1. AN INTRODUCTION TO DERIVATIVE INSTRUMENTS
Chapter 9
AN INTRODUCTION TO DERIVATIVE INSTRUMENTS

2. Chapter 9 Questions
What are the basic features of forward contracts, futures contracts, and options contracts?
Why do derivative securities exist? How do they help meet investor needs and increase market efficiency?
What are the similarities and differences between forward contracts and futures contracts?
What terminology do we use to describe option contracts?
What does a payoff diagram show?
What are the risks and potential returns from option positions such as buying and writing calls; buying and writing puts; owning long and short positions in spreads, straddles, strangles, or butterfly spreads?
What are the relationships among the prices of puts, calls, and futures?

3. Derivative Instruments
Value is determined by, or derived from, the value of another investment vehicle, called the underlying asset or security
Forward contracts are agreements between two parties - the buyer agrees to purchase an asset, the seller agrees to sell the asset, at a specific date at a price agreed upon now
Futures contracts are similar, but are standardized and traded on an organized exchange

4. Derivative Instruments
Options offer the buyer the right, but not the obligation, to buy or sell and underlying asset at a fixed price up to or on a specific date
Buyer is long in the contract
Seller or “writer” is short the contract
The price at which the transaction would we made is the exercise or strike price
The profit or loss on an option position depends on the market price

5. Why Do Derivatives Exist?
Assets are traded in the cash or spot market
Sometimes have one’s fortunes dependent on spot price movements leads to considerable risk
Various derivatives markets have evolved that allow some investors to manage these risks, while also creating opportunities for speculators to invest in the same contracts

6. Potential Benefits of Derivatives
Risk shifting
Especially shifting the risk of asset price changes or interest rate changes to another party willing to bear that risk
Price formation
Speculation opportunities when some investors may feel assets are mis-priced
Investment cost reduction
To hedge portfolio risks more efficiently and less costly than would otherwise be possible

7. Forward Contracts
An agreement between two parties to exchange an asset at a specified price on a specified date
Buyer is long, seller is short; symmetric gains and losses as price changes, zero sum game
Contracts trade OTC, have negotiable terms, and are not liquid
Subject to credit risk or default risk
Value realized only at expiration
Popular in currency exchange markets

8. Futures Contracts Like forward contracts… Unlike forward contracts…
Buyer is long and is obligated to buy
Seller is short and is obligated to sell
Unlike forward contracts…
Standardized – traded on exchange
More liquidity - can “reverse” a position and offset the future obligation, other party is the exchange
Less credit risk - initial margin required
Additional margin needs are determined through a daily “marking to market” based on price changes

9. Futures Contracts Chicago Board of Trade (CBOT)
Grains, Treasury bond futures
Chicago Mercantile Exchange (CME)
Foreign currencies, Stock Index futures, livestock futures, Eurodollar futures
New York Mercantile Exchange (NYMEX)
Crude oil, gasoline, heating oil futures
Development of new contracts
Futures exchanges look to develop new contracts that will generate significant trading volume

10. Futures Contracts Futures Quotations
One contract is for a fixed amount of the underlying asset
5,000 bushels of corn (of a certain grade)
$250 x Index for S&P 500 Index Futures (of a certain maturity)
Prices are given in terms of the underlying asset
Cents per bushel (grains)
Value of the index
Value of one contract is price x contract amount
Settle is the closing price from the previous day

11. Futures Contracts
Example: Suppose you bought (go long) the most recent (Sept.) S&P 500 contract at the settle price (see Exhibit 17.4).
What was the original contract value?
Value = $250 x = $273,800
What is your profit if you close your position (sell a contract) for ?
Value = $250 x = $280,000
Profit = $280,000 - $273,800 = $6,200

12. Options Option Terminology Option to buy is a call option
Option to sell is a put option
Option premium – price paid for the option
Exercise price or strike price – the price at which the asset can be bought or sold under the contract

13. Options Intrinsic Value of Options
Call Option Intrinsic Value = Max [0, V-X]
Put Option Intrinsic Value = Max [0, X-V]
V = Stock Value
X = Strike Price
Option values cannot be negative since they need not be exercised if it is not in the owner’s interest to do so

14. Options Option Terminology Expiration date
European: can be exercised only at expiration
American: exercised any time before expiration
In-the-money: option has positive intrinsic value, would be exercised if it were expiring
Out-of-the-money: option has zero intrinsic value, would not be exercised if expiring
If not expiring, could still have value since it could later become in-the-money

15. Options
Example: Suppose you own a call option with an exercise (strike) price of $30.
If the stock price is $40 (in-the-money):
Your option has an intrinsic value of $10
You have the right to buy at $30, and you can exercise and then sell for $40.
If the stock price is $20 (out-of-the-money):
Your option has an intrinsic value of zero
You would not exercise your right to buy something for $30 that you can buy for $20!

16. Options
Example: Suppose you own a put option with an exercise (strike) price of $30.
If the stock price is $20 (in-the-money):
Your option has an intrinsic value of $10
You have the right to sell at $30, so you can buy the stock at $20 and then exercise and sell for $30
If the stock price is $40 (out-of-the-money):
Your option has no intrinsic value
You would not exercise your right to sell something for $30 that you can sell for $40!

17. Options Chicago Board Options Exchange (CBOE)
Centralized facility for trading standardized option contracts
Clearing Corporation is the opposite party to all trades, allowing buyers and sellers to terminate positions prior to expiration with offsetting trades
Standardized expiration dates, exercise prices, and contract sizes
Secondary market with standardized contracts
Offer options on almost 1,400 stocks and also index options

18. Options Stock Option Quotations Premiums are often small
One contract is for 100 shares of stock
Quotations give:
Underlying stock and its current price
Strike price
Month of expiration
Premiums per share for puts and calls
Volume of contracts
Premiums are often small
A small investment can be “leveraged” into high profits (or losses)

19. Options
Example: Suppose that you buy a January $30 call option on Microsoft (see Exhibit 17.9).
What is the cost of your contract?
Cost = $.95 x 100 = $95
Is your contract in-the-money?
No. The current stock price is $28.48, so the intrinsic value is $0 per share.

20. Options Example (cont.):
What is your dollar profit (loss) if, at expiration, Microsoft is selling for $25?
Out-of-the-money, so Profit = ($95)
Is your percentage profit with options?
Return = (0-.95)/.95 = (100%)
What if you had invested in the stock?
Return = ( )/28.48 = (12.22%)

21. Options Example (cont.):
What is your dollar profit (loss) if, at expiration, Microsoft is selling for $30.50?
Profit = 100( ) – 95 = ($45)
Is your percentage profit with options?
Return = ( )/.95 = (47.37%)
What if you had invested in the stock?
Return = ( )/28.48 = 7.09%

22. Options Example (cont.):
What is your dollar profit (loss) if, at expiration, Microsoft is selling for $35?
Profit = 100(35-30) – 95 = $405
Is your percentage profit with options?
Return = ( )/.95 = %
What if you had invested in the stock?
Return = ( )/28.48 = 22.89%

23. Options Payoff diagrams
Show payoffs at expiration for different stock prices (V) for a particular option contract with a strike price of X
For calls:
if the V<X, the payoff is zero
If V>X, the payoff is V-X
Payoff = Max [0, V-X]
For puts:
if the V>X, the payoff is zero
If V<X, the payoff is X-V
Payoff = Max [0, X-V]

24. Option Trading Strategies
There are a number of different option strategies:
Buying call options
Selling call options
Buying put options
Selling put options
Option spreads

25. Buying Call Options
Position taken in the expectation that the price will increase (long position)
Profit for a purchasing a Call Option:
Per Share Profit =Max [0, V-X] – Call Premium
Note that profits on an option strategy include option payoffs and the premium paid for the option
The following diagram shows different total dollar profits for buying a call option with a strike price of $70 and a premium of $6.13

26. Buying Call Options Profit from Strategy 3,000 2,500
Exercise Price = $70
Option Price = $6.13
2,000
1,500
1,000
500
(500)
Stock Price at Expiration
(1,000) 40 50 60 70 80 90
100

27. Selling Call Options
Bet that the price will not increase greatly – collect premium income with no payoff
Can be a far riskier strategy than buying the same options
The payoff for the buyer is the amount owed by the writer (no upper bound on V-X)
Uncovered calls: writer does not own the stock (riskier position)
Covered calls: writer owns the stock

28. Selling Call Options Profit from Uncovered Call Strategy 1,000
Exercise Price = $70
Option Price = $6.13
500
(500)
(1,000)
(1,500)
(2,000)
(2,500)
Stock Price at Expiration
(3,000) 40 50 60 70 80 90
100

29. Buying Put Options
Position taken in the expectation that the price will decrease (short position)
Profit for purchasing a Put Option:
Per Share Profit = Max [0, X-V] – Put Premium
Protective put: Buying a put while owning the stock (if the price declines, option gains offset portfolio losses)
The following diagram shows different total dollar profits for buying a put option with a strike price of $70 and a premium of $2.25

30. Buying Put Options 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

31. Selling Put Options
Bet that the price will not decline greatly – collect premium income with no payoff
The payoff for the buyer is the amount owed by the writer (payoff loss limited to the strike price since the stock’s value cannot fall below zero)

32. Selling Put Options 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

33. Option Spreads
Many other option strategies can be crafted using combinations of option positions
Price spread (vertical spread)
Buying and selling options on the same stock with the same expiration, but with different strike prices
Time spread (horizontal or calendar spread)
Buying and selling options on the same stock with the same strike price, but with different expirations

34. Option Spreads Bullish spreads Bearish spreads Straddle
Buy a higher priced option and sell a lower priced option on the same stock
Bearish spreads
Sell a higher priced option and buy a lower priced option on the same stock
Straddle
Combination of a purchasing (long) or selling (short) a put and a call on the same expiration
Betting on a large price movement (long straddle) or little price movement (short straddle)

35. Option Spreads Strangle Butterfly spread
Combination of a call and put with the same expiration but different exercise prices (long or short)
Similar to straddle strategies
Butterfly spread
Combination strategy with 4 options, similar to straddles and strangles, but with less risk of large losses
The number of different strategies is potentially limitless

36. Put/Call Parity
Premiums for puts and calls are not completely independent otherwise arbitrage opportunities would exist
Two investments with equally risky payoffs should have similar costs
Parity relationships exist between options, also between options and futures, options and spot prices, and futures and spot prices