1. An Introduction to Derivative Markets and Securities
Chapter 11
An Introduction to Derivative Markets and Securities
Innovative Financial Instruments
Dr. A. DeMaskey

2. Learning Objectives Questions to be answered:
What are derivative securities?
What are the basic types of derivative securities and the terminology associated with them?
What are the similarities and differences in the payoff structures created by each of the derivative instruments?
How are forward contracts, put options and call options related?
What are the uses of derivative contracts?

3. Derivative Instruments
The value 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.

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

5. Characteristics of 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 margin requirements and daily settlement.
Options give the holder the right to either buy or sell a specified amount of the underlying asset at a specified price within a specified period of time.

6. Forward Contracts Buyer is long, seller is short
Contracts have negotiable terms and are traded in the OTC market
Subject to credit risk or default risk
No payments until expiration
Agreement may be illiquid

7. Payoff Structure to Long and Short Forward Positions
Long Forward
Profit
Long
Gain
Short
Gain St S1 S2
F0,T
Long
Loss
Short
Loss
Short Forward
Loss

8. Futures Contracts Standardized terms Central market (futures exchange)
More liquidity
Less liquidity risk due to initial margin
Daily settlement called “marking-to-market”

9. Option Contracts Holder vs. Grantor Call Option vs. Put Option
Exercise or Strike Price
Premium
American Option vs. European Option
At-The-Money Option
In-The-Money Option
Out-Of-The Money Option

10. Option Pricing and Valuation
An option’s value consists of two parts:
Intrinsic Value
Time Value
Intrinsic Value is the amount by which an option is in-the-money
Time Value is the amount by which an option’s value exceeds its intrinsic value

11. To Illustrate:
Suppose the current stock price is 50. The premium on a call option with an exercise price of 48 is $5.25.
What is the intrinsic value (IV)?
What is the time value (TV)?
Call Option Value
Total value
of option
Time value
Intrinsic value
Spot Rate E
Out-of-the-money
In-the-money

12. Basic Pricing Relationships
Call options are always worth at least the intrinsic value.
The lower the exercise price, the greater the call option’s premium.
The longer the time to expiration, the greater the value of any option.
The greater the volatility of the underlying asset, the greater the value of any option.
American options are at least as valuable as European options.

13. Option Pricing Relationships
Factor Call Option Put Option
Stock price
Exercise price
Time to expiration
Interest rate
Volatility of underlying asset + +
Where: + = positive or direct relationship
- = negative or inverse relationship

14. 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

15. Profits to Seller of Call Option
Profit from Strategy
1,000
Exercise Price = $70
Option Price = $6.125
500
Limited Gain
X=70
Potentially
Unlimited
Loss
(500)
Breakeven price
(1,000)
(1,500)
(2,000)
(2,500)
Stock Price at Expiration
(3,000) 40 50 60 70 80 90
100

16. 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

17. Profits to Seller of Put Option
Profit from Strategy
1,000
500
Breakeven price
Limited Gain
Potentially
Limited
Loss
X=70
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

18. Investing with Derivative Securities
Forward contract
does not require front-end payment
requires future settlement payment
Option contract
requires up front payment
allows but does not require future settlement payment

19. Put-Call-Spot Parity
A. Net Portfolio Investment at Initiation (Time 0)
Portfolio
Long 1 WZY Stock S0
Long 1 Put Option
P0,T
Short 1 Call Option
-C 0,T
Net Investment
S0 + P0,T - C 0,T
B. Portfolio Value at Option Expiration (Time T)
Portfolio
If ST  X
If ST > X
Long 1 WZY Stock ST ST
Long 1 Put Option
(X - ST)
Short 1 Call Option
-(ST - X)
Net Position X X

20. Put-Call-Spot Parity
The net position is a guaranteed contract; that is, it is riskfree.
Since the riskfree rate equals the T-bill rate, the no-arbitrage condition can be shown as:
(long stock)+(long put)+(short call)=(long T-bill)

21. Application of Put-Call Parity
If securities are properly valued, the net position has a value of zero.
Put-call-spot parity can be used to check if calls and puts are properly priced relative to each other.
Any mispricing of calls and puts offer arbitrage opportunities.

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

23. Replicating a Put Option
A. Net Portfolio Investment at Initiation (Time 0)
Portfolio
Long 1 T-Bill
X(1 + RFR)-T
Short 1 XYZ Stock
-S0
Long 1 Call Option
C 0,T
Net Investment
X(1 + RFR)-T - S0 + C 0,T
B. Portfolio Value at Option Expiration (Time T)
Portfolio
If ST  X
If ST > X
Long 1 T-Bill X X
Short 1 XYZ Stock
- ST
-ST
Long 1 Call Option
(ST - X)
Net Position
X - ST

24. Adjusting Put-Call Spot Parity For Dividends
If a stock pays a dividend, DT, immediately prior to expiration of the options, put-call parity is modified as follows: or

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
A. Net Portfolio Investment at Initiation (Time 0)
Portfolio
Long 1 Forward Contract
Long 1 Put Option
P0,T
Short 1 Call Option
-C 0,T
Net Investment
P0,T - C 0,T
B. Portfolio Value at Option Expiration (Time T)
Portfolio
If ST  X
If ST > X
Long 1 Forward Contract
ST - F0,T
ST - F0,T
Long 1 Put Option
(X - ST)
Short 1 Call Option
-(ST - X)
Net Position
X - F0,T
X - F0,T

27. Put-Call-Forward Parity
If this condition does not hold, then there are opportunities for arbitrage.
If the stock pays a dividend at times T, the condition becomes:

28. Restructuring Asset Portfolios with Forward Contracts
Tactical asset allocation to time general market movements instead of company-specific trends.
Direct Method:
Sell stock in open market and buy T-bills
Indirect Method:
Short forward contracts against a long position in underlying asset
Benefits:
Quicker and cheaper
Neutralizes risk of falling stock price
Converts beta of stock to zero

29. Dynamics of Hedge

30. Protecting Portfolio Value with Put Options
Protective Puts
Hedge potential drop in value of underlying asset
Keep from committing to sell if price rises
Asymmetric hedge
Portfolio Insurance
Hold the shares and purchase a put option, or
Sell the shares and buy a T-bill and a call option

31. Dynamics of Hedge

32. The Internet Investments Online