1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown
Chapter 21

2. Chapter 21 - An Introduction to Derivative Markets and Securities
Questions to be answered:
What distinguishes a derivative security such as a forward, futures, or option contract, from more fundamental securities, such as stocks and bonds?
What are the important characteristics of forward, futures, and option contracts, and in what sense can the be interpreted as insurance policies?

3. Chapter 21 - An Introduction to Derivative Markets and Securities
How are the markets for derivative securities organized and how do they differ from other security markets?
What terminology is used to describe transactions that involve forward, futures, and option contracts?
How are prices for derivative securities quoted and how should this information be interpreted?

4. Chapter 21 - An Introduction to Derivative Markets and Securities
What are similarities and differences between forward and futures contracts?
What do the payoff diagrams look like for investments in forward and futures contracts?
What do the payoff diagrams look like for investments in put and call option contracts?
How are forward contracts, put options, and call options related to one another?

5. Chapter 21 - An Introduction to Derivative Markets and Securities
How can derivatives be used in conjunction with stock and Treasury bills to replicate the payoffs to other securities and create arbitrage opportunities for an investor?
How can derivative contracts be used to restructure cash flow patterns and modify the risk in existing investment portfolios?

6. Derivative Instruments
Value is depends directly on, or is derived from, the value of another security or commodity, called the underlying asset
Forward and Futures contracts are agreements between two parties - the buyer agrees to purchase an asset from the seller at a specific date at a price agreed to now
Options offer the buyer the right without obligation to buy or sell at a fixed price up to or on a specific date

7. Why Do Derivatives Exist?
Assets are traded in the cash or spot market
It is sometimes advantageous enter into a transaction now with the exchange of asset and payment at a future time
Risk shifting
Price formation
Investment cost reduction

8. Derivative Instruments
Forward contracts are the right and full obligation to conduct a transaction involving another security or commodity - the underlying asset - at a predetermined date (maturity date) and at a predetermined price (contract price)
This is a trade agreement
Futures contracts are similar, but subject to a daily settling-up process

9. Forward Contracts Buyer is long, seller is short
Contracts are OTC, have negotiable terms, and are not liquid
Subject to credit risk or default risk
No payments until expiration
Agreement may be illiquid

10. Futures Contracts Standardized terms Central market (futures exchange)
More liquidity
Less liquidity risk - initial margin
Settlement price - daily “marking to market”

11. Options The Language and Structure of Options Markets
An option contract gives the holder the right-but not the obligation-to conduct a transaction involving an underlying security or commodity at a predetermined future date and at a predetermined price

12. Options Buyer has the long position in the contract
Seller (writer) has the short position in the contract
Buyer and seller are counterparties in the transaction

13. Options Option Contract Terms Option Valuation Basics
The exercise price is the price the call buyer will pay to-or the put buyer will receive from-the option seller if the option is exercised
Option Valuation Basics
Intrinsic value represents the value that the buyer could extract from the option if he or she she exercised it immediately
The time premium component is simply the difference between the whole option premium and the intrinsic component
Option Trading Markets-options trade both in over-the-counter markets and on exchanges

14. Options Option to buy is a call option Option to sell is a put option
Option premium - paid for the option
Exercise price or strike price - price agreed for purchase or sale
Expiration date
European options
American options

15. Options At the money: In-the-money Out-of-the-money
stock price equals exercise price
In-the-money
option has intrinsic value
Out-of-the-money
option has no intrinsic value

16. Investing With Derivative Securities
Call option
requires up front payment
allows but does not require future settlement payment
Forward contract
does not require front-end payment
requires future settlement payment

17. Options Pricing Relationships
Factor Call Option Put Option
Stock price
Exercise price
Time to expiration
Interest rate
Volatility of underlying stock price + +

18. Profits to Buyer of Call Option
Profit from Strategy
3,000
2,500
Exercise Price = $70
Option Price = $6.125
2,000
1,500
1,000
500
(500)
Stock Price at Expiration
(1,000) 40 50 60 70 80 90
100

19. Profits to Seller of Call Option
Profit from Strategy
1,000
Exercise Price = $70
Option Price = $6.125
500
(500)
(1,000)
(1,500)
(2,000)
(2,500)
Stock Price at Expiration
(3,000) 40 50 60 70 80 90
100

20. Profits to Buyer of Put Option
Profit from Strategy
3,000
2,500
2,000
Exercise Price = $70
Option Price = $2.25
1,500
1,000
500
Stock Price at Expiration
(500)
(1,000) 40 50 60 70 80 90
100

21. Profits to Seller of Put Option
Profit from Strategy
1,000
500
Exercise Price = $70
Option Price = $2.25
(500)
(1,000)
(1,500)
(2,000)
(2,500)
Stock Price at Expiration
(3,000) 40 50 60 70 80 90
100

22. The Relationship Between Forward and Option Contracts
Put-call parity
Long in WYZ common at price of S0
Long in put option to deliver WYZ at X on T
Purchase for P0
Short in call option to purchase WYZ at X on T
Sell for C0
Net position is guaranteed contract (risk-free)
Since the risk-free rate equals the T-bill rate:
(long stock)+(long put)+(short call)=(long T-bill)

23. Creating Synthetic Securities Using Put-Call Parity
Risk-free portfolio could be created using three risky securities:
stock,
a put option,
and a call option
With Treasury-bill as the fourth security, any one of the four may be replaced with combinations of the other three

24. Adjusting Put-Call Spot Parity For Dividends
The owners of derivative instruments do not participate directly in payment of dividends to holders of the underlying stock
If the dividend amounts and payment dates are known when puts and calls are written those are adjusted into the option prices
(long stock) + (long put) + (short call) = (long T-bill) + (long present value of dividends)

25. Put-Call-Forward Parity
Instead of buying stock, take a long position in a forward contract to buy stock
Supplement this transaction by purchasing a put option and selling a call option, each with the same exercise price and expiration date
This reduces the net initial investment compared to purchasing the stock in the spot market

26. Put-Call-Forward Parity
The difference between put and call prices must equal the discounted difference between the common exercise price and the contract price of the forward agreement, otherwise arbitrage opportunities would exist

27. An Introduction To The Use Of Derivatives In Portfolio Management
Restructuring asset portfolios with forward contracts
shorting forward contracts
tactical asset allocation to time general market movements instead of company-specific trends
hedge position with payoffs that are negatively correlated with existing exposure
converts beta of stock to zero, making a synthetic T-bill, affecting portfolio beta

28. An Introduction To The Use Of Derivatives In Portfolio Management
Protecting portfolio value with put options
purchasing protective puts
keep from committing to sell if price rises
asymmetric hedge
portfolio insurance
Either
hold the shares and purchase a put option, or
sell the shares and buy a T-bill and a call option

29. The Internet Investments Online

30. End of Chapter 21
An Introduction to Derivative Markets and Securities

31. Future topics Chapter 22
Forward and Futures Contracts