1Lec 1 Intro to Options and Futures Lec 1: Intro to Financial Risk Management (Hull, Ch 1) Call Options. (1.5) If you buy a CALL option on IBM, 1. You have the right, but not the obligation, to buy 100 shares of IBM at a specified price (Exercise Price). 2. The price of the call is known as Call Premium. 3. Call will expire at a specified date (Expiration Date). Example: Buy a European December 70 call on IBM for $5. Expiration date = 3rd Friday of December Exercise price = K = $70 Call premium (C 0 ) = $5 ( x 100) = $500

2Lec 1 Intro to Options and Futures Cash Flow Analysis: At t = 0 (now) you pay $500 to seller of call. at t = Expiration, Possible scenarios: Spot Price (S T )Exercise?Value of { +C T } Gain or Loss ➀ $50 No0-$500 ➁ 60 No0-$500 ➂ 70 Yes/No0-$500 ➃ 80 Yes$1, ➄ 90 Yes$2,000+1,500

3Lec 1 Intro to Options and Futures PUT Options. (1.5) If you buy a PUT option on BAC, 1. You have the right, but not the obligation, to sell 100 shares of BAC at a specified price (Exercise Price). 2. The put price is known as the Put Premium. 3. Put will expire at a specified date (Expiration Date). Example: Buy a European December 70 Put on BAC for $3. Expiration date = 3rd Friday of December Exercise price = K = $70 Put premium (P 0 ) = $3 ( x 100) = $300

4Lec 1 Intro to Options and Futures Cash Flow Analysis: At t = 0 (now) you pay $300 to seller of Put option. at t = Expiration, Possible scenarios: Spot Price (S T )Exercise?Value of { +P T } Gain or Loss ➀ $50 Yes$2,000$1,700 ➁ 60 Yes$1,000$700 ➂ 70 Yes/No0-$300 ➃ 80 No ➄ 90 No

5Lec 1 Intro to Options and Futures Futures and Forward contracts Basic Definitions 1. “Cash Market” or “Spot” contract is an agreement (between two parties) to trade a commodity (e.g. oranges, U.S. T-Bills, Currencies,...) for cash immediately. (Translation: the cash or spot market is like a grocery store, you buy oranges with cash today). 2. “Forward Market” or Forward contract is an agreement (signed today) to trade at a future date (say 90 days from now). The Forward (or Futures) price, is fixed today. 3. “Futures” contract is a standardized forward contract. Risk of default with a futures contract ∼ 0.

6Lec 1 Intro to Options and Futures Example 1: Hedging an A/P with a Long Forward Contract GE buys high precision parts for helicopters from a Swiss watch manufacturer for SFr 1M payable one year from now (A/P = SFr 1M). UBS makes a market in SFr. Spot and Forward Quotes are as follows: Bid Ask Spot 0.75 $/SFr 0.80 $/SFr 1-year forward0.77 $/SFr0.82 $/SFr How to hedge FX risk? A. Buy SFr right now and hold it for 1 yr Cost (today) in $ of the A/P = SFr 1M(0.80 $/SFr) = $800,000 or

7Lec 1 Intro to Options and Futures B. Buy a SFr forward contract from UBS: t=0 GE buys SFr 1M 0.82 $/SFr t=1 Transaction occurs: ▸ UBS delivers SFr 1M to GE. ▸ GE pays = SFr 1M(0.82 $/SFr) = $820,000 to UBS. ▸ GE uses the Swiss Francs to cover the A/P. (Rhetorical Question) which is better: $800,000 now or $820,000 in 1 yr?

8Lec 1 Intro to Options and Futures Example 2: How to speculate with a forward contract (“Long” Position). Suppose I am the CFO of a financial institution. I am bullish on the SFr (relative to the $), Today, I go long 1 Dec SFr forward 0.75 $/SFr, Contract Size = SFr 125,000 (Notional Amount) In English, ▸ CFO has agreed to buy SFr 125,000 and pay $93,750 (=SFr 125,000*0.75 $/SFr). ▸ Trade will take place 3 rd week in December.

9Lec 1 Intro to Options and Futures Cash Flow Analysis: At t = 0 (now) you shake hands with seller. At t = December (Forward Settle date), possible scenarios: Spot FX T $ Value of SFr 125,000Gain/Loss ( π ) ➀ 0.60 $/SFr $ 75,000- $18,750 ➁ 0.70 $/SFr 87,500- $6,250 ➂ 0.80 $/SFr 100,000+ $6,250 ➃ 0.90 $/SFr 112,500+ $18,750

Lec 1 Intro to Options and FuturesLec 1 Intro to Options and Futures10