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INTRODUCTION TO DERIVATIVE MARKET: FUTURES AND FORWARDS,

OPTIONS, SWAPS, FLOORS AND CAPS

By: Alemayohu Workine PGR/029/09


Betelhem Birhanu PGR/028/09
Nigus and
Gizachew

A Masters of Business Administration Student Assignment to be submitted to


Instructor: Dr. Kidane K.

Debre Berhan University


College of Business and Economics
Department of management
Masters of Business Administration

November, 2017
Debre Berhan, Ethiopia
CHAPTER SIX

INTRODUCTION TO DERIVATIVE MARKET

Introduction

Derivative securities, or more simply derivatives, play a large and increasingly important role in
financial markets. These are securities whose prices are determined by, or “derive from,” the
prices of other securities. These assets are also called contingent claims because their payoffs are
contingent on the prices of other securities. Options and futures contracts are both derivative
securities. We will see that their payoffs depend on the value of other securities. Swaps, which
we will see in future, also are derivatives. Because the value of derivatives depends on the value
of other securities, they can be powerful tools for both hedging and speculation. We will
investigate these applications in this chapter, starting with futures and forwards.

DERIVATIVE MARKET
There is a clear distinction between real assets, which are essentially tangible items, and financial
assets, which are pieces of paper describing legal claims. Financial assets can be further
subdivided into primary and derivative assets. A primary asset (sometimes called a primitive
asset) is a security that was originally sold by a business or government to raise money, and a
primary asset represents a claim on the assets of the issuer. Thus, stocks and bonds are primary
financial assets (D. Jordan and W. Miller, 2009).
In contrast, as the name suggests, a derivative asset is a financial asset that is derived from an
existing primary asset rather than issued by a business or government to raise capital. As we will
see, derivative assets usually represent claims either on other financial assets, such as shares of
stock or even other derivative assets, or on the future price of a real asset such as gold. Beyond
this, it is difficult to give a general definition of the term “derivative asset” because there are so
many different types, and new ones are created almost every day. On the most basic level,
however, any financial asset that is not a primary asset is a derivative asset (Ibid).
To give a simple example of a derivative asset, imagine that you and a friend buy 1,000 shares of
a dividend-paying stock, from Weyerhaeuser stock. You each put up half the money and you
agree to sell your stock in one year. Furthermore, the two of you agree that you will get all the
dividends paid while your friend gets all the gains or absorbs all the losses on the 1,000 shares.

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This simple arrangement takes a primary asset, shares of Weyerhaeuser stock, and creates two
derivative assets, the dividend-only shares that you hold and the no-dividend shares held by your
friend. Derivative assets such as these actually exist, and there are many variations on this basic
theme.

Derivatives are instruments that allow market agents to gamble on movements in the prices of
other instruments without being required to trade in the instruments themselves. There are three
major types of financial derivatives – futures, options and swaps – and myriad variations upon
them. Exchange-traded derivatives (futures and options, which are traded through financial
futures exchanges) are dealt with here. They are not OTC business. Contracts differ from those
in forward foreign exchange in the form of operation of the market, the terms of the contract, and
the likelihood of their leading to delivery of the underlying product. A crucial difference is that a
derivatives contract is a tradable instrument and can be sold on to a third party. Swaps however
are quite different in nature and operation (P. Howells and K. Bain, 2007).

Futures and Forwards

Forward Contract

By definition, a forward contract is a formal agreement between a buyer and a seller who both
commit to a commodity transaction at a future date at a price set by negotiation today. The
genius of forward contracting is that it allows a producer to sell a product to a willing buyer
before it is actually produced. By setting a price today, both buyer and seller remove price
uncertainty as a source of risk. With less risk, buyers and sellers mutually benefit and commerce
is stimulated. This principle has been understood and practiced for centuries (D. Jordan and W.
Miller, 2009).

A forward contract obliges its purchaser to buy a given amount of a specified asset at some
stated time in the future at the forward price. Similarly, the seller of the contract is obliged to
deliver the asset at the forward price. Non-delivery forwards (NDF) are settled at maturity and no
delivery of primary assets is assumed (Martin Haugh, 2016).
Forward contracts are not traded on exchanges. They are over-the-counter (OTC) contracts.
Forwards are privately negotiated between two parties and they are not liquid. Forward contracts
are widely used in foreign exchange markets. The profit or loss from a forward contract depends

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on the difference between the forward price and the spot price of the asset on the day the forward
contract matures. Forward contracts are settled only at maturity (Ibid).
 Examples of forward contracts Birhanu wants to buy a TV, which costs $ 10,000 but he
has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that
prices of televisions will rise 3 months from now. So in order to protect himself from the
rise in prices Birhanu enters into a contract with the TV dealer that 3 months from now
he will buy the TV for $ 10,000. What Birhanu is doing is that he is locking the current
price of a TV for a forward contract. The forward contract is settled at maturity. The
dealer will deliver the asset to Birhanu at the end of three months and Birhanu in turn will
pay cash equivalent to the TV price on delivery.
Other Examples of forward contracts include:
 A forward contract for delivery (i.e. purchase) of a non-dividend paying stock with
maturity 6 months.
 A forward contract for delivery of a 9-month T-Bill with maturity 3 months. (This means
that upon delivery, the T-Bill has 9 months to maturity.)
 A forward contract for the sale of gold with maturity 1 year.
 A forward contract for delivery of 10m Euro (in exchange for dollars) with maturity 6
months.
While forwards markets have proved very useful for both hedging and investment purposes, they
have a number of weaknesses. First, forward markets are not organized through an exchange.
This means that in order to take a position in a forward contract, you must first and someone
willing to take the opposite position. This is the double coincidence of wants problem. Second,
because forward contracts are not exchange-traded, there can sometimes be problems with price
transparency and liquidity. Finally, in addition to the financial risk of forward contract, there is
also counter party risk. This is the risk that one party to the forward contract will default on its
obligations. These problems have been eliminated to a large extent through the introduction of
futures markets (Martin Haugh, 2016).
Futures Contracts

In many ways, a futures contract is the simplest of all financial assets. A futures contract is just
an agreement made today regarding the terms of a trade that will take place later. For example,
suppose you know that you will want to buy 100 ounces of gold in six months. One thing you

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could do is to strike a deal today with a seller in which you promise to pay, say, $400 per ounce
in six months for the 100 ounces of gold. In other words, you and the seller agree that six months
from now, you will exchange $40,000 for 100 ounces of gold (D. Jordan and W. Miller, 2009).

The agreement that you have created is a futures contract. With your futures contract, you have
locked in the price of gold six months from now. Suppose that gold is actually selling for $450
per ounce in six months. If this occurs, then you benefit from having entered into the futures
contract because you have to pay only $400 per ounce. However, if gold is selling for $350, you
lose because you are forced to pay $400 per ounce. Thus, a futures contract is essentially a bet on
the future price of whatever is being bought or sold. Notice that with your futures contract, no
money changes hands today (Ibid).
After entering into the futures contract, what happens if you change your mind in, say, four
months, and you want out of the contract? The answer is that you can sell your contract to
someone else. You would generally have a gain or a loss when you sell. The contract still has
two months to run. If market participants generally believe that gold will be worth more than
$400 when the contract matures in two months, then your contract is valuable, and you would
have a gain if you sold it. If, on the other hand, market participants think gold will not be worth
$400, then you would have a loss on the contract if you sold it because you would have to pay
someone else to take it off your hands.

There are two broad categories of futures contracts: financial futures and commodity futures. The
difference is that, with financial futures, the underlying asset is intangible, usually stocks, bonds,
currencies, or money market instruments. With commodity futures, the underlying asset is a real
asset, typically either an agricultural product (such as cattle or wheat) or a natural resource
product (such as gold or oil) (D. Jordan and W. Miller, 2009).

A financial futures contract is a standardized agreement to deliver or receive a specified amount


of specified financial instrument at specified price and date. The buyer of financial futures buys
the financial instrument, while the seller of financial futures contract delivers the instrument for
specified price. Financial futures contracts are traded on organized exchanges, which establish
and enforce rules for such trading. Futures exchanges provide an organized market place where
futures contract can be traded. They clear, settle, and guarantee all transactions that occur in their
exchanges (Jeff Madura, 0000)

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Futures contract features
Futures are contracts and, in practice, exchange-traded futures contracts are standardized to
facilitate convenience in trading and price reporting. Standardized futures contracts have a set
contract size specified according to the particular underlying instrument. For example, a standard
gold futures contract specifies a contract size of 100 troy ounces. This means that a single gold
futures contract obligates the seller to deliver 100 troy ounces of gold to the buyer at contract
maturity. In turn, the contract also obligates the buyer to accept the gold delivery and pay the
negotiated futures price for the delivered gold.
To properly understand a futures contract, we must know the specific terms of the contract.
In general, futures contracts must stipulate at least the following five contract terms:
1. The identity of the underlying commodity or financial instrument.
2. The futures contract size.
3. The futures maturity date, also called the expiration date.
4. The delivery or settlement procedure.
5. The futures price.

First, a futures contract requires that the underlying commodity or financial instrument be clearly
identified. This is stating the obvious, but it is important that the obvious is clearly understood in
financial transactions.
Second, the size of the contract must be specified. As stated earlier, the standard contract size for
gold futures is 100 troy ounces. For U.S. Treasury note and bond futures, the standard contract
size is $100,000 in par value notes or bonds, respectively.
The third contract term that must be stated is the maturity date. Contract maturity is the date on
which the seller is obligated to make delivery and the buyer is obligated to make payment.
Fourth, the delivery process must be specified. For commodity futures, delivery normally entails
sending a warehouse receipt for the appropriate quantity of the underlying commodity. After
delivery, the buyer pays warehouse storage costs until the commodity is sold or otherwise
disposed.

Finally, the futures price must be mutually agreed on by the buyer and seller. The futures price is
quite important, because it is the price that the buyer will pay and the seller will receive for
delivery at contract maturity (D. Jordan and W. Miller, 2009).

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Futures Markets Strategies
The major economic purpose of futures contracts is to allow hedgers to transfer risk to
speculators. Therefore, a viable futures market cannot exist without participation by both hedgers
and speculators.
Speculating with futures

Suppose you are thinking about speculating on commodity prices because you believe that you
can accurately forecast future prices. The most convenient way to speculate is to use futures
contracts. If you believe that gold prices will increase, then you can speculate on this belief by
buying gold futures. Alternatively, if you think gold prices will decrease, you can speculate by
selling gold futures (D. Jordan and W. Miller, 2009).

Buying a futures contract is often referred to as “going long,” or establishing a long position.
Selling a futures contract is often called “going short,” or establishing a short position. A
speculator accepts price risk in an attempt to profit on the direction of prices. Speculators can go
long or short futures contracts. A speculator who is long benefits from price increases and loses
from price decreases. The opposite is true for a speculator who is short (Ibid).
To illustrate the basics of speculating, suppose you believe the price of gold will go up. In
particular, suppose the current price for delivery in three months is $800 per ounce (this $800 is
called the “futures” price). You think that gold will be selling for much more than $800 three
months from now, so you go long 100 gold contracts that expire in three months. When you do,
you are obligated to take delivery of gold and pay the agreed-upon price, $800 per ounce. Each
gold contract represents 100 troy ounces, so 100 contracts represents 10,000 ounces of gold with
a total contract value of 10,000 × $800 = $8,000,000. In futures jargon, you have an $8 million
long gold position.
Suppose your belief turns out to be correct, and three months later, the market price of gold is
$820 per ounce. Your three-month futures contracts have just expired. So, to fulfill the terms of
your long futures position, you accept delivery of 10,000 troy ounces of gold, pay $800 per
ounce, and immediately sell the gold at the market price of $820 per ounce. Your profit is $20
per ounce, or 10,000 × $20 = $200,000. Of course, you will pay some brokerage commissions
and taxes out of this profit.

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Suppose your belief turns out to be incorrect and gold prices fall. You will lose money in this
case because you are obligated to buy the 10,000 troy ounces at the agreed-upon price of $800
per ounce. If gold prices fell to, say, $775 per ounce, you would lose $25 per ounce, or 10,000 ×
$25 = $250,000. In addition, you will pay some brokerage commissions.
As this gold example shows, futures speculation can lead to substantial gains and losses. An
important point is that your gains from futures speculation depend on accurate forecasts of the
direction of future prices. You must ask yourself: Is it easy to forecast price changes?

Consider another example of commodity speculation. Suppose you analyze weather patterns and
you are convinced that the coming winter months will be colder than usual. You believe that this
will cause heating oil prices to rise. You can speculate on this belief by going long heating oil
futures.
The standard contract size for heating oil is 42,000 gallons. Suppose you go long 10 contracts at
a futures price of $1.90 per gallon. This represents a long position with a total contract value of
10 × 42,000 × $1.90 = $798,000.
If the price of heating oil at contract maturity is, say, $1.50 per gallon, your loss before
commissions would be 40 cents per gallon, or 10 × 42,000 × $.40 =$168,000. Of course, if
heating oil prices rose by 40 cents per gallon, you would gain $168,000 (less applicable
commissions) instead.

Once again, futures speculation can lead to substantial gains and losses. The important point
from this example is that your gains from futures speculation depend on you making more
accurate weather forecasts than other traders (D. Jordan and W. Miller, 2009).

HEDGING WITH FUTURES


PRICE RISK Many businesses face price risk when their activities require them to hold a
working inventory. By a working inventory, we mean that firms purchase and store goods for
later resale at market prices. Price risk is the risk that the firm will not be able to sell its goods at
a price sufficiently higher than the acquisition cost.
For example, suppose you own a regional heating oil distributorship and must keep a large pre
heating season inventory of heating oil of, say, 2.1 million gallons. In futures market jargon, this
heating oil inventory represents a long position in the underlying commodity.

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If heating oil prices go up, the value of the heating oil you have in inventory goes up in value,
but if heating oil prices fall, the value of the heating oil you have to sell goes down. Your risk is
not trivial, because even a 15-cent per gallon fluctuation in the price of heating oil will cause
your inventory to change in value by $315,000. Because you are in the business of distributing
heating oil, and not in the business of speculating on heating oil prices, you decide to remove this
price risk from your business operations.
THE MECHANICS OF SHIFTING PRICE RISK An important function of futures markets
is that they allow firms that have price risk to shift it to others who want price risk. A person or
company that wants to shift price risk to others is called a hedger. Hedgers transfer price risk by
taking a futures market position that is the opposite of their existing position in the underlying
asset. You can think about this using a portfolio approach. Hedgers look to add a futures market
position to their position in the underlying asset that will provide cash to the hedgers when their
position in the underlying asset declines in value. However, the cost of adding a futures position
is that the futures position draws down cash when the position in the underlying asset generates
value.
In the case of your heating oil enterprise, the heating oil you have in inventory represents a long
position in the underlying asset. Therefore, the value of this heating oil inventory can be
protected by taking a short position in heating oil futures contracts. Hedgers often say they are
“selling” futures contracts when they are initiating a short position. Because you are using this
short position for hedging purposes, you have created a short hedge.

With a short hedge in place, changes in the value of your long position in the underlying asset
are offset by an approximately equal, but opposite, change in value of your short futures position.

AN EXAMPLE OF A SHORT HEDGE One of the first questions a hedger has to answer is
how many futures contracts are needed to shift risk. This question has many answers, and most
can be found in a course devoted to futures contracts and other derivatives. However, a
reasonable hedging strategy is known as a full hedge. When a hedger has an equal, but opposite,
futures position to the position in the underlying asset, the hedger is said to have a full hedge.

Heating oil futures contracts are traded on the New York Mercantile Exchange (NYM) and the
standard contract size for heating oil futures is 42,000 gallons per contract. Because you wish to
full hedge 2.1 million gallons, you need to sell 2,100,000/42,000 = 50 heating oil contracts.

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Suppose the average acquisition price of your 2.1 million gallons of heating oil is $1.30 per
gallon, and that today’s futures price for delivery during your heating season is $1.90. In the past,
market conditions in your distribution area were such that you could sell your heating oil to your
customers at a price 20 cents higher than the prevailing futures price.
To help finance your inventory purchases, you borrowed money. During the heating season, you
have to make a debt payment of $500,000.
Given these numbers, you can forecast your pretax profit per gallon of heating oil. Revenues
are 2,100,000 × $2.10 = $4,410,000. The cost of the heating oil is 2,100,000 × $1.30 =
$2,730,000. Subtracting this cost and the debt payment of $500,000 from revenue results in a
pretax profit of $1,180,000, or $1,180,000/2,100,000 = $.56 per gallon.
However, if heating oil prices decrease by $.40, your pretax profit per gallon of heating oil will
only be $.16. You view this risk as unacceptable and decide to hedge by selling 50 heating oil
futures contracts at a price of $1.90 per gallon. Table 14.1 summarizes three possible outcomes:
heating oil prices remain steady, they increase by $.40, and they decrease by $.40.
As you can see in Table 14.1, your pretax profit will be $.56 in all three cases. To see this,
suppose heating oil prices fall by $.40. In this case, revenues are 2,100,000 × $1.70 =
$3,570,000. The cost of the heating oil is 2,100,000 × $1.30 = $2,730,000. Subtracting this cost
and the debt payment of $500,000 from revenues results in an un hedged pretax profit of
$340,000, or $340,000/2,100,000 = $.16 per gallon. However, if you had a short hedge in place,
your pretax futures profit is $840,000 because ($1.90 -$1.50) × 42,000 × 50 = $840,000. Adding
$840,000 to the unhedged pretax profit of $340,000 results in a hedged pretax profit of
$1,180,000, which is $1,180,000/2,100,000 = $.56 per gallon.
In fact, your pretax profit will remain steady for a wide range of prices. We illustrate this result
in Figure 14.2. In the blue line represents your pretax profit per gallon of heating oil for a wide
range of possible heating oil selling prices. The red line represents your futures market gains or
losses. Note that heating oil futures prices and futures contract gains (losses) appear across the
top and on the right side of the graph. If futures prices remain unchanged at $1.90, you have no
futures gain or loss. If futures prices fall to $1.50, your futures gain is $.40.
In Figure 14.2, the purple line remains steady at a value of $.56. This means that for a wide range
of heating oil selling prices, your pretax profit remains unchanged if you employ the short hedge.

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Your business activities may also include distributing other petroleum products like gasoline and
natural gas. Futures contracts are also available for gasoline and natural gas, and therefore they
may be used for hedging purposes. In fact, your business activities might dictate you use another
common hedge, known as a long hedge.
Firms that use a long hedge do not currently own the underlying asset, but plan to acquire it in
the future. In this case, it is as if the firm is “short” the underlying asset because if the price
increases between now and the time at which the firm actually purchases the underlying asset,
the firm will pay more than it thought. Note that the firm does not go into the market and
establish a short position in the underlying asset. That would be speculating.
Rather, its planned business activities create situations where the firm is exposed to price
increases in the underlying asset. This exposure is what gives rise to the saying that the firm is
effectively “short the underlying.”
OPTION CONTRACTS
An option contract is an agreement that gives the owner the right, but not the obligation, to buy
or sell (depending on the type of option) a specific asset at a specific price for a specific period
of time based on some option premium (Margin). The most familiar options are stock options.
Options are a very flexible investment tool, and a great deal is known about them (D. Jordan and
W. Miller, 2009).
Option terminology
Options come in two flavors, calls and puts. The owner of a call option has the right, but not the
obligation, to buy an underlying asset at a fixed price for a specified time. The owner of a put
option has the right, but not the obligation, to sell an underlying asset at a fixed price for a
specified time. Options occur frequently in everyday life. Suppose, for example, that you are
interested in buying a used car. You and the seller agree that the price will be $3,000. You give
the seller $100 to hold the car for one week, meaning that you have one week to come up with
the $3,000 purchase price, or else you lose your $100. This agreement is a call option. You paid
the seller $100 for the right, but not the obligation, to buy the car for $3,000. If you change your
mind because, for example, you find a better deal elsewhere, you can just walk away. You’ll lose
your $100, but that is the price you paid for the right, but not the obligation, to buy. The price
you pay to purchase an option, the $100 in this example, is called the option premium. A few
other definitions will be useful. First, the specified price at which the underlying asset can be

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bought or sold with an option contract is called the strike price, the striking price, or the
exercise price. Using an option to buy or sell an asset is called exercising the option.

The last trading day for all listed stock options in the United States is the third Friday of the
option’s expiration month (except when Friday falls on a holiday, in which case the last trading
day is the third Thursday). The expiration day for stock options is the Saturday immediately
following the last trading day. The expiration day is the last day (in the case of American-style
options) or the only day (in the case of European-style options) on which an option may be
exercised (D. Jordan and W. Miller, 2009).

Example: Profits and Losses on a Call Option


Consider the January 2010 expiration call option on a share of IBM with an exercise price of
$130 that was selling on December 2, 2009, for $2.18. Exchange-traded options expire on the
third Friday of the expiration month, which for this option was January 15, 2010. Until the
expiration date, the purchaser of the calls may buy shares of IBM for $130. On December 2,
IBM sells for $127.21. Because the stock price is currently less than $130 a share, exercising the
option to buy at $130 clearly would make no sense at that moment. Indeed, if IBM remains
below $130 by the expiration date, the call will be left to expire worthless. On the other hand, if
IBM is selling above $130 at expiration, the call holder will find it optimal to exercise. For
example, if IBM sells for $132 on January 15, the option will be exercised, as it will give its
holder the right to pay $130 for a stock worth $132. The value of the option on the expiration
date would then be
Value at expiration = Stock price - Exercise price = $132 - $130 = $2
Despite the $2 payoff at expiration, the call holder still realizes a loss of $.18 on the investment
because the initial purchase price was $2.18:

Profit = Final value - Original investment = $2.00 - $2.18 = -$.18

Nevertheless, exercise of the call is optimal at expiration if the stock price exceeds the exercise
price because the exercise proceeds will offset at least part of the cost of the option. The investor
in the call will clear a profit if IBM is selling above $132.18 at the expiration date. At that stock
price, the proceeds from exercise will just cover the original cost of the call.

Example 2 Profits and Losses on a Put Option

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Now consider the January 2010 expiration put option on IBM with an exercise price of $130,
selling on December 2, 2009, for $4.79. It entitled its owner to sell a share of IBM for $130 at
any time until January 15. If the holder of the put buys a share of IBM and immediately exercises
the right to sell at $130, net proceeds will be $130 - $127.21 = $2.79.
Obviously, an investor who pays $4.79 for the put has no intention of exercising it immediately.
If, on the other hand, IBM sells for $123 at expiration, the put turns out to be a profitable
investment. Its value at expiration would be

Value at expiration = Exercise price - Stock price = $130 - $123 = $7

and the investor’s profit would be $7.00 - $4.79 = $2.21. This is a holding period return of
$2.21/$4.79 = .461, or 46.1% over only 44 days! Apparently, put option sellers on December 2
(who were on the other side of the transaction) did not consider this outcome very likely.

The Options Clearing Corporation

Option traders who transact on option exchanges have an important ally. The Options Clearing
Corporation (OCC), founded in 1973, is the clearing agency for these options exchanges: the
American Stock Exchange, the Chicago Board Options Exchange, the International Securities
Exchange, NYSE Arca, Philadelphia Stock Exchange, and the Boston Stock Exchange. Once an
option trade is made on an options exchange, the Options Clearing Corporation steps in and
becomes a party to both sides of the trade. In other words, the option buyer effectively purchases
the option from the OCC, and the seller effectively sells the option to the OCC. In this way, each
investor is free from the worry that the other party will default. Each option investor simply
looks to the OCC (D. Jordan and W. Miller, 2009).

Options contract Terms

Because options are contracts, an understanding of stock options requires that we know the
specific contract terms. In general, options on common stock must stipulate at least the following
six contract terms:
1. The identity of the underlying stock.
2. The strike price, also called the striking or exercise price.
3. The option contract size.

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4. The option expiration date, also called the option maturity.
5. The option exercise style.
6. The delivery or settlement procedure.
First, a stock option contract requires that the specific stock issue be clearly identified. While this
may seem to be stating the obvious, in financial transactions it is important that the “obvious” is
in fact clearly and unambiguously understood by all concerned parties.
Second, the strike price, also called the exercise price, must be stipulated. The strike price is
quite important, because the strike price is the price that an option holder will pay (in the case of
a call option) or receive (in the case of a put option) if the option is exercised.
Third, the size of the contract must be specified. As stated earlier, the standard contract size for
stock options is 100 stock shares per option.
The fourth contract term that must be stated is the option expiration date. An option cannot be
exercised after its expiration date. If an option is unexercised and its expiration date has passed,
the option becomes worthless.
Fifth, the option’s exercise style determines when the option can be exercised. There are two
basic exercise styles: American and European. American options can be exercised any time
before option expiration, but European options can be exercised only at expiration. Options on
individual stocks are normally American style, and stock index options are usually European
style.
Finally, in the event that a stock option is exercised, the settlement process must be stipulated.
For stock options, standard settlement requires delivery of the underlying stock shares several
business days after a notice of exercise is made by the option holder.

OPTIONS VERSUS FUTURES


Our discussion thus far illustrates the two crucial differences between an option contract and a
futures contract. The first is that the purchaser of a futures contract is obligated to buy the
underlying asset at the specified price (and the seller of a futures contract is obligated to sell).
The owner of a call option has the right, but not the obligation, to buy. The second important
difference is that when you buy a futures contract you pay no money at the time of purchase (and
you receive none if you sell). However, if you buy an option contract, you pay the premium at
the time of the purchase; if you sell an option contract, you receive the premium at the time of
the sale (D. Jordan and W. Miller, 2009).
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Option Payoffs and Profits
In fact, there is essentially no limit to the number of different investment strategies available
using options. However, fortunately for us, only a small number of basic strategies are available,
and more complicated strategies are built from these. We discuss the payoffs from these basic
strategies here and in the next section (D. Jordan and W. Miller, 2009).
OPTION WRITING
Thus far, we have discussed options from the standpoint of the buyer only. However, options are
contracts, and every contract must link at least two parties. The two parties to an option contract
are the buyer and the seller. The seller of an option is called the “writer,” and the act of selling an
option is referred to as option writing.
By buying an option you buy the right, but not the obligation, to exercise the option before the
option’s expiration date. By selling or writing an option, you take the seller’s side of the option
contract. As a result, option writing involves receiving the option price and, in exchange,
assuming the obligation to satisfy the buyer’s exercise rights if the option is exercised. For
example, a call writer is obligated to sell stock at the option’s strike price if the buyer decides to
exercise the call option. Similarly, a put writer is obligated to buy stock at the option’s strike
price if the buyer decides to exercise the put option (Ibid).
OPTION PAYOFFS
It is useful to think about option investment strategies in terms of their initial cash flows and
terminal cash flows. The initial cash flow of an option is the price of the option, also called the
option premium. To the option buyer, the option price (or premium) is a cash outflow. To the
option writer, the option price (or premium) is a cash inflow. The terminal cash flow of an option
is the option’s payoff that could be realized from the exercise privilege. To the option buyer, a
payoff entails a cash inflow. To the writer, a payoff entails a cash outflow.
For example, suppose the current price of IBM stock is $80 per share. You buy a call option on
IBM with a strike price of $80. The premium is $4 per share. Thus, the initial cash flow is -$400
for you and +$400 for the option writer. What are the terminal cash flows for you and the option
writer if IBM has a price of $90 when the option expires? What are the terminal cash flows if
IBM has a price of $70 when the option expires?
If IBM is at $90, then you experience a cash inflow of $10 per share, whereas the writer
experiences an outflow of $10 per share. If IBM is at $70, you both have a zero cash flow when

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the option expires because it is worthless. Notice that in both cases the buyer and the seller have
the same cash flows, just with opposite signs. This shows that options are a “zero sum game,”
meaning that any gains to the buyer must come at the expense of the seller and vice versa (D.
Jordan and W. Miller, 2009).
Option Strategies
An unlimited variety of payoff patterns can be achieved by combining puts and calls with
various exercise prices. We explain in this section the motivation and structure of some of the
more popular ones (Bodie, Kane and Marcus, 2011).
Protective Put
Imagine you would like to invest in a stock, but you are unwilling to bear potential losses beyond
some given level. Investing in the stock alone seems risky to you because in principle you could
lose all the money you invest. You might consider instead investing in stock and purchasing a
put option on the stock. Whatever happens to the stock price, you are guaranteed a payoff at least
equal to the put option’s exercise price because the put gives you the right to sell your shares for
that price.

Table 20.1 shows the total value of your portfolio at option expiration:
Example 20.3 Protective Put
Suppose the strike price is X = $100 and the stock is selling at $97 at option expiration. Then the
value of your total portfolio is $100. The stock is worth $97 and the value of the expiring put
option is
X - ST = $100 - $97 = $3
Another way to look at it is that you are holding the stock and a put contract giving you the right
to sell the stock for $100. The right to sell locks in a minimum portfolio value of $100. On the
other hand, if the stock price is above $100, say, $104, then the right to sell a share at $100 is

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worthless. You allow the put to expire unexercised, ending up with a share of stock worth S T =
$104 (Ibid).
Covered Calls
A covered call position is the purchase of a share of stock with a simultaneous sale of a call on
that stock. The call is “covered” because the potential obligation to deliver the stock is covered
by the stock held in the portfolio. Writing an option without an offsetting stock position is called
by contrast naked option writing. The value of a covered call position at the expiration of the
call, presented in Table 20.2 , equals the stock value minus the value of the call. The call value is
subtracted because the covered call position involves writing a call to another investor who may
exercise it at your expense.

Example 20.4 Covered Call


Assume a pension fund holds 1,000 shares of stock, with a current price of $100 per share.
Suppose the portfolio manager intends to sell all 1,000 shares if the share price hits $110, and a
call expiring in 60 days with an exercise price of $110 currently sells for $5. By writing 10 call
contracts (for 100 shares each) the fund can pick up $5,000 in extra income.
The fund would lose its share of profits from any movement of the stock price above $110 per
share, but given that it would have sold its shares at $110, it would not have realized those profits
anyway (Bodie, Kane and Marcus, 2011).
Straddle
A long straddle is established by buying both a call and a put on a stock, each with the same
exercise price, X, and the same expiration date, T. Straddles are useful strategies for investors
who believe a stock will move a lot in price but are uncertain about the direction of the move.
For example, suppose you believe an important court case that will make or break a company is
about to be settled, and the market is not yet aware of the situation. The stock will either double
in value if the case is settled favorably or will drop by half if the settlement goes against the

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company. The straddle position will do well regardless of the outcome because its value is
highest when the stock price makes extreme upward or downward moves from X.
The worst-case scenario for a straddle is no movement in the stock price. If S T equals X, both
the call and the put expire worthless, and the investor’s outlay for the purchase of both options is
lost. Straddle positions, therefore, are bets on volatility. An investor who establishes a straddle
must view the stock as more volatile than the market does.
Conversely, investors who write straddles selling both a call and a put must believe the stock is
less volatile. They accept the option premiums now, hoping the stock price will not change much
before option expiration.
Strips and straps are variations of straddles. A strip is two puts and one call on a security with
the same exercise price and maturity date. A strap is two calls and one put (Ibid).

Spreads
A spread is a combination of two or more call options (or two or more puts) on the same stock
with differing exercise prices or times to maturity. Some options are bought, whereas others are
sold, or written. A money spread involves the purchase of one option and the simultaneous sale
of another with a different exercise price. A time spread refers to the sale and purchase of
options with differing expiration dates.
Consider a money spread in which one call option is bought at an exercise price X 1, whereas
another call with identical expiration date, but higher exercise price, X 2, is written. The payoff
to this position will be the difference in the value of the call held and the value of the call
written, as in Table 20.4 .
There are now three instead of two outcomes to distinguish: the lowest-price region where S T is
below exercise prices, a middle region where S T is between the two exercise prices, and a high-
price region where S T exceeds both exercise prices. Figure 20.10 illustrates the payoff and profit

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to this strategy, which is called a bullish spread because the payoff either increases or is
unaffected by stock price increases. Holders of bullish spreads benefit from stock price increases.
One motivation for a bullish spread might be that the investor thinks one option is overpriced
relative to another. For example, an investor who believes an X = $100 call is cheap compared to
an X = $110 call might establish the spread, even without a strong desire to take a bullish
position in the stock (Bodie, Kane and Marcus, 2011).

Collars
A collar is an options strategy that brackets the value of a portfolio between two bounds.
Suppose that an investor currently is holding a large position in FinCorp stock, which is currently
selling at $100 per share. A lower bound of $90 can be placed on the value of the portfolio by
buying a protective put with exercise price $90. This protection, however, requires that the
investor pay the put premium. To raise the money to pay for the put, the investor might write a
call option, say, with exercise price $110. The call might sell for roughly the same price as the
put, meaning that the net outlay for the two options positions is approximately zero. Writing the
call limits the portfolio’s upside potential. Even if the stock price moves above $110, the investor
will do no better than $110, because at a higher price the stock will be called away. Thus the
investor obtains the downside protection represented by the exercise price of the put by selling
her claim to any upside potential beyond the exercise price of the call.
Example 20.5 Collars
A collar would be appropriate for an investor who has a target wealth goal in mind but is
unwilling to risk losses beyond a certain level. If you are contemplating buying a house for
$220,000, for example, you might set this figure as your goal. Your current wealth may be
$200,000, and you are unwilling to risk losing more than $20,000. A collar established by (1)
purchasing 2,000 shares of stock currently selling at $100 per share, (2) purchasing 2,000 put
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options (20 options contracts) with exercise price $90, and (3) writing 2,000 calls with exercise
price $110 would give you a good chance to realize the $20,000 capital gain without risking a
loss of more than $20,000.
Exotic Options
Options markets have been tremendously successful. Investors clearly value the portfolio
strategies made possible by trading options; this is reflected in the heavy trading volume in these
markets. Success breeds imitation, and in recent years we have witnessed considerable
innovation in the range of option instruments available to investors. Part of this innovation has
occurred in the market for customized options, which now trade in active over the counter
markets. Many of these options have terms that would have been highly unusual even a few
years ago; they are therefore called “exotic options.” In this section we survey some of the more
interesting variants of these new instruments (Bodie, Kane and Marcus, 2011).
Asian Options
You already have been introduced to American- and European-style options. Asian-style options
are options with payoffs that depend on the average price of the underlying asset during at least
some portion of the life of the option. For example, an Asian call option may have a payoff equal
to the average stock price over the last 3 months minus the strike price if that value is positive,
and zero otherwise. These options may be of interest, for example, to firms that wish to hedge a
profit stream that depends on the average price of a commodity over some period of time.
Barrier Options
Barrier options have payoffs that depend not only on some asset price at option expiration, but
also on whether the underlying asset price has crossed through some “barrier.” For example, a
down-and-out option is one type of barrier option that automatically expires worthless if and
when the stock price falls below some barrier price. Similarly, down-and in options will not
provide a payoff unless the stock price does fall below some barrier at least once during the life
of the option. These options also are referred to as knock-out and knock-in options.
Look back Options
Look back options have payoffs that depend in part on the minimum or maximum price of the
underlying asset during the life of the option. For example, a look back call option might provide
a payoff equal to the maximum stock price during the life of the option minus the exercise price,
instead of the final stock price minus the exercise price. Such an option provides (for a price, of

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course) a form of perfect market timing, providing the call holder with a payoff equal to the one
that would accrue if the asset were purchased for X dollars and later sold at what turns out to be
its high price.
Currency-Translated Options
Currency-translated options have either asset or exercise prices denominated in a foreign
currency. A good example of such an option is the quanto, which allows an investor to fix in
advance the exchange rate at which an investment in a foreign currency can be converted back
into dollars. The right to translate a fixed amount of foreign currency into dollars at a given
exchange rate is a simple foreign exchange option. Quantos are more interesting, however,
because the amount of currency that will be translated into dollars depends on the investment
performance of the foreign security. Therefore, a quanto in effect provides a random number of
options.
Digital Options
Digital options, also called binary or “bet” options, have fixed payoffs that depend on whether a
condition is satisfied by the price of the underlying asset. For example, a digital call option might
pay off a fixed amount of $100 if the stock price at maturity exceeds the exercise price

SWAPS

Swaps are an agreement between two counter streams to exchange cash flows in the future
according to predetermined formulas. These streams or each side of the swap are called the legs
of the swap. The cash flows are calculated over a notional principal amount. Swaps are often
used to hedge certain risks, for instance interest rate risk. Another use is speculation.
Swaps are considered to be interest rate risk management tools because they give an efficient
means of adjusting the interest rate exposure of a company’s assets and liabilities. It should be
noted that other financial instruments, such as exchange-traded interest rate futures and option
contracts, are often capable of achieving the similar results. Swaps are long-term OTC
instruments. A great flexibility in setting the terms of the swap agreement makes it a very
effective instrument in risk management (Jeff Madura).
There are two major types of Swaps: interest rate and currency. An interest rate swaps occur
when two parties exchange interest payments periodically. Currency swaps are agreement to
deliver one currency against another.

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Swaps are multiperiod extensions of forward contracts. For example, rather than agreeing to
exchange British pounds for U.S. dollars at an agreed-upon forward price at one single date, a
foreign exchange swap would call for an exchange of currencies on several future dates. The
parties might exchange $2 million for £1 million in each of the next 5 years. Similarly, interest
rate swaps call for the exchange of a series of cash flows proportional to a given interest rate for
a corresponding series of cash flows proportional to a floating interest rate. One party might
exchange a variable cash flow equal to $1 million times a short term interest rate for $1 million
times a fixed interest rate of 8% for each of the next 7 years. The swap market is a huge
component of the derivatives market, with well over $500 trillion in swap agreements
outstanding (Bodie, Kane and Marcus, 2011).

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REFERENCES

1. Bodie, Alex Kane, Alan Marcus, Investments, McGraw-Hill Irwin, 9th Ed, 2010.
2. Jeff Madura, Financial Markets and Institutions, Cengage Learning, 9th Ed, 2010
3. Bradford D. Jordan and Thomas W. Miller Jr., Fundamentals of Investments, McGraw-
Hill Companies, 5th Ed, 2011.
4. Martin Haugh Foundations of Financial Engineering, 1st Ed, 2016.

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