1. Introduction Chapter 1
Geng Niu
Gezhi Building 1220

2. Course evaluation Assignments + participation (30%) Midterm exam (30%)
Final exam (40%)

3. Textbook (main)
Options, Futures, and Other Derivatives, 8th edition (John C. Hull)
Classical textbook; many editions (very similar across editions though).
Used wildly in Master of Finance programs and MBA programs with finance tracks around the world.
Less on math, more on intuitions

4. Supplementary materials:
Fixed Income Markets and Their Derivatives, 2th edition (Suresh M. Sundaresan)
Bond Markets, Analysis and Strategies, 5th edition (Frank J. Fabozz)
FRM (Financial Risk Management) Exam notes.

5. Some useful online resources
(Chicago Mercantile Exchange & Chicago Board of Trade)
(China Finance Futures Exchange)
(Shanghai Futures Exchange)
(Dalian Commodity Exchange)
(Zhengzhou Commodity Exchange)
(China Futures Association)

6. Dynamics of some assets: what’s in common?

7. How Derivatives are Used
To hedge risks: risk management
To speculate (bet on the future direction of the market)
To lock in an arbitrage (riskless) profit 4

8. Derivatives are relevant to many sectors
Financial sector (banks, hedge funds, mutual funds, asset management company, etc): provide competitive financial products
 Other companies: interest rates, exchange rates, commodity prices (grain, oil, gold, copper…)
Government: how to regulate financial market properly?

9. Why Study Derivatives Pricing
Learn the language of modern finance
Foundation of financial engineering and risk management
Prepare for graduate studies in finance
Prepare for professional certificates: CFA, FRM, ect..
Prepare for job interviews
Understand financial news

10. The derivatives pricing literature is very huge.
Mathematical techniques involved can be quite challenging
Advanced computational skills are also needed.
Derivatives pricing is
considered “rocket science”.

11. What you will learn in this course are still the basics.
They are mostly “toy models”.
However, this course prepares you for future learning.
Intuitions are often more
Impartment and useful.
So, be confident and
have fun !

12. What is a Derivative?
A derivative is an instrument whose value depends on, or is derived from, the value of another asset (the underlying asset).
Examples: futures, forwards, swaps, options, exotics…

13. Examples
Forward & Future: an agreement to buy or sell an asset at a certain time for a certain price.
Call Option: the holder has the right to buy the underlying asset by a certain date for a certain price.
Put Option: the holder has the right to sell the underlying asset by a certain date for a certain price.

15. 19th US grain trade finance
Inland farmers came to east coast to sell their grain to dealers who, in turn, shipped it all over the country.
Too much supply right after the harvest. Unpurchased crops were left to rot.
In the off-season price became too high when crops were unavailable.
Not good for both the farmers and the dealers.

16. 19th US grain trade finance
Farmers (sellers) and dealers (buyers) began to commit to future exchanges of grain for cash: forward contract
Such contracts became common and began to change hands before the delivery date.
The (forward) price would go up and down depending on market conditions.
people who had no intention buying or selling grain began to trade: speculators

17. 19th US grain trade finance
Forward contracts are often not easy to change hands.
Standardized forward contracts began to emerge: futures contract.
A counterparty to every trade – its members buy every contract that traders sell and sell every contract that traders buy: cleaning house.
Exchanges in Chicago and New York began to develop.

18. How Derivatives Are Traded
On exchanges such as the Chicago Board Options Exchange
In the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contact each other directly

19. Size of OTC and Exchange-Traded Markets (Figure 1.1, Page 3)
Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

20. Motivating example
On Sep 1, your company, based in the U.S., agreed to buy heavy equipment from a German manufacturer.
Payment of 1 million euro was due upon delivery, Dec 1.
Between Sep 1 and Dec 1, the price of the euro in relation to the U.S. dollar will fluctuate: hard to predict.
What if the value of the euro were to rise, say, from 1.36 dollar/euro to dollar/euro?

21. Motivating example

22. Motivating example: To get rid of this risk, the U.S company could:
Bought the euros they needed for this purchase on Sep 1: a large amount of working capital would be tied up.
Or, hedge their exposure to FX risk by purchasing forward or futures contracts: agree to pay million U.S. dollar. to buy 1 million euro on Dec 1.
Who would take the other side of this trade?

23. Forward Price
The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)
The forward price may be different for contracts of different maturities (as shown by the table) 11

24. Foreign Exchange Quotes for USD/GBP, May 24, 2010 (See page 5)
Bid
Offer
Spot
1.4407
1.4411
1-month forward
1.4408
1.4413
3-month forward
1.4410
1.4415
6-month forward
1.4416
1.4422

25. Terminology
The party that has agreed to buy has what is termed a long position
The party that has agreed to sell has what is termed a short position 10

26. Example (page 5)
On May 24, 2010 the treasurer of a US corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of
This obligates the corporation to pay $1,442,200 for £1 million on November 24, 2010
What are the possible outcomes?

27. Profit from a Long Forward Position (K= delivery price=forward price at time contract is entered into)
Profit
Price of Underlying at Maturity, ST: USD/GPB K 14

28. Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into)
Profit
Price of Underlying
at Maturity, ST: USD/GPB K
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 15

29. Futures Contracts (page 7)
Agreement to buy or sell an asset for a certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

30. Exchanges Trading Futures
CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade)
NYSE Euronext
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see list at end of book)

31. Examples of Futures Contracts
Agreement to:
Buy 100 oz. of US$1400/oz. in December
Sell US$/£ in March
Sell 1,000 bbl. of US$90/bbl. in April 9

32. Options
A call option is an option to buy a certain asset by a certain date for a certain price (the strike price)
A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

33. Long Call (Figure 9.1, Page 195)
Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months 30 20 10 -5 70 80 90
100
110
120
130
Profit ($)
Terminal
stock price ($) 33

34. American vs European Options
An American option can be exercised at any time during its life
A European option can be exercised only at maturity

35. Bid price: the price at which the market maker is prepared to buy
Offer price: the price at which the market maker is prepared to sell

36. Google Call Option Prices (June 15, 2010; Stock Price is bid 497
Google Call Option Prices (June 15, 2010; Stock Price is bid , offer ); See Table 1.2 page 8; Source: CBOE
Strike Price
Jul 2010 Bid
Jul 2010 Offer
Sep 2010 Bid
Sep 2010 Offer
Dec 2010 Bid
Dec 2010
Offer
460
43.30
44.00
51.90
53.90
63.40
64.80
480
28.60
29.00
39.70
40.40
50.80
52.30
500
17.00
17.40
28.30
29.30
40.60
41.30
520
9.00
9.30
19.10
19.90
31.40
32.00
540
4.20
4.40
12.70
13.00
23.10
24.00
560
1.75
2.10
7.40
8.40
16.80
17.70

37. Google Put Option Prices (June 15, 2010; Stock Price is bid 497
Google Put Option Prices (June 15, 2010; Stock Price is bid , offer ); See Table 1.3 page 9; Source: CBOE
Strike Price
Jul 2010 Bid
Jul 2010 Offer
Sep 2010 Bid
Sep 2010 Offer
Dec 2010 Bid
Dec 2010
Offer
460
6.30
6.60
15.70
16.20
26.00
27.30
480
11.30
11.70
22.20
22.70
33.30
35.00
500
19.50
20.00
30.90
32.60
42.20
43.00
520
31.60
33.90
41.80
43.60
52.80
54.50
540
46.30
47.20
54.90
56.10
64.90
66.20
560
64.30
66.70
70.00
71.30
78.60
80.00

38. Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price
An option gives the holder the right to buy or sell at a certain price

39. Types of Traders Hedgers: to reduce risk
Speculators: to make profit from taking the risk
Arbitrageurs: look for riskless profit 15

40. Hedging Examples (pages 10-12)
A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract
An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts 16

41. Value of Microsoft Shares with and without Hedging (Fig 1.4, page 12)

42. Speculation Example
An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of is $1
What are the alternative strategies? 17

43. Arbitrage Example
A stock price is quoted as £100 in London and $140 in New York
The current exchange rate ($/ £ )is
What is the arbitrage opportunity?
What if the exchange rate ($/ £ ) is

44. Different Opinions on Derivatives
“Derivatives are extremely efficient tools for risk management”
“Derivatives are financial weapons of mass destruction”

45. Why Derivatives Are Important
Derivatives play a key role in transferring risks in the economy
The underlying assets include stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, the weather, etc
Many financial transactions have embedded derivatives
The real options approach to assessing capital investment decisions has become widely accepted

46. Dangers
Traders can switch from being hedgers to speculators or from being arbitrageurs to speculators
It is important to set up controls to ensure that trades are using derivatives in for their intended purpose
Soc Gen (see Business Snapshot 1.3 on page 17) is an example of what can go wrong

47. China Aviation Oil suffers $550 million derivatives loss
China Aviation Oil (CAO): a Singapore listed company that purchases jet fuel and supplies jet fuel  to China’s civil aviation  industry.
In early 2004, the management team judged that oil price would further decrease and began to heavily sell calls and buy puts: speculating!
 However, the Nymex oil futures contract increased to $55.17 per barrel on October 26 compared with just $34 at in early 2004: resulting a huge loss for CAO.

49. China Aviation Oil suffers $550 million derivatives loss
 CAO concealed these losses by accounting manipulation.
The managing director,  Chen Jiulin, was sentenced for 3 years and 4 months by the  Singapore court.   Q1 Q2 Q3
First 9 months
CAO EBT
19.0
 19.3
11.3
49.6
PwC adjusted EBT
-6.4
-58.0
-314.6
-379.0

50. Hedge Funds (see Business Snapshot 1.2, page 11)
Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly: only to sophisticated individuals.
Mutual funds must
disclose investment policies,
makes shares redeemable at any time,
limit use of leverage
take no short positions.
Hedge funds are not subject to these constraints.
Hedge funds use complex trading strategies are big users of derivatives for hedging, speculation and arbitrage

51. No Arbitrage Theory and Efficient Market Hypothesis
No Arbitrage: Two assets with the same future payoffs must have the same price today.
Otherwise, you can earn a positive profit for certain.
How? Buy the cheap asset and sell the expensive one.
Result: Demand for the cheap asset increases and so is its price.

52. Assumption The market is efficient.
If there were arbitrage opportunities, some investors would have taken these opportunities already.
Thus, these opportunities will be eliminated immediately.

53. An old joke
An economist will not pick up a twenty-dollar bill on the ground.
Why?
If it were really there, someone would have picked it up already.
Arbitrage opportunities (free money) cannot exist.

54. Derivatives Market in China
Commodity-based financial derivatives:
The first commodities futures market in China, the China Zhengzhou Grain Wholesale Market, opened on 12 October 1990.
Subsequently, the Shanghai Futures Exchange and Dalian Commodity Exchange have also started operations

55. Derivatives Market in China
Exchange rate derivatives
RMB forwards: In April 1997, the Bank of China started its RMB forward exchange settlement and sales business.
RMB foreign exchange swaps: introduced in April 2006.
RMB futures: In August 2006, CME launched futures and option contracts on the CNY against the US dollar, euro and Japanese yen.
Wulin Suo

56. China Financial Futures Exchange (CFFEX) was jointly founded by Shanghai Futures Exchange, Zhengzhou Commodity Exchange, Dalian Commodity Exchange, Shanghai Stock Exchange and Shenzhen Stock Exchange on September 8, 2006 in Shanghaj

57. Derivatives Market in China
CSI 300: 300 largest A-Shares listed on the Shanghai Stock Exchange and Shenzhen Stock Exchange.
SSE 50 : 50 largest stocks of good liquidity and representativeness from Shanghai security market

58. Derivatives Market in China
Stock index option
An option based on the SSE 50 Index ETF was launched as the debut product on February 9, 2015 in China, traded in Shanghai stock exchange.

59. Derivatives Market in China
Exchange Traded Fund (ETF): an open-ended index fund that is listed and traded on the stock exchange like any other ordinary stocks.
China 50 ETF: closely track the Shanghai Stock Exchange 50 (SSE 50) Index