CHAPTER 4 Introduction To Derivatives

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Introduction (I)
In the financial marketplace some instruments are regarded as fundamentals,
while others are regarded as derivatives.

Financial Marketplace

Derivatives

Fundamentals

Simply another way to catagorize the diversity in the FM*.

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*Financial Market

Introduction (II)
Financial Marketplace

Derivatives Futures Forwards Options Swaps

Fundamentals Stocks Bonds Etc.

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What is a Derivative? (I)

Options

Futures

The value of the derivative instrument is DERIVED from the underlying security

Forwards

Swaps

Underlying instrument such as a commodity, a stock, a stock index, an exchange rate, a bond, another derivative etc..
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 The financial derivative is an asset whose value is derived from the value of some other asset(s) or derivatives, known as underlying asset(s). Example:
An orange juice can be considered as a derivative of the oranges since its price can be derived from that of oranges. A financial contract on selling 100 barrels of crude oil at $70/barrel in three months. (Forward or futures contract)
It can also extend to something like a reimbursement program for college credit. Consider that if your firm reimburses 100% of costs for an A, 75% of costs for a B, 50% for a C and 0% for anything less. Your right to claim this reimbursement, then is tied to the grade you earn. The value of that reimbursement plan, therefore, is derived from the grade you earn. We also say that the value is contingent upon the grade you earn. Thus, your claim for reimbursement is a contingent claim. The terms contingent claims and derivatives are used interchangeably.
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Types is a Derivative? (II)

Futures
The owner of a future has the OBLIGATION to sell or buy
something in the future at a predetermined price.

Forwards

The owner of a forward has the OBLIGATION to sell or buy

something in the future at a predetermined price. The difference

to a future contract is that forwards are not standardized. The owner of an options has the OPTION to buy or sell something at a predetermined price and is therefore more costly than a futures contract.

Options

Swaps

A swap is an agreement between two parties to exchange a sequence of cash flows.

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Forward Contracts
A forward contract is an agreement between two parties to buy or sell an asset at a certain future time for a certain future price.
Forward contracts are normally not exchange traded. The party that agrees to buy the asset in the future is said to have the long position. The party that agrees to sell the asset in the future is said to have the short position. The specified future date for the exchange is known as the delivery (maturity) date.
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Forward Contracts
The specified price for the sale is known as the delivery price, we will denote this as K.
Note that K is set such that at initiation of the contract the value of the forward contract is 0. Thus, by design, no cash changes hands at time 0.

As time progresses the delivery price doesnt change, but the current spot (market) rate does. Thus, the contract gains (or loses) value over time.

Consider the situation at the maturity date of the contract. If the spot price is higher than the delivery price, the long party can buy at K and immediately sell at the spot price ST, making a profit of (ST-K), whereas the short position could have sold the asset for ST, but is obligated to sell for K, earning a profit (negative) of (K-ST).
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Forward Contracts
Example:
Lets say that you entered into a forward contract to buy wheat at Birr 4.00/ kilogram, with delivery in December (thus K= Birr 3.64.) Lets say that the delivery date was December 14 and that on December 14th the market price of wheat is unlikely to be exactly Birr 4.00/ kilogram , but that is the price at which you have agreed (via the forward contract) to buy your wheat. If the market price is greater than Birr 4.00/ kilogram, you are pleased, because you are able to buy an asset for less than its market price. If, however, the market price is less than Birr 4.00/ kilogram, you are not pleased because you are paying more than the market price for the wheat. Indeed, we can determine your net payoff to the trade by applying the formula: payoff = ST K, since you gain an asset worth ST, but you have to pay birr K for it. We can graph the payoff function:
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Forward Contracts

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Forward Contracts
Example:
In this example you were the long party, but what about the short party? They have agreed to sell wheat to you for Birr 4.00/ kilogram on December 14. Their payoff is positive if the market price of wheat is less than Birr 4.00/ kilogram they force you to pay more for the wheat than they could sell it for on the open market.

Their payoff is negative, however, if the market price of wheat is greater than Birr 4.00/ kilogram

Indeed, you could assume that what they do is buy it on the open market and then immediately deliver it to you in the forward contract.

So their payoff function is the mirror image of your payoff function:

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They could have sold the wheat for more than Birr 4.00/ kilogram had they not agreed to sell it to you.

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Forward Contracts

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Forward Contracts
Clearly the short position is just the mirror image of the long position, and, taken together the two positions cancel each other out:

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Forward Contracts

Short Position Long Position

Net Position

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Futures Contracts
A futures contract is similar to a forward contract in that it is an agreement between two parties to buy or sell an asset at a certain time for a certain price. Futures, however, are usually exchange traded and, to facilitate trading, are usually standardized contracts. This results in more institutional detail than is the case with forwards. The long and short party usually do not deal with each other directly or even know each other for that matter. The exchange acts as a clearinghouse. As far as the two sides are concerned they are entering into contracts with the exchange. In fact, the exchange guarantees performance of the contract regardless of whether the other party fails.
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Futures Contracts
The largest futures exchanges are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). Futures are traded on a wide range of commodities and financial assets. Usually an exact delivery date is not specified, but rather a delivery range is specified. The short position has the option to choose when delivery is made. This is done to accommodate physical delivery issues.
Harvest dates vary from year to year, transportation schedules change, etc. Note however, that the basic payoffs are the same as for a forward contract.
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Options Contracts
The owner of an options has the OPTION to buy or sell something at a predetermined price and is therefore more costly than a futures. There are two basic types of options:
A Call option is the right, but not the obligation, to buy the underlying asset by a certain date for a certain price. A Put option is the right, but not the obligation, to sell the underlying asset by a certain date for a certain price.
Note that unlike a forward or futures contract, the holder of the options contract does not have to do anything - they have the option to do it or not.
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Options Contracts
The date when the option expires is known as the exercise date, the expiration date, or the maturity date. The price at which the asset can be purchased or sold is known as the strike price. If an option is said to be European, it means that the holder of the option can buy or sell (depending on if it is a call or a put) only on the maturity date. If the option is said to be an American style option, the holder can exercise on any date up to and including the exercise date. An options contract is always costly to enter as the long party. The short party always is always paid to enter into the contract
Looking at the payoff diagrams you can see why
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Options Contracts
Lets say that you entered into a call option on OIB stock:
Today OIB is selling for roughly $78.80/share, so lets say you entered into a call option that would let you buy IBM stock in December at a price of $80/share. If in December the market price of OIB were greater than $80, you would exercise your option, and purchase the OIB share for $80. If, in December OIB stock were selling for less than $80/share, you could buy the stock for less by buying it in the open market, so you would not exercise your option. Thus, your payoff diagram is:
Thus your payoff to the option is $0 if the OIB stock is less than $80 It is (ST-K) if OIB stock is worth more than $80

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Options Contracts

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Options Contracts
What if you had the short position? Well, after you enter into the contract, you have granted the option to the long-party. If they want to exercise the option, you have to do so. Of course, they will only exercise the option when it is in there best interest to do so that is, when the strike price is lower than the market price of the stock.
So if the stock price is less than the strike price (ST<K), then the long party will just buy the stock in the market, and so the option will expire, and you will receive $0 at maturity. If the stock price is more than the strike price (ST>K), however, then the long party will exercise their option and you will have to sell them an asset that is worth ST for $K. payoff = min(0,ST-K), which has a graph that looks like:
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We can thus write your payoff as:

Options Contracts

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Options Contracts
This is obviously the mirror image of the long position. Notice, however, that at maturity, the short option position can NEVER have a positive payout the best that can happen is that they get $0.
This is why the short option party always demands an up-front payment its the only payment they are going to receive. This payment is called the option premium or price.

Once again, the two positions net out to zero:

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Options Contracts

Long Call Net Position

Short Call

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Options Contracts
Recall that a put option grants the long party the right to sell the underlying at price K. Returning to our OIB example, if K=80, the long party will only elect to exercise the option if the price of the stock in the market is less than $80, otherwise they would just sell it in the market.

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Options Contracts
Traders frequently refer to an option as being in the money, out of the money or at the money.
An in the money option means one where the price of the underlying is such that if the option were exercised immediately, the option holder would receive a payout. An at the money option means one where the strike and exercise prices are the same. An out of the money option means one where the price of the underlying is such that if the option were exercised immediately, the option holder would NOT receive a payout.
For a call option this means that St<K For a put option this means that St>K.
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For a call option this means that St>K For a put option this means that St<K

Options Contracts
So who trades options contracts? Generally there are three types of options traders:
Hedgers Speculators Arbitrageurs

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Hedging
If someone bears an economic risk and uses the futures market to reduce that risk, the person is a hedger Hedging is a prudent business practice and a prudent manager has a legal duty to understand and use the futures market hedging mechanism
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Speculation
A person or firm who accepts the risk the hedger does not want to take is a speculator Speculators believe the potential return outweighs the risk The primary purpose of derivatives markets is not speculation. Rather, they permit the transfer of risk between market participants as they desire
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Hedgers and Speculators

Risk Transfer Hedgers Speculators

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Arbitrage
Arbitrage is the existence of a riskless profit Arbitrage opportunities are quickly exploited and eliminated

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Arbitrage (contd)
Persons actively engaged in seeking out minor pricing discrepancies are called arbitrageurs Arbitrageurs keep prices in the marketplace efficient
An efficient market is one in which securities are priced in accordance with their perceived level of risk and their potential return

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Market participants
Hedger The hedgers can use the derivatives to reduce their risk on the unfavorable movement of market variables such as exchange rates and commodity prices. Example 1.3 Suppose ABC Airline Co. knows that it will have to buy on 31 Dec 2011 (date T) 1 million tons of fuel. To hedge against the possible increase in fuel price between today and T, he could

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 In summary, forward contracts are designed to neutralize the risk by fixing price. By contrast, option contracts offer a way for investors to protect themselves against adverse price movements in the future while still allowing them to benefit from favorable price movements. Unlike forwards, options involve the payment of an upfront fee.

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Market participants
Speculator The speculator wishes gain profit from taking the market movement. Either they are betting that the price of the asset will go up or go down. The financial derivatives allow them to create the speculative position in a much lower cost than by actually trading the underlying asset. This is called leverage.

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Arbitrageur An arbitrage is a deal that produces risk-free profit by exploiting a mispricing in the market. An arbitrageur can purchase an asset cheaply in one location and simultaneously sell it in another at a higher price. The arbitrage opportunities cannot last for long. More complicated arbitrage trading strategies can be created from financial derivatives.

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