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444 Introduction to Financial Derivatives

Introduction Weeks of September 4 and September 9, 2013



David R Audley, Ph.D.; Sr. Lecturer in AMS

david.audley@jhu.edu Office: WH 212A; 410-516-7136 Office Hours: 4:30 5:30 Monday

Teaching Assistant(s)
Huang, Qiushun (qhuang13@jhu.edu)
Office Hours: Friday 4pm 6pm

Ward, Brian (bward16@jhu.edu)

Office Hours: Monday & Wednesday 2pm 3 pm


Lecture Encounters
Monday & Wednesday, 3:00 - 4:15pm, Mergenthaler 111

Section 1: Friday 3:00 - 3:50pm, Hodson 211 Section 2: Thursday 3:00 - 3:50pm, WH 304



Lecture Mandatory (default) for MSE Fin Math majors
Quizzes & Clickers

Section Strongly Advised/Recommended

Due as Scheduled (for full credit)
Must be handed in to avoid incomplete

Exceptions must be requested in advance



John C Hull: Options, Futures, and Other Derivatives, Prentice-Hall 2012 (8e)
Recommended: Student Solutions Manual

On Reserve in Library Text Resources

http://www.rotman.utoronto.ca/~hull/ofod/Errata8e/index.html http://www.rotman.utoronto.ca/~hull/TechnicalNotes/index.html



Supplemental Material
As directed

AMS Website
http://jesse.ams.jhu.edu/~daudley/444 Additional Subject Material
Class Resources & Lecture Slides

Industry & Street Research (Optional)

Consult at your leisure/risk Interest can generate Special Topics sessions



Measures of Performance

Mid Term Exam (~1/3 of grade) Final Exam (~1/3 of grade) Home work as assigned and designated and Quizzes (~1/3 of grade)



Thru week of Sept 9 (Next Week)

Read: Hull Chapter 1 (Introduction) Read: Hull Chapter 2 (Futures Markets) Problems (Due September 16)
Chapter 1: 17, 18, 22, 23; 34, 35
Chapter 1 (7e): 17, 18, 22, 23; 30, 31

Chapter 2: 15,16, 21, 22; 30

Chapter 2 (7e): 15, 16, 21, 22; 27



For week of Sept 16 (in 2 Weeks)

Read: Hull Chapters 3 (Hedging with Futures) Problems (Due September 23)
Chapter 3: 4, 7, 10, 17, 18, 20, 22; 26
Chapter 3 (7e): 4, 7, 10, 17, 18, 20, 22; 26


Assets and Cash

Stock, Bond, Commodity, (Assets)

Risk vs. Return (Expected Return)

Cash (or Currency)

Held, on Deposit or Borrowed

Assets things we own (long) Liabilities what we owe (short)

How Things Work

True Assets A house, a company, oil, Ownership rights, contracts, & other legal instruments which represent the true asset
For us, many are indistinguishable from the asset; are the asset Provide properties that can be quantified, assigned, subordinated and made contingent Can be modeled

Who Makes it Work

Investment Banks: Capital Intermediation

Companies into Stock Borrowings into Bonds

Broker-Dealers & Markets (Exchanges)

Create everything else Facilitate transfer/exchange (trading)

Investors Under the Watchful Eyes of Regulators, Professional Associations and the Rule of Law

Creation & Exchange of Securities and Instruments

Secondary Issues


Create Securities New Issue Securities

Make Markets

Securities & Contracts

Manage Invested Funds

Investment Banking

Broker-Dealers & Exchanges

Institutional Investors


Two Fundamental Ideas in Modeling


Repayment of Loan w/Interest at t0+T
t, time Pay Amount of Loan, t0

Cash Flow
Cash flow diagram
Receive vs. Pay over Time


Payoff Cashflow
Payoff diagram
Gain vs. Loss against Price


S, Price


Cashflows can depend on some other variable



Real World Situation - Cash

Japanese Bank; borrow US dollars (USD) to loan to its customers; term, 3 months Go to Euromarket where it might be able to get an Interbank Loan
Receive (Borrow) USD t0 + T t0 Pay Back USD+Lt0x(.25)xUSD T = 1/4 year Lt0 = 3 month interest rate in effect at t0

Borrow: USD Pay Back: USD x (1 + Lt0 x T)


Real World Situation - Cash

What if Bank did not have credit line? Could perform the same transaction as a Synthetic in the FX and domestic Yen mkt
Borrow Yen in local mkt for term T, at L(t0,Y) Sell Yen and buy USD in spot FX mkt at e(t0,Y) Finally, the bank buys Yen and sells USD in the forward FX market for delivery at t0+T


Real World Situation - Cash

Cash Flows are Additive

Y + Yx(1+L(t0,Y)xT)
Buy USD sell Y at e(t0,Y) Y = e(t0,Y) x USD Borrow Y for T



Buy Y forward for t0+T Y x (1 + L(t0,Y)xT) = f(t0,T;Y) x USD1 USD1 = USD x (1 + L(t0,$) x T)



USDx(1+L(t0,$)xT) t0 t0+T 1.17

Real World Situation - Cash

Whats the difference; whats interesting

International Banks have credit risk in the USD loan For the synthetic, the International Bank exposure is in the forward contract only
No principal risk Yen loan default is a domestic issue (central bank)

The synthetic can be used to price the derivative, excredit risk (whats the derivative in this example?) Each side could be the others hedge Different markets involve many legal & regulatory differences

Real World Situation - Tax

In Sept 02, investor bought asset S, S0=$100 EOM Nov, asset target reached at $150 (sell) Sale yields gain of $50 (taxable) Wash-Sale Rule prohibits:
Sell winner at $50 gain Sell another asset, Z thats down $50 to $50 to offset gain Buy asset Z back next day as investor still likes it Prohibited since trade is intentionally washing gain


Real World Situation - Tax

Alternative Synthetic using Options Call Option (Strike = S0)

Long has right to buy underlying at pre-specified price, S0 Short has obligation to deliver underlying at that price

Expiration Payoff Chart

+ S S0 +


For the LONG

For the SHORT


Real World Situation - Tax

Put Option (Struck at S0)

Long has right to sell underlying at pre-specified price, S0 Short has obligation to accept delivery of underlying at S0

Expiration Payoff Chart

+ S S0 + S0 S

For the LONG

For the SHORT


Real World Situation - Tax

Consider the Synthetic (to offset 50 gain)

Buy another Z asset at 50 in Nov (11/26/02) Sell an at-the-money call on Z
Strike, Z0 = 50 Expiration >= 31 days later, but in 2002 (12/30/02)

Buy an at-the-money put on Z (same expiry)

At expiration, sell the Z asset or deliver into Call


Real World Situation - Tax

Payoff Charts for the Synthetic


Price at the expiration of the options, Ze 50

Z If Ze > 50: Short Call looses money as short has to deliver Z for 50 Long Put is worthless If Ze < 50: Short Call is worthless Long Put gains as the long can sell Z for 50 In either case the investor has locked in the 50 price for the stock 1.23 bought at 100 (FIFO)

Short Call

Long Put

50 Z +

Synthetic Short in Z

50 Z

Real World Situation - Tax

The timing issue is important

According to US Tax law, wash sale rules apply if the investor acquires or sells a substantially identical property within a 31-day period In the synthetic strategy, the second Z is purchased on 11/20; while the options expire on 12/30 when the first Z is sold (and the tax loss is booked FIFO accounting)


Real World Examples Consequences & Implications

Strategies are Risk Free and Zero Cost (aside from commissions and fees) We created a Synthetic (using Derivatives) and used it to provide a solution Finally, and most important, these examples display the crucial role Legal & Regulatory frameworks can play in engineering a financial strategy (its the environment)

Two Points of View

Manufacturer (Dealer) vs. User (Investor) Dealers View: there are two prices
A price he will buy from you (low) A price he will sell to you (high) Its how the dealer makes money

Dealer never has money; not like an investor

Must find funding for any purchase Place the cash from any sale Leverage

Two Points of View

Dealers prefer to work with instruments that have zero value at initiation (x bid/ask)
Likely more liquid No principal risk

Regulators, Professional Organizations, and the Law are more important for market professionals than investors
Dealers vs. Investors

The Nature of Derivatives

A derivative is an instrument whose value depends on the values of other more basic underlying variables


Examples of Derivatives

Futures Contracts Forward Contracts Swaps Options


Derivatives Markets

Exchange traded
Traditionally exchanges have used the openoutcry system, but increasingly they are switching to electronic trading Contracts are standard; virtually no credit risk

Over-the-counter (OTC)
A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard and there is some (small) amount of credit risk

Size of OTC and Exchange Markets

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market 1.31

Ways 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

Forward Price

The forward price (for a contract) is the delivery price that would be applicable to a forward contract if were negotiated today (i.e., the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities



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



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?

Profit (or Payoff) from a Long Forward Position


Price of Underlying at Maturity, ST Payoff at T = ST K


Profit from a Short Forward Position

Profit = Payoff at T = K - ST

Price of Underlying at Maturity, ST


Foreign Exchange Quotes for GBP May 24, 2010

Bid 1.4407 1.4408 Offer 1.4411 1.4413

Spot 1-month forward

3-month forward
6-month forward




Foreign Exchange Quotes for JPY Jan 22, 2007 (16:23 EST)
Bid 121.62 121.08 Offer 121.63 121.09

Spot 1-month forward

3-month forward
6-month forward



1. Gold: An Arbitrage Opportunity?

Suppose that: The spot price of gold is US$900 The 1-year forward price of gold is US$1,020 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?


2. Gold: Another Arbitrage Opportunity?

Suppose that: The spot price of gold is US$900 The 1-year forward price of gold is US$900 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?


The Forward Price of Gold The Principal of Cash and Carry

If the spot price of gold is S(t0) and the forward price for a contract deliverable in T years is F(t0,T), then Can borrow money, buy gold, and sell the commodity forward - where there should be no arbitrage:

F(t0,T) - S(t0) x (1+r )T = 0

where r is the 1-year money rate of interest to finance the gold carry trade. In our examples, S = 900, T = 1, and r =0.05 so that F(t0,T) = 900(1+0.05) = 945 The no arbitrage 1 year forward price of gold is $945

The Forward Price of Gold The Principal of Cash and Carry

How does this come about?

receive pay t0 S(t0)

Borrow S(t0)


Buy Gold at S(t0)


F(t0) Gold

Sell Gold Forward at F(t0)

Own Deliver Gold Gold

No Arbitrage condition says: F(t0) S(t0)x(1+r) = 0 1.43

Gold Arbitrage?

The no arbitrage gold, 1-year forward condition is

F(t0,T) - S(t0) x (1+r )T = 0

If 1-year forward is $1020, then

F(t0,T) - S(t0) x (1+r )T > 0

so our strategy is to borrow money, buy gold, sell it forward, deliver gold, and pay off loan for a riskless profit of $75 If 1-year forward is $900, then

F(t0,T) - S(t0) x (1+r )T < 0

and if I own gold, I can sell it, deposit proceeds, buy forward, pay with the proceeds of the deposit and collect a riskless profit of $45 over the 1-year period

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


Futures Contracts

Forward contracts are similar to futures except that they trade in the over-thecounter market Forward contracts are particularly popular on currencies and interest rates


Exchanges Trading Futures

Chicago Board of Trade (CME) Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more (see list at end of book)

Examples of Futures Contracts

Agreement to: Buy 100 oz. of gold @ US$1080/oz. in December (NYMEX) Sell 62,500 @ 1.4410 US$/ in March (CME) Sell 1,000 bbl. of oil @ US$120/bbl. in April (NYMEX)

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)


American vs European Options

An American style option can be exercised at any time during its life A European style option can be exercised only at maturity


Intel Option Prices (Sept 12, 2006; Stock Price=19.56)

Strike Price 15.00
17.50 20.00

Oct Call 4.650

2.300 0.575

Jan Call 4.950

2.775 1.175

Apr Call 5.150

3.150 1.650

Oct Put 0.025

0.125 0.875

Jan Put 0.150

0.475 1.375

Apr Put 0.275

0.725 1.700









Exchanges Trading Options

Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) and many more (see list at end of book)

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


Types of Traders
Speculators Arbitrageurs
Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators (See, for example, SocGen (Jerome Kerviel) in Business Snapshot 1.3, page 17)

Hedging Examples (pages 10-12)

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 An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put option with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

Hedging Example

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 Possible strategies:
Buy now, deposit in bank, withdraw 10 million in 3 months, pay for imports Buy 10 million forward in 3 months, deposit USD, use deposit proceeds to settle and pay for imports Do nothing now and buy 10 million in the spot FX market in 3 months

First 2 are riskless, third has currency risk. Which makes most sense?

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


Speculation Example

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 alternative strategies?

Buy 100 shares or Buy 20 Calls (on 100 shares each)


Arbitrage Example

A stock price is quoted as 100 in London and $140 in New York The current exchange rate is 1.4410 What is the arbitrage opportunity? Buy 100 shares in NY; sell 100 in London
= 100 [(1.441 x 100) 140] = 410

Futures Contracts

Available on a wide range of underlyings Exchange traded Specifications need to be defined:

What can be delivered, Where it can be delivered, & When it can be delivered

Settled daily

Forward Contracts vs Futures Contracts

FORWARDS Private contract between 2 parties Non-standard contract Usually 1 specified delivery date Settled at end of contract FUTURES Exchange traded Standard contract Range of delivery dates Settled daily

Delivery or final cash settlement usually occurs

Some credit risk

Contract usually closed out prior to maturity

Virtually no credit risk 1.61


A margin is cash or marketable securities deposited by an investor with the broker

Initial Margin Maintenance Margin

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

Example: Futures Trade (page 27-28)


A Possible Outcome
Table 2.1, Page 28


Other Key Points About Futures

They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity


Collateralization in OTC Markets

It is becoming increasingly common for contracts to be collateralized in OTC markets They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week)


Another Detail for Cash and Carry Arbitrage

Contract price changes with longer term

Higher or Lower

To this point we have neglected storage cost Lets re-visit no-arbitrage equation
F(t0,T) - S(t0) x [(1+r )T ] = Storage (T)

Storage costs ignored in earlier gold example No storage costs for FX Convenience Yield

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?

2. Oil: Another Arbitrage Opportunity?

Suppose that: - The spot price of oil is US$95 - The quoted 1-year futures price of oil is US$80 - The 1-year US$ interest rate is 5% per annum - The storage costs of oil are 2% per annum Is there an arbitrage opportunity?

Futures Prices for Gold on Jan 8, 2007: Prices Increase with Maturity


Futures Price ($ per oz)

640 630 620 610

Contract Maturity Month

600 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08


Futures Prices for Orange Juice on Jan 8, 2007: Prices Decrease with Maturity

Futures Price (cents per lb)

210 205 200

190 185 180 175 170 Jan-07 Mar-07 May-07 Jul-07

Contract Maturity Month

Sep-07 Nov-07



If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash


Some Terminology

Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of contracts traded in 1 day

Convergence of Futures to Spot

Futures Price Spot Price

Spot Price Futures Price






When a new trade is completed what are the possible effects on the open interest? Can the volume of trading in a day be greater than the open interest?


Regulation of Futures

Regulation is designed to protect the public interest

CFTC the Feds

Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups
NFA the industry

The End for Today