INTRODUCTION TO DERIVATIVES PRICING LECTURES: 7, 8& 9 DERIVATIVES Derivatives are nancial securities whose payos are explicitly given

by the value of some other underlying asset. Important examples are Forward contracts, Futures contracts, Options, Swaps. 1. Forward contracts Forward contract on an asset is a contract to buy or sell a specic amount of the asset at a specic price and at a specic time in the future. Example. Consider a Forward contract to buy 100, 000 kg of sugar at 40 Rs per kg on 15th December. Some features of Forward contracts. The contract is between two parties. The asset involved in the forward contract is called the underlying asset. Buyer is said to be in long position of the Forward contract. Seller is said to be in short position. The agreed price of the asset in the contract is called the Forward price. The time of trading of the asset in the contract is called maturity The open market for immediate delivery of the asset is called the Spot market. The price of the asset in the open market is called Spot price. Forward price formula To nd the forward price, we need to introduce a trading mechanism called Short selling. By Short selling we mean borrow the asset and sell it in the spot market. Suppose you are short selling a stock for the period [0, T ]. Assume that the stock will pay a dividend some time before T . What is your cash ow? We make the following assumptions about the Market. There is an ideal bank with a spot rate curve {st |t = 1, 2, } Market contains the underlying asset. No arbitrage. Short selling of the underlying asset is allowed.
1

INTRODUCTION TO DERIVATIVES PRICING LECTURES: 7, 8& 9

Theorem 1.1. Let F denote the forward price, T maturity time, d(0, T ) the discount factor for the period [0, T ] and S current spot price of the underlying asset. Also assume that there is no storage cost or dividend for the underlying asset. Then F = S . d(0, T )

Proof. The proof is based on the no arbitrage argument. Suppose S F > . d(0, T ) Borrow S from Bank. Buy unit asset from the spot market and store. Short unit forward contract. This creates an arbitrage. Initial value of the above investment is zero and it has a nal payo of S F d(0 ,T ) , an arbitrage opportunity. Note F is the amount the investor receives at T from the forward contract S and d(0 ,T ) is the liability to the bank at time T . Hence F Now show that (exercise) F S . d(0, T ) S . d(0, T )

Now we assume the underlying asset has carrying cost c(k ) for the period [k, k + 1) , k = 0, 1, , M payable at the beginning of the period. M is the number of periods until maturity T of the forward contract. If underlying is a commodity, then carrying cost (storage cost) can be cost to store or insurance fee etc. which in general positive. If the underlying is a nancial security such as stock, carrying is cost is dividend and hence is negative.

Theorem 1.2. The forward price assuming carrying cost is given by F = S + d(0, M )
M 1 k=0

c(k ) . d(k, M )

INTRODUCTION TO DERIVATIVES PRICING

LECTURES: 7, 8& 9

Proof. If F < Then Short sell one unit of underlying asset and receive S at time 0. Invest S in Bank at time 0. Long one unit Forward contract at time 0. Receive c(k ) at the beginning of the period [k, k + 1) and invest in Bank. Clearly net value of the above investment at 0 is 0. The value at T is c(0) c(1) c(M 1) S + + + + F > 0. d(0, M ) d(0, M ) d(1, M ) d(M 1, M ) Therefore, the above investment strategy is an arbitrage. Hence F S + d(0, M )
M 1 k=0

S + d(0, M )

M 1 k=0

c(k ) . d(k, M )

c(k ) . d(k, M )

Similarly, we have (exercise) S + F d(0, M )

M 1 k=0

c(k ) . d(k, M )

Suppose short selling of the asset is not allowed or a situation where no one is willing to lend you the asset. This can arise, if the asset is in short supply and it is anticipated that asset will be in short supply in future also, i.e. a tight market. This happens mainly for commodities. See the illustration based on soybean given in Luenberger, page 272. The the forward price only satises the inequality (Why?) F S + d(0, M )
M 1 k=0

c(k ) . d(k, M )

Now introducing the notion of convenience yield y , the forward price formula becomes F = S + d(0, M )
M 1 k=0

c(k ) d(k, M )

M 1 k=0

y . d(k, M )

Convenience yield represents the value of holding the asset. If short selling is possible, then y = 0.

INTRODUCTION TO DERIVATIVES PRICING LECTURES: 7, 8& 9

Value of a Forward contract. Forward price varies with time. i.e. it is a function of time. So let Ft denote the forward price at time t. Thus we have the following question. Suppose you are holding a long forward contract at time 0 and current time is t. What is the value of your contract today? i.e. suppose you would like to transfer your contract to a second party, how much she will pay(+ or -) for it. Answer : Value of the contract, ft = (Ft F0 )d(t, T ). Solution: Hint: Use arbitarge argument. 2. Swaps Swap is a contract to exchange one cash ow for the other. For example(vanilla swap): Consider a contract which allows party A to receives spot price of a unit of an asset for each period(end of) while paying the party B a xed amount X at each period for a xed number of periods M. What is right choice of X ? Note A is at risk, since A receives random cash ow. How can A eliminate this risk. If A takes short position on forwards with underlying as the asset in the swap and maturity as end of each period. Then at the end of ith period his receipt will be Fi = Si + Fi Si where Fi denote the forward price for the forward contract with maturity end of ith period. Now choice of X is such that the cash ows (0, X, X, X ), (0, F1 , F2 , , FM ) have same present value. i.e.
M M

d(0, i)X =
i=1 i=1

d(0, i)Fi

Hence X = 1
M M i=1 d(0, i) i=1

d(0, i)Fi .

Now one can use no-arbitrage argument to show that that 1

M

M i=1 d(0, i) i=1

d(0, i)Fi

is the right choice for X , i.e., anything else will create arbitrage.

INTRODUCTION TO DERIVATIVES PRICING

LECTURES: 7, 8& 9

To see this, suppose X > Then Enter into the xed leg of the swap, i.e. receive X while paying Si at end of period i, i = 1, 2, cdots, M . Take long i-forward on the asset (whose price at the end of period i is Si ), i = 1, 2, M . (Here i-forward contract means forward contract with maturity as end of period i. At the end of period i put X Fi in risk-free asset. This is an arbitrage. The reverse inequality is similar. 3. Futures contract Futures contract is like forward contract with the dierence of being traded in an organized exchange. Futures contract is designed to eliminate the default risk associated with forward contract. It is achieved through the process called marking to the market. While entering into the futures contract both parties need to deposit an amount with the broker called the margin account. At the end of each day, the net receipt will be marked. i.e. at the end of each day, the delivery price will be revised to the current delivery (futures price) and the net receipt from this process is added to the market. For example, at the end of day one, for the party holding the long position in the futures contract F1 F0 will be deposited in her/his margin account, where F0 is the futures price at the time of entry of the contract and F1 is the futures price at the end of day one. when the margin value falls below a certain level, the contract holder need to pay money to makeup the margin account. 1
M M i=1 d(0, i) i=1

d(0, i)Fi .

4. Options: basic facts. Denition: Option is a nancial contract where the buyer of the contract has the right to buy/sell specic number of units of the underlying asset at a specic price by a specic time in the future. Some terminologies Buyer of the option is called holder and seller is called writer.

INTRODUCTION TO DERIVATIVES PRICING LECTURES: 7, 8& 9

If the holder has the right to buy, then it is a call option. If the holder has the right to sell, it called put option. Agreed price to buy/sell is called strike price. The specic time till the option is valid is called the maturity. If the holder can buy/sell the underlying only at maturity, then it is called European option. If the holder can buy/sell at any time till maturity, it is called American option. A call option with strike K is said to be in the money, at the money and out of the money if S0 > K, S0 = K and S0 < K respectively, where S0 denotes the current price of the underlying. A put option with strike K is said to be in the money, at the money and out of the money if S0 < K, S0 = K and S0 > K respectively. The payo at maturity of a European call option(Holder) is given by max{ST K, 0} where ST price of the underlying at maturity T and K strike price. Exercise. What is the payo at maturity of the above option for the writer (i.e. the party which is selling the option)? Exercise. What about the payo of the European put option ? Holder of the option always has a non negative payo. Need to pay to buy an option: the option price. How to nd the option price? We will try to answer this question. Factors which aect option price. Current price of the underlying: Bigger the current price bigger the call option price. What about put option? Strike price: Bigger the strike price smaller the call option price. What about put option? High volatility (i.e. variance of the underlying per annum) implies high price (both call and put). Large time to maturity imply high option price (both call and put). Risk-free rate : More complex

INTRODUCTION TO DERIVATIVES PRICING

LECTURES: 7, 8& 9

4.1. Trading strategies involving options. In principle, one can construct any payo pattern at maturity( which is L2 -integrable) by combining options of various strikes and the underlying asset. We will see some very common trading strategies below. Trading strategies involving a single option and a stock 1 Covered call: Portfolio of a long position in the underlying asset and a short position in the call option. Covered call protects the writer of the call option from the upward movement of the stock price. 2 Protective put: Portfolio of a long position in put option and a long position in the underlying stock. To see the prot patterns of the above, see page 246 of [Hull]. Trading strategies involving two or more options of the same type (Spreads) All options are assumed to be with same maturity and same underlying. 1 Bull Spread: Portfolio of a long position in call option with strike K1 and a short position in call option with strike K2 , where K1 < K2 . Payo at maturity T is given by 0 if ST K1 ST K1 if K1 < ST K2 K2 K1 if ST > K2 . Looking at the payo pattern, one can observe that an investor who anticipates the up movement of the underlying will prefer Bull spread. If both the calls are out of the money, then (a) Cost of buying the bull spread is low. (b) Small probability of receiving the maximum payo K2 K1 . If Both calls are in the money, then (a) Cost of buying the bull spread is high. (b) High probability of receiving the maximum payo K2 K1 . 2 Bear spread: Portfolio of a short position in put option with strike K1 and a long position in put option with strike K2 , where K1 < K2 . Payo at maturity T is given by K2 K1 if ST K1 K2 ST if K1 < ST K2 0 if ST > K2 . Looking at the payo pattern, one can observe that an investor who anticipates down movement of the underlying will prefer Bear spread. Exercise. Analysis what happens when options are in the money and out of the money.

INTRODUCTION TO DERIVATIVES PRICING LECTURES: 7, 8& 9

3 Buttery spread: Portfolio of a long position in a call option with strikes K1 , K3 and two short positions in a call option with strike K2 , where 2K2 = K1 + K3 . Payo at maturity is 0 ST K1 2K2 K1 ST 2K2 K1 K3 = 0 if if if if ST K1 K1 < ST K2 K2 < ST K3 ST > K3 .

To see the prot patterns of the above, see pages 247-253 of [Hull]. Student is advised to read pages 254-259 of [Hull] to see other trading strategies involving options.