Lecture Notes:

INTRODUCTION TO
FINANCIAL DERIVATIVES

Jaeyoung Sung
School of Business Administration
Ajou University
Spring 2017
Chapter 1

Introduction

1.1 What is a derivative security?

A derivative security (or contingent claim) is an instrument whose value depends
on the prices of other underlying securities or on some designated indices. Thus,
the price of a derivative security is a function of price/index characteristics of
underlying securities/indices. This function is usually independent of factors such
as investors risk aversion. (Does this mean prices of derivatives are independent
of investors risk aversion?)

Examples include forward/futures, options, and swaps. Derivatives can be based

on various underlying assets/indices:

corporate securities and equities

foreign currencies
stock-market indices, index volatilities
commodities
weather, carbon

Why do we need derivative securities?

1. Hedging
2. Speculation
3. Arbitrage
4. Risk management

In this course, we study uses of derivatives and pricing relationships between

derivative securities and underlying securities.

1-1
1-2 J.Sung

1.2 Derivative Securities

Major examples are forward contracts, futures contracts and options.

1.2.1 Forward and Futures Contracts

An agreement between two parties to buy or sell underlying assets at a prespecified
price on a prespecified future date.

Example: A farmer and a food processor enter into an agreement that the farmer
will sell to the food processor 50,000 bushels of soybeans 6 months from now at 807
cents per bushel.

Types of Forward and Futures Contracts

Agricultural and metallurgical contracts:

Agricultural grains (corn, oats, and wheat), oil and meal (soybeans, soymeal,
and soyoil, and sunflower seed and oil), livestock (live hogs, cattle, and pork
bellies), forest products (lumber and plywood), textile (cotton), and foodstuff
(cocoa, coffee, orange juice, rice, and sugar).
Metallurgical genuine metals (gold, silver, platinum, palladium and copper)
and petroleum products (heating oil, crude oil, gasoline and propane).

Interest-earning assets: T-bills, T-notes, T-bonds, Eurodollar deposits, and mu-

nicipal bonds.

Foreign currencies: British pound, Canadian dollar, Japanese yen, Swiss franc,
German mark, Australian Dollar, Mexican Peso, Brazilian Real, and Euro.

Indexes: S&P 500, DJIA, NYSE Index, ...

Foreign exchanges traded index futures: Nikkei 225.

1.2.2 Options
Call: A call option gives the holder the right (but not an obligation) to buy an asset
at a fixed price (the exercise or strike price) by a certain date (the maturity or
expiration date)

Put: A put option gives the holder the right (but not an obligation) to sell an asset
at a fixed price by a certain date

Example: An investor buys a call option contract on Intel (INTC) stock with an
exercise price of $35 and a maturity date of two months from now. The price of the
Introduction 1-3

call is $1.06. This call option generates a positive cashflow if exercised when the Intel
stock rises higher than $35.

Unlike the case with futures, the holder of an option is not required to buy or sell
the asset it is his or her option. Thus the holder will not exercise unless his or her
payoff is positive.

Types of Options Contracts

Stock Options

Stock Index Options: DJIA, S&P 500, S&P 100, Russel 2000, Major Market, ...

LEAPS (Long-Term Equity Anticipation Securities)

Equity LEAPS: long term stock options

Index LEAPS: long term index options on indices such as DJIA, S&P500,
S&P 100.

Foreign Currency Options

Futures Options: Agricultural, Oil, Livestock, Metal, Interest Rate, Currency,

Index.

OTC Options

Others

1.3 Derivatives Trading

1.3.1 Types of Traders
Classification by trading purposes
Hedgers

Speculators

scalpers
day traders
position traders

Arbitrageurs
1-4 J.Sung

Types of traders in options markets

market maker

floor brokers

order book official

1.3.2 Types of Orders

- Market order buy or sell immediately at the best possible price.

- Limit order buy below a specified price or sell above a specified price.

- Stop order (stop-loss order) Stop-sell order: To sell, set a stop price below current
price. Then order becomes a market order if and when traded price hits or drops
below the stop price.
Stop-buy order: The opposite.

- Stop-limit order Here you specify two prices: a stop price and a limit price. The
order acts like a stop order until the traded price reaches the stop price, then it
becomes a limit order.

- Market-if-touched (MIT) order When the market reaches a specified limit price,
an MIT order becomes a market order for immediate execution. An MIT sell
(buy) order is placed at a price above (below) the existing market. (Note: This
is in contrast with a stop-buy (stop-sell) order placed at a price above (below)
the existing market.)

Duration of outstanding orders

- Day order, week order, month order.

- Open order : GTC order (good-till-canceled). A GTC order remains in effect until
they are either filled or canceled by the investor.

- Fill-or-kill (FOK) order. This type of order will be canceled immediately if the broker
is unable to execute it.

1.4 Short Sales

- Sell first, buy later.

- Short seller must borrow certificates and sell them. Later (s)he has to buy back to
return them to the loaner.
Introduction 1-5
Before Transaction:
Dividends,
annual reports, - Forwards
XYZ Corp voting rights Broker everything
- Ms. Certificate Loaner

During:

Mr. New Owner

6
Receives stock
$ proceeds certificate
?
XYZ Corp  Notifies of Broker  Allows stock
Ms. Certificate Loaner
new owner to be lent
6
$ initial margin

Mr. Shortseller

After:

Mr. New Owner


Dividends,
annual reports,
voting rights

Annual report Annual report,

XYZ Corp - Broker - Ms. Certificate Loaner
dividends
6
$ for
dividend

Mr. Shortseller
1-6 J.Sung

Closing out the short position:

Ms. New Seller

6
send stock
$price certificate
?
XYZ Corp  Notifies that Broker
Original position-
Ms. Certificate Loaner
Ms. C. Loaner restored
is the new owner
Receives the mgn bal.
net of $ price
?
Mr. Shortseller

Example: Current price of XYZ stock is $50 per share. It is known that the stock
does not pay dividends in one month. Based on his information, investor A thinks that
current price is overvalued. In particular, he expects the stock price drop to around
$40 per share in one month.
In order to capitalize on his information, he borrows 100 shares from his broker, short-
sells 100 shares of XYZ stock at $50 per share, and receives $5,000 as proceeds which is
deposited with his broker in his margin account. After a month, in fact, the stock price
falls to $42 per share. Thinking that it is the right time for him to close out the short
position, he withdraws $4200 from his margin account to buy back 100 shares at $42
per share, and return them to the broker. His profit from these shortsale transactions
is $800.

1.5 Compounding
Example: Annual interest rate is equal to 7%. You deposit $1000 in a savings account
at 7% per year. Then you will get at the end of the year

- with annual compounding, 1000(1 + .07) = $1070

- with semiannual compounding, 1000(1 + .07 2

)2 = $1071.22.
The effective annual yield in this case is
0.07 2
(1 + ) 1 = 0.07122, i.e. 7.122%.
2
.07 4
- with quarterly compounding, 1000(1 + 4
) = $1071.85
.07 12
- with monthly compounding, 1000(1 + 12
) = $1072.29
Introduction 1-7

.07 n
- with compounding n-times, 1000(1 + n
)

- with infinitely many (continuous) compounding,1

.07 n
1000 lim (1 + ) = 1000 e.07 = $1072.51
n n
The effective annual yield with continuous compounding is 7.251%.

At an annual rate of r, P dollars will grow for T years to FT dollars, where FT =

P erT with continuous compounding, and FT = P (1 + r/n)nT with compounding n
times.
This implies that the present value of FT dollars is equal to FT erT with continuous
compounding and to FT (1 + r/n)nT with compounding n times.

Exercise 1.1 $1000 to be paid in one year. Find PV with continuous compounding at
an annual rate of 10%.

Exercise 1.2 $1000 in savings will grow with continuous compounding at an annual
rate of 9%. Find FV of savings next year. What is the effective annual yield?

Exercise 1.3 Bank A pays interests on savings with monthly compounding at 9% p.a.
If a customer desires continuous compounding on her savings, what interest rate p.a.
should the bank quote to the customer?

Exercise 1.4 Bank A quotes the interest rate on savings deposits as 5% p.a. with quar-
terly compounding, and Bank B quotes it as 4.75% p.a. with continuous compounding.
You want to deposit $10,000 for 9 months. Which bank would you choose?

1.6 Arbitrage
Arbitrage: Making a riskfree profit out of a zero investment portfolio - - the act of
buying an asset at one price and simultaneously selling it at a higher price.

Law of one price: Equivalent securities or bundles of securities are equally

priced so that riskfree arbitrage is not possible. When the law of one price is
violated, an arbitrage opportunity arises: shortsell the asset in a high-priced
market and buy it in a low-priced market.
1
Recall the following mathematical definition.
1 n m n
e := lim (1 + ) = em = lim (1 + ) .
n n n n
1-8 J.Sung

Exercise 1.5 (Law of one price) Suppose that there are two assets as below:


*
 $10 
*
 $10
   
A: $8 
HH B: $9 
HH
HH HH
j
H
$7 j
H
$7

Construct an arbitrage portfolio.

It is said that security A dominates security B (in the sense of the first-degree
stochastic dominance), if As future payoff is greater than Bs future payoff in at
least one possible state of world; and greater than or equal to Bs future payoff in
all other possible states of world. If stock A dominates stock B in this sense, the
price of A, a dominating security, has to be higher than that of B, a dominated
security. Otherwise, arbitrage.

Exercise 1.6 Suppose that there are two assets as below:


* $10 
* $11
 
 
A: $8 HH B: $8 HH
H H
HH HH
j $7 j $7

Construct an arbitrage portfolio.

Arbitrage may involve not one security but combinations of securities.

Exercise 1.7 Suppose that there are three assets as below:

*
 $10 *
 $12 * $14

  
  
A: $8 
H
HH
B: $9 
H
HH
C: $10 
H
HH
H H H
j
H
$7 j
H $5 j $4
H

Construct an arbitrage portfolio.