Fundamentals

of Futures and Options Markets, 7th Ed, Ch

20, Copyright John C. Hull 2010
Chapter 1 Introduction

This book addresses derivatives markets; how they work, can be used and what determines prices in
them. A derivative is an instrument whose value depends on the values of other more basic
underlying variables. A derivative can be constructed on anything that has a price
Futures contracts
Futures contract = Agreement to buy or sell an asset at a certain time in the future for a certain price.
Long = agreement to buy
Short = agreement to sell
Spot price = immediate delivery

History of future markets
1848 the Chicago Board of Trade (CBOT) was established to bring farmers and merchants together to
agree on the price for production in the near future. Speculators at the time traded the contract.

The Chicago Mercantile Exchange organized futures trading in foreign currencies.
Open-outcry-system is the traditional trading on the exchange floor (trading pit).
Electronic trading has led to algorithmic trading (automated high-frequency trading).

The over-the-counter market (ten times larger than exchange)
OTC is an alternative to exchanges; a telephone and computer network of dealers.
Financial institutions act as market makers for the more commonly traded instruments:
They quote
Bid price = a price at which the financial institution is prepared to buy
Offer price = a price at which the financial institution is prepared to sell
Advantage of OTC:
- Terms of a contract do not have to be those specified by an exchange; market participants
are free to negotiate any mutually attractive deal.
Disadvantage of OTD:
- Credit risk (risk that the contract will not be honored)

Forward contracts
A forward is the same as a future, but is traded on the OTC market.
Spot traders are trading a foreign currency for immediate delivery.

Options (Both exchange and OTC)
Call option gives the holder the right to buy an asset by a certain date for a certain/strike price
Put option gives the holder the right to sell an asset by a certain date for a certain/strike price
The contract contains the following:
- Exercise- or strike-price
- Expiration- or maturity-date
Maturity dates is for European options only, American can be exercised at any time.

An option gives the right to do something, but the holder does not have to exercise its right
Option premium = the up-front price that has to be paid by the investor for the option contract.


Properties of options:
As strike-price increases, the price of a call option decreases, but a put option increases. Both
options become more valuable as time to maturity increases.
In the USA an option contract is a contract to buy or sell 100 shares. The price is always given for one
share.
History of options markets
Selling and option is also known as writing an option

The Put and Call Brokers and Dealers Association
- Brought buyers and seller together for options
Deficiencies:
1. There was no secondary market (no right to sell the option to another party)
2. No mechanism to guarantee that the writer of the option would honor the contract.

These days the NASDAQ is the premier exchange for trading foreign options. Most exchanges also
offer combinations of futures contracts and options on these contracts.

Types of trader:
Hedgers use derivatives to reduce the risk from potential future movements in the market
Comparison:
Futures neutralize risk by fixing the price to be paid or received.
Options provide insurance; protecting for adverse movements while allowing to benefit from
favorable price movements

Speculators Use derivatives to bet on future directions of the market
Futures possibilities:
Possibility 1 = An upfront investment
Possibility 2 = Take a long position on futures contracts (small margin account as initial investment)
Option possibilities:
Options can be ten times more profitable, but are greater in potential loss.
However, the loss is limited to the amount paid for the options.

Arbitrageurs take offsetting positions in two or more instruments to lock in a profit
e.g. the stock price in NY is $162 and P100 in London when the exchange rate is $1.650 per pound.
At 100 shares the profit (in absence of transaction costs) is $300.
Forces of supply and demand will cause the price of dollar to rise so opportunities dont last long.
In practice very small arbitrage opportunities are observed.

Hedge funds have become big users of derivatives for all three purposes
Similar to mutual funds; invest funds on behalf of clients. However, they accept only from financially
sophisticated people and do not publicly offer their securities.
Mutual funds are subject to regulations requiring:
- Shares are redeemable at any time
- Investment policies are disclosed
- Use of leverage is limited
- No short positions are taken
- Etc.
Hedge funds are relatively free of these regulations
Fees are typically 1-2% of investment + 20% of the profits.
Funds of funds Invest in a portfolio of hedge funds


The hedge fund manager must:
1. Evaluate the risks to which the fund is exposed
2. Decide which risks are acceptable and which will be hedged
3. Devise strategies to hedge unacceptable risks
Labels:
Long/short equities: Purchase undervalued securities and short overvalued in such a way that the
exposure to the overall direction of the market is small
Convertible arbitrage: Long position on a convertible bond combined with an actively managed short
position in the underlying equity.
Distressed securities: Buy securities issued by companies in or close to bankruptcy
Emerging markets: Invest in debt or equity of companies in developing countries
Global macro: Carry out trades that reflect anticipated global macroeconomic trends
Merger arbitrage: Trade after an M&A is announced so that a profit is made if the deal takes place.

Dangers
Traders who have a mandate to hedge or follow an arbitrage strategy become (consciously or
unconsciously) speculators.
Risk limits should be set and activities of traders monitored.

Chapter 2 Mechanics of Futures and Forward Markets

This chapter covers how futures markets work.
- Specification of contracts
- Operation of margin accounts
- Organization of exchanges
- Regulation of markets
- The way in which quotes are made
- Treatment of transactions for accounting and tax purposes
Forward contracts are also discussed

Closing out futures positions
Most futures are never delivered. Most traders choose to close out their position which means
entering into the opposite trade to the original one.
Gain or loss is determined by the change in the futures price between closing out and going
short/long.
The possibility of final delivery however ties the futures price to the spot price.

Specification of a futures contract
When ready to deliver, the short party files a notice of intention to deliver with the exchange.
1. The asset (commoditys range of grades and quality)
2. The contract size (the amount of the asset) size depends for hedgers
3. Delivery arrangements (location determines price if its far from the source of commodity)
4. Delivery months (period that delivery can be made)
5. Price quotes (e.g. in dollars and cents)
6. Price limits and Position limits (Price limit is to prevent large price movements because of
speculation. A limit move is a move in either direction equal to the daily price limit. The
contract is said to limit up or limit down).

(Position limit is the number of contracts a speculator may hold; purpose is to prevent the
exercise of undue influence on the market)

Convergence of futures price to spot price
When the delivery period approaches, the futures price converges to the spot price.
When futures price above the spot price a clear arbitrage opportunity exists:
1. Short the futures contract
2. Buy the asset
3. Make delivery
When futures price below the spot price:
Companies interested in requiring the asset will wait for delivery to be made.

The operation of margins
Margins are a tool to avoid contract default (e.g. opposite party has no money).
1. Daily settlement
`The investor deposits money in the margin account when the contract is entered (initial margin). At
the end of each trading day, the margin account is adjusted to reflect the investors gain or loss.
Referred to as daily settlement or marking to market.
The maintenance margin ensures the balance never goes negative; if the account falls below this, the
investor receives a margin call from which he needs to deposit a variation margin. May this margin
not be provided; the broker closes out the position.
- Margin levels are determined by the variability of the price of the underlying asset.
- Usually maintenance margin is about 75% of the initial margin.
Day trade = closing out the position on the same day
Spread transaction = take both a short and long position in a contract

2. The clearing house and Clearing margins
Clearing house is an intermediary in futures transactions.
The house keeps track of all transactions and calculates the net position of each of its members. Both
broker and clearing house member are required to maintain a margin account.
The latter is clearing margin and is adjusted just as margin accounts of investors.
However, the balance is maintained at an amount to the original margin times the number of
contracts outstanding.
- On gross base: sum of the long and short positions
- On net base: long and short offsets against each other. (see example book)

OTC markets
Reducing credit risk in over-the-counter markets:
1. Collateralization
Similar to margin; transaction is valued every day and the positive is paid by the other party, or you
own the negative amount to the other party.
2. Use of clearing houses in OTC markets
Since the 2007-2009 crises some OTC transactions are obligated to use clearing houses.
The clearing house takes on the credit risk of both party A and B and manages it by requiring an
initial margin and daily variation margins from them.
Systemic risk = risk a large financial institution fails and leads to failures by other large financial
institutions can a collapse of the financial system.

Forward contracts
A forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a
certain price. There is no daily settlement (but collateral may have to be posted). At the end of the
life of the contract one party buys the asset for the agreed price from the other party.


Profit form a long (left) and short (right) forward or future position

Long position if the prices goes up you benefit from it and if the prices goes down you lose from it.
The value of the contract is zero (this is not the case with this option)
Short position if the prices goes down you benefit from it and if the prices goes up you lose from it.
The value of the contract is zero (this is not the case with this option)

Forward vs. Futures contracts
Forward
Futures
Private contract between 2 parties (OTC)
Traded on exchange
Not standardized
Standardized contract
Usually one specified delivery date
Range of delivery dates
Settled at end of contract
Settled daily
Delivery or cash settlement usually takes place
Contract is usually closed out prior to maturity
Some credit risk
Almost no credit risk

- The forward contract will make its profit at one time at the final maturity whereas the future
contract will lose and gain spread over the period and at the end make the same profit.

CH3 Hedging strategies using futures

Hedge to reduce risk
Risks related to fluctuations, foreign exchange rate, level of stock market and other variables.

Perfect hedge = one that completely eliminates the risk.

Basic principles
Take a position that neutralizes the risk as far as possible.
e.g. take a short position on a commodity that may either increase or decrease in price.

- Short hedges
Involves a short position in futures contract (example above)
Do this when you already (or will) own the asset and expect to sell in the future.
This leads to a loss if the value increases but a gain if the value decreases.
- Long hedges
When you know you will purchase in the future and want to lock a price down.

Arguments for and again hedging
Interest, exchange and commodity prices are difficult to predict so these risks can be hedged.
Why some risks are not hedged:
- Hedging and shareholders
Shareholders can hedge themselves and take a diversified portfolio. However, the transaction and
commission costs may be expensive.
- Hedging and competitors
When competitive pressures within the industry may be such that the price of goods/services
fluctuates to reflect raw material costs/interest/exchange rates, a company that hedges can expect
to have fluctuating profit margins.
- Other considerations
Although a hedging position is perfectly logical, it might be difficult to justify in the case of a loss.

Convergence of futures to spot

Hedge initiated at time t1 and closed out at time t2 the tangency point is the maturity date at which
the future contract ends. Price of future is almost always equal to the sport price. The spot price is
only above the future price when the asset pays out dividend before maturity.

Cross hedging
When the asset being hedged and the underlying asset are different.
Hedge ratio = the ratio of the size of the position in future contracts to the size of exposure.
h* = the ratio of average change in S for a particular change in F (optimal ratio is h* = 1)

optimal hedge ratio

Depends on volatility
S = change in spot price during the hedges lifetime
F = change in futures price during the hedges lifetime
! is the standard deviation of S, the change in the spot price during the hedging period
! is the standard deviation of F, the change in the future price during the hedging period
p = the correlation coefficient between S and F
The formula for the best fit slope:

if p is zero then there is no correlation, and therefore it isnt useful to hedge one asset with the other.

Tailing the Hedge
Two ways of determining the number of contract to use for hedging are:
1. compare the exposure to be hedged with the value of the assets underlying one futures
contract.
!

!
2. Compare the exposure to be hedged with the value of one futures contract (=future price
time size of future contract). The second approach incorporates an adjustment for the daily
settlement of futures.
!
!

=

!
!

Hedging using index futures
!
To hedge the risk in a portfolio the number of contracts that should be shorted is ! where ! is
!!

the current value of the portfolio, is its beta (systematic risk), and ! is the current value of one
futures(=futures price times contract size. If the beta equals 1 then the return of the portfolio equals
return of the market. If the beta is higher then 1 the portfolio is more riskier then the market.

- Reasons for hedging an equity portfolio
If the hedger feels the stock have been chosen well, the performance of the market may be
uncertain, but the stock in the portfolio will outperform the market (after appropriate adjustments
for the beta in the portfolio).

Futures price of S&P 500 is 1,000
Size of portfolio is $5 million
Beta of portfolio is 1.5
One contract is on $250 times the index

Answer (1.5* (5mln/250*1000)= 30 contracts)

CH5 Determination of Forward and Futures Prices

Consumption vs Investment Assets
Investment assets are assets held by significant numbers of people purely for investment purpose
(example: gold, silver).
Consumption assets are assets held primarily for consumption (example: copper, oil).

Short selling
Short selling involves selling securities you do not own. Your broker borrows the securities from
another client and sells them in the market in the usual way. At some stage you must buy the
securities back so they can be replaced in the account of the client. You must pay dividend and other
benefits the owner of the securities receives.

Assumptions and notation
1. The market participants are subject to no transaction costs when they trade
2. The market participants are subject to the same tax rate on all net trading profits
3. The market participants can borrow money at the same risk-free rate of interest as they can
lend money
4. The market participant take advantage of arbitrage opportunities as they occur

T
: Time until delivery date in a forward or future contract
!
: Price of the asset underlying the forward or future contract today
!
: Forward of future price today
r
: Zero-coupon risk-free rate of interest per annum, expressed with continuous compounding.

Forward price for an investment asset

If ! > ! !" , arbitrageurs can long (buy) the asset and short (sell) forward contracts on the asset.
If ! < ! !" , arbitrageurs can short (sell) the asset and long (buy) forward contract on the asset.
If short sales are not possible the formula still works for an investment asset because investors who
hold the asset will sell it and buy forward contracts when the forward price is too low.

! > (! ) !" , arbitrageurs can long(buy) the asset and short(sell) forward contracts on the asset.
! < (! ) !" ,arbitrageurs can short (sell) the asset and long (buy) forward contract on the asset.
Value of a long forward contract = (! ) !!"
Value of a short forward contract = ( ! ) !!"
Forward and future prices are usually assumed to be the same. When interest rates are uncertain
they are, in theory, slightly different. A strong positive correlation between interest rates and the
assets price implies the futures price is slightly higher than the forward price. A strong negative
correlation implies the reverse.

Future on Consumption Assets
! (! + ) !" Where u is the storage cost

CH7 Swaps
A swap is an agreement between two companies to exchange cash flows in the future.
1. Interest rate swap
2. Currency swap
Mechanics of interest rate swaps
Plain vanilla interest rate swap = the most common type of swap.
- A company agrees to pay cash flows equal to interest at a predetermined fixed rate on a
notional principal for a number of years. In return it receives interest at a floating rate.
Floating rate = an interest rate that changes on a periodic basis
- The notional principle (e.g. 100mil) is not exchanged, only the interest.

- Interest rate is set at the beginning of the period to which it applies, and paid at the end.
LIBOR
The floating rate in most swap agreements is the LIBOR (for maturities till 12 months).

Typical uses of an interest rate swap
Converting a liability/borrowing or an investment from:
fixed rate to floating rate
You have to pay 5.2% on a debt to a lender, then you can enter a swap that you receive a
fixed rate and pay a floating, like Intel does.
floating rate to fixed rate
You will have to pay a LIBOR rate to a lender, then you can enter a swap that you receive a
LIBOR rate and pay a fixed, like MS does.

Swap can similarly be used to transform an asset
A financial institution is usually involved as intermediary

Market maker
Display bid and offer prices from their own accounts. They must carefully quantify and hedge the risk
they are taking. Quotes by a swap market maker:

Bfix = Value of fixed-rate bond underlying the swap
Bfl = Value of floating-rate bond underlying the swap

The comparative-advantage argument
Some companies have comparative advantages in fixed-rate markets while other have the advantage
in floating-rate markets. Suppose:
AAA-Corp wants to borrow floating (AAA rating)
BBB-Corp wants to borrow fixed (BBB rating)

Difference in borrowing fixed rates is higher than in floating rates. AAAs advantage is in fixed rates.

AAA-Corp: pay LIBOR-0.35%

BBB-Corp: pay 4.95% fixed rate

When a financial institution is involved:

AAA-Corp: pay LIBOR-0.33%

BBB-Corp: pay 4.97%
F.I.: profit 0.04%

Valuation of interest rate swaps
Interest rate swaps is worth 0 when initiated.
Two valuation approaches:
1. Difference between two bonds
2. Valued as a portfolio of forward rate agreements (FRAs)
In terms of bond prices:
With a long position in fixed-rates and a short position in floating-rate bond:
Vswap= Bfix- Bfl
With a long position in floating-rates and a short position in fixed-rate bond:
Vswap= Bfl- Bfix

In terms of FRAs
As time passes, floating rates changes unexpectedly, swap has a value, and can be valued as a
portfolio of forward rate agreements (FRAs)
Each exchange of payments in an interest rate swap is an FRA
The FRAs can be valued on the assumption that todays forward rates are realized, and
todays forward rate can be derived from todays LIBOR curve.
1. Use LIBOR rate to calculate forward rates for each of the LIBOR rates that will determine
swap cash flows
2. Calculate swap cash flows on the assumption that the LIBOR rates will equal the forward
rates
3. Discount these swap cash flows (using LIBOR) to obtain the swap value
Example
Pay six-month LIBOR, receive 8% (s.a. compounding) on a principal of $100 million
Remaining life 1.25 years
LIBOR rates for 3-months, 9-months and 15-months are 10%, 10.5%, and 11% (cont comp)
6-month LIBOR on last payment date was 10.2% (s.a. compounding)

Currency swap
Exchanging principal and interest payments in one currency for principal and interest payments in
another currency.
E.g. An agreement to pay 5% on a sterling principal of 10,000,000 & receive 6% on a US$ principal of
$18,000,000 every year for 5 years

Similarly one can use this swap to transform liabilities and assets, motivated by comparative
advantage.
In a currency swap the principal is exchanged!
- Principal amounts are usually chosen to be approximately equivalent using the exchange rate
at the swaps initiation
- The exchange of the principal happens at the beginning in the opposite direction of interest
cash flow, and at the end of the swap in the direction of interest cash flow
Cash flow of currency swap:

Typical uses of currency swaps
Conversion from borrowing in one currency to a borrowing in another currency, or from an
investment in one currency to an investment in another currency
Without swap: IBM can issue $18mln of US$-dominated bonds at 6% interest. (borrowing in
US$ with an interest of 6%)
With swap: in addition to bond issue
1. exchange $18mln (using bond issue proceeds) for receiving 10mln,
2. pay 5% interest in , receive 6% interest in $ (used to pay bond interest)
3. pay 10 mln, receive $18 mln (used to pay bond principal).
Valuation of Currency Swaps
Like interest rate swaps, currency swaps can be valued as a portfolio of forward contracts
Assuming that forward exchange rates will be realized:

Example
All Japanese LIBOR/swap rates are 4%
All USD LIBOR/swap rates are 9%
5% is received in yen; 8% is paid in dollars. Payments are made annually
Principals are $10 million and 1,200 million yen
Swap will last for 3 more years
Current exchange rate is 110 yen per dollar

Credit risk
A swap is worth zero to a company initially
At a future time its value is liable to be either positive or negative
The company has credit risk exposure only when its value is positive, because the value to
the counterparty is negative, and it might default.

CH8 Securitization and the credit Crisis of 2007

Financial derivatives: Helps transferring risk in the economy to the party who is willing to
take it (for compensation).
Securitization: A process of taking an illiquid asset, or group of assets (residential
mortgages), and transforming them into a security.
In 1960s, Mortgage-backed security (MBS) was created so that proceeds from the sale of
MBS can be used to finance the loan to mortgage borrower. So banks can lend faster than
what their deposits allows.

Asset Backed Security (Simplified)

Getting Principal back depends on loss on the underlying asset
Rating agencies rated the securities

Finding investors for the Mezzanine tranches was more difficult, leading to the creation of ABSs of
ABSs: ABS CDOs (Collateralized Debt Obligation)



In the ABS CDO, the senior tranche accounts for 65% of the principle amount of the ABS mezzanine
tranche. The senior tranche of the ABS CDO is also rated AAA; meaning that the total of the AAArated instruments created are about 90% [80% + (65% of 15%)]
Before the credit crunch:
Starting in 2000, mortgage originators in the US relaxed their lending standards and created
large numbers of subprime first mortgages.
This, combined with very low interest rates, increased the demand for real estate and prices
rose.
To continue to attract first time buyers and keep prices increasing they relaxed lending
standards further (e.g.100% mortgages, ARMs, teaser rates)
Subprime mortgages were frequently securitized, and sold to investors with little information
about the mortgages, except loan-to-value ratio and FICO score which can be manipulated.
Quality of the mortgage is low. E.g. NINJAs, liar loans, non-recourse borrowing
Banks found it profitable to invest in the AAA rated tranches because the promised return
was significantly higher than the cost of funds and capital requirements were low
When the bubble busted:
In 2007 the bubble bursts. Some borrowers could not afford their payments when the teaser
rates ended. Others had negative equity and recognized that it was optimal for them to
exercise their put options.
Mortgage is non-recourse, meaning lender can take possession of the house when borrower
defaults, but other assets of the borrower are off-limits. This also means borrower can sell
the house for the outstanding principal on the mortgage. (essentially an American put
option, taken advantages of by many speculative defaulters)
U.S. real estate prices fell and products (ABS, ABS CDO), created from the mortgages, that
were previously thought to be safe began to be viewed as risky
Investors (pension funds, banks) in these products incurred big losses. Insurance company
(like AIG) who provide the guarantees also loses.
The loss banks led to credit crisis. Their capital eroded, more risk-averse, credit spreads increased
Key mistakes:
Default correlation goes up in stressed market conditions
Assumption that a BBB tranche is like a BBB bond
Need to Align Interests of Originators and Investors
There is evidence that mortgage originators used lax lending standards because they knew
loans would be securitized
For a rebirth of securitization it is necessary to align the interests of originators and investors

Regulators are insisting that when credit risk is transferred a certain percentage (5% to 10%)
of each tranche is retained by the originator
Role of Compensation Plans
Short term compensation (the end-of-year bonus) is the most important part of the
compensation for many employees of financial institutions
This creates short term horizons for decision making
Financial institutions are now realizing that bonuses should be based on performance over 3
to 5 years.
Transparency
ABSs and ABS CDOs were complex inter-related products
Once the AAA rated tranches were perceived as risky they became very difficult to trade
because investors did not understand the risks
To help them understand the risks, creators of the products should provide a way for
potential purchasers to assess the risks (e.g., by providing software)
Need for Models
Most financial institutions did not have models to value the tranches they traded (It appears
that they did not follow their own procedures on this)
Without a valuation model risk management is virtually impossible
More Emphasis on Stress Testing
We need more emphasis on stress testing and managerial judgement; less on the
mechanistic application of VaR models (particularly when times are good)
Senior management must be involved in the development of stress test scenarios

CH9 Mechanics of Options Markets

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
Short call: selling the option which gives you the right to buy
Long call: buying the option which gives you the right to buy

Short put: selling the option which gives you the right to sell
Long put: buying the options which gives you the right to sell
Long call is a call option you want to buy. If the strike price is 100, then below 100 you dont buy the
stock via the option contract.
Short call is a call option you want to sell. If the strike price is 100, then below 100 you dont sell the
stock via the option contract.
Long put is put option you want to buy. If the strike price is 70, then below 70 you buy the option
Short put is option you want to sell. If the strike price is 70, then below 70 you dont sell the option
Anything that has a price can be an option (stocks, foreign currency, stock index, futures)


Terminology
At the money option
In the money option




Out the money option

(stock price=strike price)

Call option (stock price > strike price = profit)
Put option (stock price < strike price = profit)
Call option (stock price < strike price = loss)
Put option (stock price > strike price = loss)

Dividends & Stock Splits

When there is a n-for-m stock split, the strike price is reduced to mK/n. the number of shares that
can be bought is increased to nN/m.

CH10 properties of stock options

There are 6 factors that affect the price of a stock option:

1. Current stock price

S 0
2. Strike price


K
3. Time to expiration

T
4. Volatility



5. Risk free interest rate
r
6. Dividends expected to be paid

c :
European call option price
p :
European put option price
C :
American Call option price
P :
American Put option price

ST :
Stock price at option maturity
D :
Present value of dividends during options life

Summary of the effect on the price of a stock option of increasing one variable while keeping all
others fixed


Higher stock price

-
call increases, put decreases
Higher strike price

-
call decreases, put increases
Longer time to expiration
-
both increase, but call double as much/long as put
Higher volatility

-
both increase, but call starts higher
Higher risk-free rate
-
call increases, put decreases

Upper and lower bounds
If an option price is above the upper bound or below the lower bound, there are profitable
opportunities for arbitrageurs.
An American option is worth at least as much as the corresponding European option:



C c
c S0



P p
Upper bound to call option price: C S
0

Upper bound to put option price: P K

p Ke rT
The worst that can happen to a call option is that is expires worthless, its value cannot be negative:
-rT
Lower bound to call option: c S0 Ke
-rT
Lower bound to put option:
p Ke S0

Put-call parity
Consider the following 2 portfolios:
Portfolio A: European call on a stock + zero-coupon bond that pays K at time T
Portfolio C: European put on the stock + the stock
Values of the portfolios:

ST > K

ST < K

Portfolio A

Call option

ST K

Zero-coupon bond

Total

ST

Portfolio C

Put Option

K ST

Share

ST

ST

Total

ST

Put-call parity result:

Equation 10.6, page 236
Both are worth max(ST , K ) at the maturity of the options
They must therefore be worth the same today. This means that
c + Ke -rT = p + S0

Arbitrage opportunities
Suppose that

C = 3
S0= 31

T = 0.25 r = 10%

K = 30 D = 0
What are the arbitrage possibilities when
p = 2.25 ?


p = 1 ?
c + Ke -rT = p + S0

Early Exercise
Usually there is some chance that an American option will be exercised early
An exception is an American call on a non-dividend paying stock
This should never be exercised early

An Extreme Situation
For an American call option:
S0 = 100; T = 0.25; K = 60; D = 0
Should you exercise immediately?
What should you do if

You want to hold the stock for the next 3 months?

You do not feel that the stock is worth holding for the next 3 months?

Reasons For Not Exercising a Call Early (No Dividends)
No income is sacrificed
You delay paying the strike price
Holding the call provides insurance against stock price falling below strike price


Should Puts Be Exercised Early?
Yes, always exercise when a put is deep in the money.
Protect against price fall, but price can never be negative
Earn interest on proceeds

The Impact of Dividends on Lower Bounds to Option Prices
(Equations 10.8 and 10.9, pages 243-244)
c S D Ke rT
0

rT

p D + Ke

S0

CH11 Trading strategies involving options

With options you may create several payoff functions: the payoff as a function of the stock price.
These trading strategies ignore the time value of money. The profit is shown as the final payoff minus
the initial cost. In theory, you should calculate the present value of final payoffs minus initial costs.

Strategies involving a single option and stock
The following give the difference between payoff and profit of holding one option.


The following profit patterns are the same as in CH9 for single option. Put-call parity gives an
understanding why this is so: S0 c = Ke(-rT) + D - p

a.
b.
c.
d.

Long stock + short call

Short stock + long call
Long put + long stock
Short put + short stock

Spreads
1. Bull spread (limits both upside and downside risk) (hope stock price increases)
Buy a c1 with lower strike; sell a c2 with a higher strike, Negative initial cash flow
Using calls:


3 types of bull-spreads exist:
1. Both calls initially out of the money (most aggressive, small probability of high payoff)
2. One call initially in the money, the other call initially out of the money
3. Both calls initially in the money (more conservative)
Using puts:

2. Bear spreads (hope stock price declines) (limit both upside and downside potential)
Strike price of option bought is higher than strike price of option sold
Initial cash outflow
Using puts:

Using calls:



3. Box spreads
Combination of bull call spread (2 different strike prices K1 & K2) and a bear put spread (with
the same two strike prices).
- Only work with European options
- Payoff is always K2 - K1 and the present value is (K2 - K1)e-rT
4. Butterfly spreads (if stock moves are assumed to be unlikely)
Options with 3 different strike prices
e.g. high call 1, low call 3, and halfway between sell two call options at price 2.
Price 2 is generally close to the current stock price.
Butterfly leads to profit if the stock price stays at price 2, but gives loss if the price moves in
either direction.
Has a negative initial cash flow
Using calls:

Using puts:

5. Calendar spreads (same strike price but different expiration dates)
Up to now the options all expired at the same time.
Short call, long (great maturity) call with same strike price.
Profit is made when stock price at expiration of the short-maturity option is close to the
strike price of the short-maturity. Loss occurs at a significant rise or decline or stock price.
Neutral strike price close to current stock price
Bullish Higher strike price
Bearish Lower strike price
6. Diagonal spreads (both expiration date and strike price are different)
Bull, bear and calendar are created from a long position in one option, and a short in another.

Combinations
An option trading strategy that takes position in both calls and puts on the same stock
1. Straddle (Buy a call and a put with the same K (strike price), initial cash outflow)
When expecting a large move in stock price but dont know which direction. However, carefully
consider if this jump is already reflected in the option price.

2. Strips and Straps (buy one call and 2 puts with same K, or buy two calls and 1 put with same K)
Strip considers a big move > decrease in stock price
Strap considers a big move > increase in stock price

3. Strangles (Buy a put at a lower strike, and a call at a higher strike
Compared with a straddle, stock price has to move further away
In order to make a profit)
- When expecting a large move in stock price but dont know which direction. However,
carefully consider if this jump is already reflected in the option price.



CH12 Introduction to Binomial Trees
Technique to price an option
Diagram of possible paths that can be followed by the stock price over the life of the option.

1. Explains nature of no-arbitrage arguments
2. Binomial tree numerical procedure to value American options
3. Principle of risk-neutral valuation

A one-step binomial model (and a no-arbitrage argument)
A stock price of $20 will be $22, or $18 in three months.
A three month call option has a strike price of $21

Portfolio is riskless when 22 - 1 = 18 or = 0.25 [1-0/22-18]
(22 x .25 1 = 4.5, and 18 x .25 = 4.5)
is the number of shares necessary to hedge a short position in one option
Because it has no risk, the return must equal the risk-free interest rate (e.g. 12%):
4.5e-0.12x3/12=4.367
So the portfolio that is long 0.25 shares and short 1 position is worth 4.367

To calculate the option price (denoted as f):
Current stock price is $20 > 20 x 0.25 f = 5 f



5 f = 4.367




f = 0.633


A generalization
A derivative lasts for time T and is dependent on a stock:
S0=stock price
f = option price
u > 1; d < 1

The portfolio is riskless when
=
or:

Value of portfolio at time T =

Value of portfolio today =

0
The cost of setting up portfolio = S -f

0
Hence S -f =



P = the risk neutral probability of up and downward movements =
Two-step binomial trees
The stock price starts at $20 and in each of the two time steps may go up/down by 10%.
Each time step is three months and the risk-free interest rate is 12%
Option strike price is $21
Objective is to calculate the value of the option










Value at note B =

Value at note A =




= 1.2823
Note C is zero because it leads to both E and F

The value of the option is 1.2823


A generalization
S0 during each step moves up u or goes down d; so after two up movements the value is fuu
The length of a step is now t (otherwise calculate p again for the next node)

A put example
These procedures can be used to price both puts and calls












American options
The procedure is to work back from end of the tree to the beginning, testing at each node to see
whether early exercise is optimal.

Steps in the binominal tree valuation:

1. Work out possible stock prices at all nodes
2. Calculate the payoff of the option at maturity
3. Work backwards, calculate the value of the option at earlier nodes
(Using risk-neutral probabilities), use other value if early exercise is possible and gives a
higher value.
4. Do this until the initial node

Choosing u and d
In practice they are determined by the volatility:

= stock price volatility
t = length of one time step on the tree

CH13 Valuing stock options: The black-Scholes-Merton

model
Model that influenced the way to price options

Black & Scholes used capital pricing model to relate required return on the option to the required
return on the stock (depends on stock price and time)
Merton sets up a riskless portfolio of an option and underlying stock and argues that the return
must be the risk-free return.

Assumptions about how stock prices evolve
What is the probability distribution in a day, week, month or year?
The BSM-model considers a non-dividend-paying stock and assumes normal distribution on returns.
The returns in two different, non-overlapping periods are assumed to be independent.
= Expected return on the stock
= Volatility of the stock price
S = Stock price

Mean of return
= t
Standard deviation
= t
Assumption of the model = S/S ~ N(t, 2t)
Normal distribution = N(m,v)
Variance

= 2t


The lognormal distribution
The assumption is that stock price at any future time has a lognormal distribution (always positive
and skewed)

These assumptions imply ln ST is normally distributed with mean: ln S 0 + ( 2 / 2)T
And standard deviation: T

ln ST N ln S 0 + ( 2 2)T , 2T
Alternatively, ST is log normally distributed
or
(Because the logarithm of ST is normal)
S

ln T N ( 2 2)T , 2T

S0

Expected return
R is the continuously compounded return per annum, E(R)= 2/2
Expected value of the stock price is E(ST)=S0eT
S

ln T = RT ~ N ( 2 2)T , 2T
Expected return =
S0

or R ~ N ( 2 2), 2


Volatility
The standard deviation of the return in time t (expressed in years) is: t
If a stock price is $50 and its volatility is 25% per year what is the standard deviation of the price
change in one day? 25x1/252 = 1.57% x 50 = $78.74

Because volatility is much higher when the market is open, time is measured in trading days (a 252)
when options are valued.
Estimating volatility from historical data
n+1 = number of observations
Si = stock price at end of ith interval, where i=0,1,2,3.n
t = length of time interval in years

1. Take observations S0, S1,.Sn on the variable of each trading day
Si

2. Define the continuously compounding rate as --------------------- ui = ln

S
i 1
3. Calculate SD, s, of the is
4. The historical volatility per year estimate is: s x 252

We can estimate how much this estimate will vary from the standard deviation of this sampling
distribution, which we call the standard error (SE) of the estimate: / 2n

14
20.90 1.00000
0.00000

!!!

!
!!!

!
!! ! ! !!!

!
!!!

15
16
17
18
19
20

21.25
21.40
21.40
21.25
21.75
22.00

1.01675
1.00706
1.00000
0.99299
1.02353
1.01149

0.01661
0.00703
0.00000
-0.00703
0.02326
0.01143

daily std. Dev
0.01216

vol
0.19302


The concept underlying Black-Scholes
The option price and the stock price depend on the same underlying source of uncertainty
We can form a portfolio consisting of the stock and the option which eliminates this source
of uncertainty
The portfolio is instantaneously riskless and must instantaneously earn the risk-free rate

Assumptions for BM model
1. Stock price is log-normally distributed
2. No transaction costs and taxes
3. No dividend on the stock during the life of option
4. No riskless arbitrage opportunities
5. Security trading is continuous
6. Investor can borrow and lend at the same risk free rate
7. Short-term risk free rate is constant.


The Black-Scholes Formulas:

Implied volatility: implied by the option prices, market opinion about stocks future volatility,
forward looking
Historical volatility: direct measure of the movement of the stock price over the history,
realized volatility, backward looking