1. Introduction to Derivatives
Advanced Investments 1
Introduction to Derivatives
What Is a Derivative?
Uses and Misuses
Forwards
Futures
Options

2. What Is a Derivative? Definition Types Uses
Advanced Investments 1
What Is a Derivative?
Definition
An agreement between two parties which has a value determined by the price of something else
Types
Options, futures and swaps
Uses
Risk management (hedging risks)
Speculation
Reduce transaction costs
Regulatory arbitrage
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3. Increased Volatility…
Advanced Investments 1
Increased Volatility…
Oil prices:
DM/$ rate:
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4. …Led to New and Big Markets
Advanced Investments 1
…Led to New and Big Markets
Exchange-traded derivatives
Over-the-counter traded derivatives: even more!
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5. It’s Not What It Is, It’s How You Use It…
Risk management or speculation?
How big a bet can you make with derivatives?
Q: How can one trader bring down the oldest British bank?
A: Futures and Options! (see Nick Leeson)
What about closer to home?
Orange County, CA went bankrupt in 1994
When Genius Failed - LTCM debacle in 1998
Avoiding regulations, taxes, and transaction costs – is it always worth it?
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6. Financial Engineering
Advanced Investments 1
Financial Engineering
The construction of a financial product from other products
New securities can be designed by using existing securities
Financial engineering principles
Facilitate hedging of existing positions
Enable understanding of complex positions
Allow for creation of customized products
Render regulation less effective
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7. Forward Contracts
Advanced Investments 4
Definition: a binding agreement (obligation) to buy/sell an underlying asset in the future, at a price set today
Hedges risk by locking in future price
A forward contract specifies
The features and quantity of the asset to be delivered
The delivery logistics, such as time, date, and place
The price the buyer will pay at the time of delivery
Pros:
Flexible
Cons:
Lack of liquidity: hard to find counterparty
Subject to default risk: requires information to screen good from bad risk
Today
Expiration
date
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8. Payoff on a Forward Contract
Advanced Investments 4
Payoff on a Forward Contract
Long position = agree to buy securities (commodities) at future date
Short position = agree to sell securities (commodities) at future date
Payoff for a contract is its value at expiration:
Long forward = Spot price at expiration – Forward price
Short forward = Forward price – Spot price at expiration
Example 2.1: S&R (special and rich) index:
Today: Spot price = $1,000, 6-month forward price = $1,020
In six months at contract expiration: Spot price = $1,050
Long position payoff = $1,050 – $1,020 = $30
Short position payoff = $1,020 – $1,050 = ($30)
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9. Payoff Diagram for Forwards
Advanced Investments 4
Payoff Diagram for Forwards
Long and short forward positions on the S&R 500 index
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10. Futures Markets Financial Futures Contract
Advanced Investments 4
Financial Futures Contract
Futures are just standardized forward contracts that are traded on exchanges
At expiration date, price of contract = price of the underlying asset delivered
Prior to the expiration date, it is easily prices using the “cash and carry” approach
Exchanges: CBOE, CME, etc.
Regulated by CFTC (Commodity Futures Trading Comission)
Success of Futures Over Forwards
Futures more liquid: standardized, can be traded again, delivery of range of securities
Mark to market and margin requirements: avoids default risk
Anybody can write (issue) futures and options
Flexible types of settlement
Cash settlement by netting: less costly and more practical
Physical delivery: often avoided due to significant costs
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11. Options - Introduction
BUSI 186: Investments 19
Options - Introduction
Definition
Option is a right to buy or sell an underlying asset at a specified price on or before a specified date
Key Elements
Specified Price: Exercise or Strike Price
Specified date: Expiration date
Exercise only on expiration date: European Option
Exercise on or before expiration: American Option
Option Premium or Price: the price of the option
Call: Right to buy
Put: Right to sell
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12. Options - Introduction
BUSI 186: Investments 19
Options - Introduction
Example: on 11/29/2005, MSFT Jan 27 Call trades at $1.20; MSFT stock price is $27.68
What does it tell us?
Style: American Call
Underlying Security: MSFT Stock
Strike Price: $27
Expiration Month: Jan, 2006
Expiration Date: The 3rd Friday
Current asset price: $27.68
Call price (premium): $1.20
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13. Option Values Option Creation and Exercise:
11/29/2005: 1 contract of MSFT Jan 27 call created
1/20/2006 or before: buyer exercises call
When to exercise?
Decision: exercise if St > $27
Payoff per share: St - $27
Pay Option Premium = $1.20 x 100
Option Buyer
(Long position)
Option Seller
(Short position)
MSFT Jan 27 Call
Pay $27 x 100
Option Buyer
(Long position)
Option Seller
(Short position)
100 shares of MSFT stock
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14. Option Values Moneyness
In-the-money (ITM): positive payoff for immediate exercise
For call: St – X > 0
For put: St – X < 0
At-the-money (ATM): zero payoff for immediate exercise
For both call and put: St – X = 0
Out-of-the-money (OTM): negative payoff for immediate exercise
For call: St – X < 0
For put: St – X > 0
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15. Option Values Example: If current MSFT stock price $27
Option 1: Jan 25 MSFT call
in-the-money call
Option 2: Jan 27 MSFT call
at-the-money call
Option 3: Jan 30 MSFT call
out-of-the-money call
Option 4: Jan 30 MSFT put
in-the-money put
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16. Option Values Payoff versus P/L (Profit/Loss) Notation
Security Price: St
Strike (Exercise) Price: X
Payoff per share at expiration for a call
Payoff = max(ST – X, 0)
Payoff = ST –X if ST > X or the option is in-the-money
Payoff = 0 if ST < X or the option is out-of-the-money
Profit or loss
P/L = Payoff – Option Premium
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17. Option Values MSFT Jan 27 call trading at $1.20
Decision Time: 1/20/2006
Possible Price of ST - X Exercise Option Option
MSFT on 1/20/06 (X = $27) Decision Payoff P/L
$25 $25-$27 < 0 No Exercise
$26 $26-$27 < 0 No Exercise
$27 $27-$27 = 0 No Exercise
$28 $28-$27 > 0 Exercise $
$29 $29-$27 > 0 Exercise $
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18. Option Values Payoff Diagram of MSFT Jan 27 Call X = $27 Payoff of A
Call Option
Value
P/L
ITM Region
OTM Region
X = $27 ST
MSFT price at T
-$1.20
(Premium)
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19. Options magnify both gains and losses
Option Value
Leverage Effect of a Call
MSFT price $20; MSFT Jan 20 ATM call price $4
Start with $1,000 in the account
Strategy 1 (all equity): buy 50 shares of MSFT
Strategy 2 (all option): buy 2.5 contract* call
Strategy Strategy 2
ST Gain at T Return Gain at T Return
$ *10 50% 2.5*100*6 150%
$ *(-10) -50% 2.5*100*(-4) -100%
Options magnify both gains and losses
* for 100 shares each
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20. Option Value Payoff Diagram for MSFT Jan 27 Put Value
Payoff of Puts at T:
= X - ST if ST < X
= if ST > X
$27
Payoff
P/L
X = $27 ST
MSFT Price at T
ITM Region
OTM Region
-$0.30
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21. Option Strategy Building Blocks: Call and long stock Payoff at T
long call
call - premium ST
Payoff at T
long stock at $27
X=27
-$1.20
stock - $27
Payoff at T ST
X=27
$1.20
-$27 ST X
short a call + premium
short call
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22. Option Strategy Building Blocks: put and short stock long a put
short a stock
at 27 ST X ST X
short a put ST X
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23. Option Strategy Protective Put Long stock + Long put
Pay put premium for downside protection
Long a stock ST X
Protective put X ST X X
Long a put ST X
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24. Option Strategy Covered Call Long stock + short call
Sacrifice upside potential for call premium
Payoff at T
Write a call X ST
Keep the
Stock X
Sell the
stock for X
Payoff at T
Long a
stock at X ST X ST X
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25. Example – BXM Index Covered Index Strategy
BXM – CBOE Buy-Write Monthly Index
Introduced in 2002
Long S&P 500 Index Exposure
Short at-the-money 1-month call option on the S&P 500
Rebalance monthly on expiration Friday
Idea: ATM S&P 500 call options are relatively overpriced
Investments 21

26. BXM Index Performance In 1990 – 2004: Recent developments: PBP ETF
HVPW ETF
Annual Return (%)
Annual Risk (%)
S&P 500
10.94
14.65
BXM
11.34
9.92
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27. Option Strategy Vertical Spread
Long call with strike X1 and short a call with X2
Limited up- and down-side P/L
Payoff at T
Long Jan 27 call
Bullish Spread
X2 > X1
X2 - X1 ST ST
X1=27
X2=30 X1 X2 X2 X1 ST
Short Jan 30 call
Bearish Spread
X2 < X1 ST
X2 - X1 X1 X2
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28. Option Strategy Straddle
Long a call and a put with the same strike price
Benefit from big jumps in stock prices
Payoff at T
Long Jan 30 call ST
X=30
Straddle X X ST X
Long Jan 30 Put ST X
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29. Variations Index Options Futures Options Foreign Currency Options
Options on index level: e.g. call on S&P 500, NASDAQ100, etc.
Futures Options
Options on futures: e.g. put on gold futures
Foreign Currency Options
Options on foreign currency: e.g. call on Euro
Interest Rate Options
Options on interest rate: e.g. Interest rate caps as call option on LIBOR rate
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30. Other Options Warrants Bermudan Options Asian Options
Essentially call options issued by a firm
Bermudan Options
Discrete time multiple exercises
Asian Options
Payoff based on average price
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31. Option Pricing and Volatility
Options price uncertainty (or volatility)!
Example: Call Option Prices
Option price prior to expiration
Option price at expiration
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32. Implied vs. Realized Volatility
Which one is more useful?
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33. Wrap-up Futures markets – hedging or speculation? What is an option?
Why do we need options?
What are the common investment strategies involving options?
What is in the price of an option, and what it tells us about the underlying security?
How big a bet can you make with derivatives?
Can one trader bring down a bank?
Investments 21