivatives

Examples Commodity Derivatives - Pork Bellies (Trading Places), Precious Metals Equity Derivatives - Stocks / Bonds Interest Rate Derivatives - Interest Rates Currency Derivatives - Currency Exchange Rates (Yen vs. Euro) Property Derivatives - Real Estate Other More Exotic Derivatives

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Why trade derivatives?

Used to protect assets from drastic uctuations Covers many kinds of risk. Allows access to nancial instruments with considerably larger risk than conventional assets (speculation).

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Types of Markets trading derivatives

Exchange-traded Markets: Examples: Chicago Board of Trade & Chicago Mercantile Exchange. This is an open-outcry exhange where traders meet physically and negotiate trades via signals and shouts. There are also electronic exchanges where traders enter desired trades and computers match the trades. Over-the-counter (OTC) Markets: These are telephone and computer run exchanges. Large nancial companies act as market makers for commonly traded instruments. This requires them to quote both a bid and oer price. Markets are huge. OTC market on the order of $ 298 Trillion in 2005. The Exchange-traded market was on the order of $ 49 Trillion in 2004.

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Financial instruments used in derivative transactions

Forwards

Futures

Options

Swaps

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Forward Contracts

Denition: A forward contract is an agreement to buy or sell an asset at a certain time for a certain price. Usually traded in the OTC market. One party assumes a long position by agreeing to buy the underlying asset on a specied future date for a specied price. The other party assumes a short position by agreeing to sell the underlying asset on the same date and at the same price.

Denition: A spot contract is an agreement to buy or sell an asset today. Spot contracts are for immediate delivery of the asset. Common among currency derivatives.

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Example of a useful forward contract

Spot and forward quotes for USD/GBP exchange rate, June 1, 2007

Spot 1-month forward 3-month forward 5-month forward

Bid 1.6281 1.6248 1.6187 1.6094

Oer 1.6285 1.6253 1.6192 1.6100

Suppose today is June 1, 2007. US corporation will need to pay 1 million on December 1, 2007. Company wants to hedge against a change in the exchange rate. Using the table above, the company agrees to buy 1 million 6-month forward contract at the exchange rate of 1.6100 . The company has a long forward contract on GBP, i.e. the bank will pay $ 1.610 million for 1 million. Participating bank has a short forward contract to sell 1 million for $ 1.610 million on Dec. 1, 2007.
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Payos from Forward Contracts

Outcomes Suppose spot exchange rises to 1.7000 by Dec. 1, 2007, then the forward contract would be worth: $1, 700, 000 $1, 610, 000 = $90, 000 to the US corporation. Enables the corporation to pay at a cheaper rate. If the spot exchange falls to 1. 500 on Dec. 1, 2007, then the forward contract would be worth: $1, 500, 000 $1, 610, 000 = $ 110, 000 so the corporation would be paying more for pounds than the current market.

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Payos for Forward Contracts, cont.

In general if K is the delivery price ($1.61 million) and ST is the spot price of the asset at maturity ($1.5 million) then we dene the following payos for forward contracts. The payo for a long forward contract is ST K.

The payo for a short forward contract is K ST .

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Futures Contracts

Similar to a forward contract - it is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. However, futures are usually traded in exchanges. Mechanisms by the exchange to guarantee that the contract will be honored. Example: Chicago Mercantile Exchange (CME) trades futures on commodities such as pork bellies, orange juice, copper, sugar, etc. nancial assets such as stock indices, currencies, Treasury bonds, etc. Mechanisms for such exchanges will be explained next week.

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Options Contracts

The third type of derivative we will discuss is an options contract. These are divided into two types: A call option entitles the holder the right to buy the underlying asset by a certain date for a certain price. A put option entitles the holder the right to sell the underlying asset by a certain date for a certain price. Some more terminology: The price in the contract is the strike price or the exercise price. The date in the contract is known as the expiration date or maturity.

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Types of options

American options can be exercised at any time up to the expiration date. European options can be exercised only on the expiration date. Mathematics involved in American options is more dicult than European options.

One contract is usually an agreement to buy or sell 100 shares.

Note an option is exactly that - an option to exercise the right to buy or sell. The holder of the option does not need to exercise the option.

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Example of Stock Options

Calls June 1.25 0.20 Calls July 1.60 0.45 Calls Oct. 2.40 1.15 Puts June 0.45 1.85 Puts July 0.85 2.20 Puts Oct. 1.50 2.85

Strike Price($) 20.00 22.50

Prices of options on Intel, May 29, 2003. Stock price = $20.83

Consider the following scenario. Investor instructs broker to buy one October call option contract on Intel with strike price of $ 22.50. This is negotiated at CBOE with the price $1.15. This is the price for an option to buy one share. The US contract reects 100 shares; therefore, the investor must pay $115 to the exchange through the broker. The exchange passes this amount to the party on the other side. Summary: our investor has paid $115 for the right to buy 100 shares of Intel at $22.50 each by the October maturity. The party on the other side received $115 to agree to sell 100 shares of Intel at $22.50 (if the investor chooses).
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Example, cont.

Possible scenarios: If the price of Intel remains below $22.50 before the October maturity date, the option is not exercised and the investor loses $115. If the price of Intel rises to $31 before the October maturity date then the call is exercised and the investor makes [$31.00 100 $22.50 100] $115 = $735.

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Example, cont.

Strike Price($) 20.00 22.50

Calls June 1.25 0.20

Calls July 1.60 0.45

Calls Oct. 2.40 1.15

Puts June 0.45 1.85

Puts July 0.85 2.20

Puts Oct. 1.50 2.85

Consider a new scenario with Intel options. Purchase one July put option contract with strike price of $20.00 for $85. The investor now has the right to sell 100 shares of Intel at $20.00 each prior to the July exercise date. If Intel stays above $20 then the option is not exercised and the investor loses $85. If Intel drops to $12 then the investor earns [$20.00 100 $12.00 100] $85 = $715
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Participants in Options Markets

Four types of participants in the Options markets, as yet: Buyers of calls Sellers of calls Buyers of puts Sellers of puts a long position a short position a long position a short position

Selling an option is also known as writing the option.

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Types of derivative traders in the market

Hedgers - use derivatives to reduce risk in the market from potential future market movements. Speculators - trade derivatives to bet on the future direction of a market variable. Arbitrageurs - take osetting positions in two or more instruments to lock in a prot. (usually short-lived)

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Hedgers - reducing risk exposure

Example: Using forward contracts. Recall

Spot and forward quotes for USD/GBP exchange rate, June 1, 2007

Spot 1-month forward 3-month forward 5-month forward

Bid 1.6281 1.6248 1.6187 1.6094

Oer 1.6285 1.6253 1.6192 1.6100

June 1, 2003. ImportCo knows it needs to pay 10 million on September 1, 2007 for goods it purchased from a British supplier. ImportCo can hedge its foreign exchange risk by buying points from the nancial institution in the 3-month forward market at 1.6192. This xes the cost at $1,6192,000.

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Example, cont.

Next, another US company ExportCo, is exporting goods to the UK. It will receive 30 million 3 months later. ExportCo can hedge its foreign exchange risk by selling 30 million in the 3-month forward market at an exchange rate of 1.6187. Then ExportCo is assured of $ 48,561,000. A company may do better without hedging - consider ImportCo. If it does not hedge then the 10 million may cost $ 15 million if the exchange rate drops to 1.500, :) . On the other hand if the rate increases to 1.7000 then the cost becomes $17 million, :( . Hedging forward contracts locks in particular rates that may or may not be better than the spot contract. However, it reduces uncertainty.

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Another example of Hedging

Example: Using option contacts. Consider Fred who in May 2003 owns 1000 shares of Microsoft. Current price is $28. Concerned about possible decline in next 2 months and wants protection. Investor buys ten July put option contracts on Microsoft on the CBOE with strike price of $ 27.50. This would give Fred the right to sell 1000 shares of Microsoft for a price of $27.50 per share. If the option price is $1, then each option contract costs $1 100 = $100 and the total cost of the hedging strategy is $ 1000, where the value of the portfolio is $27,500. If the stock falls below $27.50, then the options can be exercised. When the option is exercised the amount realized is $26, 500. If the market stays above $27.50, then the options are not exercised and expire. The portfolio always retains a value of at least $26,500 .
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Summary: hedging

Forward contracts neutralize risk by xing prices that the hedger will pay or receive for the underlying asset. Options contracts oer insurance for investors to protect against adverse price movements. Options involve upfront fee, unlike forwards.

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Speculators - increasing risk

Example of speculating using stock options. Using $2000 to speculate on Amazon.com stock. Investor Strategy Buy 100 shares Buy 2000 call options Dec. Stock price $15 ($500) ($2000) Dec. Stock price $27 $700 $7000

The stock is currently selling at $20, and 2 month call option with $22.50 strike price is currently selling at $1. Two scenarios above for investing $2000. Alternative 1: purchase 100 shares. Suppose stock rises to $ 27, then prot of 100 [$27 $20] = $700. If the stock drops to $ 15, then the investor loses 100 [$20 $15] = $500.

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Speculators, cont.

Alternative 2: purchase 2000 call options. If the price rises to $ 27, then prot of $4.50 per share yields 2000 $4.50 = $9000. However, we paid $ 2000, so we prot $7000. This is ten times more protable! On the other hand if the price drops to $15, then loss of $ 2000, since the options are not exercised, but we paid $ 2000 for the options (compared to ($500) in the stock transaction). Futures and options speculation both oer leverage (high risk, high return). However, forward contract speculation can create very large losses; whereas, options contract losses are limited to the price of the contract.

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Arbitrageurs
Third important group of traders in derivatives. Involves locking in riskless prot by simultaneously entering into transactions in two or more markets. Mostly possible when future prices become out of line with spot prices. Example: Consider a stock being traded on NYSE and LSE (London Stock Exchange). Suppose the price of the stock is $ 172 in New York and 100 in London at a time when the exchange rate is 1.7500 per pound. Arbitrageur simultaneously buys 100 shares of stock in New York and sells them in London to obtain a riskless 100 [($1.75 100) $172] = $300. Transaction costs may gobble up most of the prot for small investments, but large nancial institutions could prot. Furthermore, arbitrage opportunities are quickly lost.
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Homework

Due Sept. 5, 5PM. 1.1-1.4, 1.6, 1.13, 1.19 Graded: 1.26, 1.27, 1.28, 1.29

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