ASB4417/4817 Financial Engineering

Lecture 1: Introduction
Gwion Williams

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

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

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

Size of OTC and Exchange-Traded Markets

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
5

The Lehman Bankruptcy

Lehmans filed for bankruptcy on September 15, 2008.
This was the biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives
markets and got into financial difficulties because it took
high risks and found it was unable to roll over its short
term funding
It had hundreds of thousands of transactions
outstanding with about 8,000 counterparties
Unwinding these transactions has been challenging for
both the Lehman liquidators and their counterparties

How Derivatives are Used

To hedge risks
To speculate (take a view on the future direction of
the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without
incurring the costs of selling one portfolio and
buying another

Foreign Exchange Quotes for GBP, May

24, 2010

Spot

Bid
1.4407

Offer
1.4411

1-month forward

1.4408

1.4413

3-month forward

1.4410

1.4415

6-month forward

1.4416

1.4422

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)

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

Class Exercise
On May 24, 2010 the treasurer of a corporation enters
into a long forward contract to buy 1 million in six
months at an exchange rate of 1.4422
This obligates the corporation to pay $1,442,200 for 1
million on November 24, 2010
What are the possible outcomes?
HINT consider different market conditions in 6 months

11

Profit from a Long Forward Position

(K= delivery price=forward price at time contract is
entered into)
Profit

Price of Underlying at
Maturity, ST

12

Profit from a Short Forward Position

(K= delivery price=forward price at time contract is entered
into)
Profit

Price of Underlying
at Maturity, ST

13

Futures Contracts
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
Less risk involved compared to forwards:
exchange traded means guarantee of
contract being honored

14

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)

15

Types of underlying assets in futures contracts

Commodities:
Pork bellies, live cattle, sugar, wool, copper, gold, oil.

Financial assets:
Stock indices, currencies and Treasury bonds

16

Examples of Futures Contracts

Agreement to:
Buy 100 oz. of gold @ US$1400/oz. in
December
Sell 62,500 @ 1.4500 US$/ in March
Sell 1,000 bbl. of oil @ US$90/bbl. in
April

17

Class Exercise 2
Gold: An Arbitrage Opportunity?
Suppose that:
The spot price of gold is US$1,400
The 1-year quoted futures price of gold is
US$1,500
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?

18

Gold: Another Arbitrage Opportunity?

Suppose that:
- The spot price of gold is US$1,400
- The 1-year quoted futures price of gold is
US$1,400
- The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?

19

2. Gold: Another Arbitrage Opportunity?

Sell short gold at spot of $1,400
Invest $1,400 at 5% for 1 year = $1,470
Enter long into futures contract to buy back in 1 year at
$1,400

After 1 year you gross $70

(note that we have ignored the borrowing cost of the short
position in the gold)

20

1. Oil: An Arbitrage Opportunity?

Suppose that:

- The spot price of oil is US$95

- The quoted 1-year futures price of
-

oil is US$125
The 1-year US$ interest rate is
5% per annum
The storage costs of oil are 2%
per annum

Is there an arbitrage opportunity?

21

The Forward Price of Oil

If the spot price of gold is S and the
forward price for a contract deliverable in
T years is F, then
F = S (1+r )T
where r is the 1-year (domestic
currency) risk-free rate of interest.
In our examples, S = 95, T = 1, and r
=0.05 so that
F = 95(1+0.05) = $99.75
22

1. Oil: An Arbitrage Opportunity?

Borrow $95 at 5%, use to buy oil, then pay back loan in 1 year
time $99.75
Storage cost 2% of $95 = $1.9
Sell 1 year futures $125
Total cost $99.75 + $1.9 = $101.65
Receive $125
Profit = $23.35

23

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)
Traded both OTC and on exchange

24

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
Most exchange traded are American options
Exchange traded equity options are usually an
agreement to buy or sell 100 shares.
OTC options can have virtually any condition, which are
agreed on by both counterparties
25

Google Call Option Prices (June 15, 2010; Stock Price is bid
497.07, offer 497.25) Source: CBOE

Strike
Price

Jul 17
2010 Bid

Jul 17
2010
Offer

Sep 18
2010 Bid

Sep 18
2010 Offer

Dec 18
2010 Bid

Dec 18
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
26

Google Put Option Prices (June 15, 2010; Stock Price is bid
497.07, offer 497.25); Source: CBOE

Strike
Price

Jul 17
2010 Bid

Jul 17
2010
Offer

Sep 18
2010 Bid

Sep 18
2010 Offer

Dec 18
2010 Bid

Dec 18
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
27

Class exercise
You want to buy one December call option on Google with
strike of $520
Offer price is $32.00, this is for an option to buy one share,
but exchange traded are on 100 shares
So you need $3,200 to buy contract
You now have the right to buy 100 Google shares at $520 each
on December 18th 2010.

Consider 3 market scenarios after 6 months.

i) Google < $520
ii) Google =$530
iii) Google = $600
28

Alternative strategy
Sell one September put option with strike price of $480
Price is $22.20 for 1 (remember you have to agree on 100 shares)
Cash inflow = $2,220 (Youve sold the put contract)
If Google share price remains above $480 by 18th September, you
will earn $2,220, because the trader will not exercise the put option
If shares = $420 at maturity
You must buy 100 shares at $480 = $48,000, but they are only worth $420
= $3,780 total loss when accounting for the cash inflow from selling of put

29

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 but not the
obligation

30

Forward/futures payoffs

31

Option payoffs

32

What can derivatives be used for

Hedging
Speculating
Arbitrage

33

Hedge example using forward

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

34

Foreign Exchange Quotes for GBP, May

24, 2010

Spot

Bid
1.4407

Offer
1.4411

1-month forward

1.4408

1.4413

3-month forward

1.4410

1.4415

6-month forward

1.4416

1.4422

35

Hedge example using forward

Exporter can hedge against FX risks with a 3-month forward
contract
3-month offer quote is 1.4415, in effect this fixes the prices to be
paid to $14,415,000 = 10,000,000
The hedge can work in favour of the company or not.
Scenario 1: Ex rate is 1.3 on 24 Aug, company will wish it had not
hedged because,
10,000,000 is only worth $13,000,000, but company is locked in at
$14,415,000!
Scenario 2: Ex rate is 1.5, company is glad it has hedged otherwise it
would have cost them $15,000,000 to deliver the 10m
Risk vs reward
36

Hedge example using options

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
This investor is concerned about Microsoft share loosing
value
Remember exchange traded options must be bought by
the 100s..
10 contracts = put option on 1,000 shares
Total cost of hedge is $1,000

37

Hedge example using options

Hedge costs $1,000 but guarantees sale of shares for
$27.50
If share price falls below $27.50, the investor will
exercise option, and sell shares for $27,500.
Taking into account option cost = $26,500 for investor
If share price stays above $27.50, option will not be
exercised, but investor will still get back more than
$26,500
If at $28.00, investor will get $27,000 (taking option cost
into account.
Due to cost of the hedge, investor will always be $1,000
worse off if share price is above $27.50

38

Value of Microsoft Shares with and

without Hedging
40,000

Value of Holding
($)

35,000
No Hedging

30,000

Hedging

25,000
Stock Price ($)
20,000
20

25

30

35

40

39

Forwards/futures vs options
Forwards/futures neutralise risk by fixing the price paid or
received for underlying asset
Option contracts provide insurance, because there is limited
downfall, whilst allowing benefit from favourable price
movements
Downside of option is the cost/premium
Forwards/futures have no upfront cost/premium

40

Speculation
Class exercise
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 22.50 is $1
What are the strategies?
Consider
i) Buying shares
ii) Buying call options

41

Margins
A margin is cash or marketable securities deposited by
an investor with his or her broker
The balance in the margin account is adjusted to reflect
daily settlement
Margins minimize the possibility of a loss through a
default on a contract
Forwards are different, there are risks, counterparty may
not have financial resources to honor contract
Forwards are settled at maturity, whilst Futures are
settled daily
Futures are rarely held till maturity
42

Review of Option Types

A call is an option to buy
A put is an option to sell
A European option can be exercised only
at the end of its life
An American option can be exercised at
any time

43

Option Positions

Long call
Long put
Short call
Short put

44

Long Call
Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months
30 Profit ($)
20
10
70
0
-5

80

90

100

Terminal
stock price ($)
110 120 130
45

Short Call
Profit from writing one European call option: option
price = $5, strike price = $100
Profit ($)
5
0
-10

110 120 130

70

80

90 100

Terminal
stock price ($)

-20
-30
46

Long Put
Profit from buying a European put option: option
price = $7, strike price = $70
30 Profit ($)
20
10

0
-7

Terminal
stock price ($)
40

50

60

70

80

90 100

47

Short Put
Profit from writing a European put option: option
price = $7, strike price = $70
Profit ($)
7
0

40

50

Terminal
stock price ($)

60
70

80

90 100

-10

-20
-30
48

Payoffs from Options

What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
Payoff

Payoff

Payoff = max(ST K, 0)

K
K

ST

Payoff

Payoff = -max(ST K,
0)

ST
Payoff

Payoff = max(K - ST, 0)

ST

Payoff = -max(K - ST, 0)

ST
49

Assets Underlying
Exchange-Traded Options

Stocks
Foreign Currency
Stock Indices
Futures

50

Specification of
Exchange-Traded Options

Expiration date
Strike price
European or American
Call or Put (option class)

51

Terminology
Moneyness :
At-the-money option
In-the-money option
Out-of-the-money option
Calls:
ATM Strike = Spot
ITM Strike < Spot
OTM Strike > Spot

Puts:
ATM Strike = Spot
ITM Strike > Spot
OTM Strike < Spot

52

Google Call Option Prices (June 15, 2010; Stock Price is bid
497.07, offer 497.25) Source: CBOE

Strike
Price

Jul 17
2010 Bid

Jul 17
2010
Offer

Sep 18
2010 Bid

Sep 18
2010 Offer

Dec 18
2010 Bid

Dec 18
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
53

Google Put Option Prices (June 15, 2010; Stock Price is bid
497.07, offer 497.25); See Table 1.3 page 9; Source: CBOE

Strike
Price

Jul 17
2010 Bid

Jul 17
2010
Offer

Sep 18
2010 Bid

Sep 18
2010 Offer

Dec 18
2010 Bid

Dec 18
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
54