An Introduction to Forwards and Options

Forward contracts
Call options
Put options
Summary of forward and option
positions
Options are insurance
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Introduction
Basic derivatives contracts
Forward contracts
Call options
Put Options
Types of positions
Long position
Short position
Graphical representation
Payo diagrams
Prot diagrams
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Forward Contracts
Denition: a binding agreement (obligation) to buy/sell
an underlying asset in the future, at a price set today
Futures contracts are the same as forwards in principle
except for some institutional and pricing dierences.
A forward contract species
The features and quantity of the asset to be delivered
The delivery logistics, such as time, date, and place
The price the buyer will pay at the time of delivery
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Reading Price Quotes
Reading Price Quotes
Daily change
Open interest
Settlement price
Lowof the day
High of the day
The open price
Expiration month
Index futures price
listings.
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Payo on a Forward Contract
Payo for a contract is its value at expiration
Payo for
Long forward payo = ? - ?
Short forward payo = ? - ?
Example: S&R (special and rich) index:
Today: Spot price = $1,000, 6-month forward price
= $1,020
In six months at contract expiration: Spot price S
180
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Payo on a Forward Contract-contd
spot price (S
180
) forward price long position short position
900
950
1000
1020
1050
1100
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Payo Diagram for Forwards: Long and short
forward positions on the S&R 500 index
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Forward Versus Outright Purchase
Comparison of payo after 6 months of a long position in
the S&R index versus a forward contract in the S&R
index.
Whats the same, whats dierent?
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Comparison of payo after 6 months of a long position in the S&R index
versus a forward contract in the S&R index.
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Adding a zero coupon bond
What if we invest a zero coupon bond? Assume 6-month
interest rate is 2%.
Forward+bond = Spot price at expiration $1, 020

Forward payo
+ $1, 020

Bond payo
= Spot price at expiration
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Payo vs. Prot diagram
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Additional Considerations
Type of settlement
Cash settlement: less costly and more practical
Physical delivery: often avoided due to signicant
costs
Credit risk of the counter party
Major issue for over-the-counter contracts
Credit check, collateral, bank letter of credit
Less severe for exchange-traded contracts
Exchange guarantees transactions, requires
collateral
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Call Options
A non-binding agreement (right but not an obligation) to
buy an asset in the future, at a price set today
Preserves the upside potential, while at the same time
eliminating the unpleasant downside (for the buyer)
The seller of a call option is obligated to deliver if asked
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Denition and Terminology
A call option gives the owner the right but not the
obligation to buy the underlying asset at a predetermined
price during a predetermined time period
Strike (or exercise) price: the amount paid by the option
buyer for the asset if he/she decides to exercise
Exercise: the act of paying the strike price to buy the asset
Expiration: the date by which the option must be
exercised or become worthless
Exercise style: species when the option can be exercised
European-style: can be exercised only at expiration
date
American-style: can be exercised at any time before
expiration
Bermudan-style: Can be exercised during specied
periods
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Closing prices, daily volume, and open interest for S&P 500 options, listed
on the Chicago Board Options Exchange, on August 14, 2007. The S&P
500 index closed that day at 1426.54
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Examples
Today: call buyer acquires the right to pay $1,020 in six
months for the index, but is not obligated to do so
In six months at contract expiration: if spot price is
$1,100, call buyers payo =
$900, call buyers payo =
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Examples
Today: call seller is obligated to sell the index for $1,020
in six months, if asked to do so
In six months at contract expiration: if spot price is
$1,100, call sellers payo =
$900, call sellers payo =
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Payo/Prot of a Purchased Call
Payo = Max [0, spot price at expiration strike price]
Prot = Payo future value of option premium
Examples 2.5 & 2.6:
S&R Index 6-month Call Option
Strike price = $1,000, Premium = $93.81,
6-month risk-free rate = 2%
If index value in six months = $1100
Payo = max [0, $1,100 $1,000] = $100
Prot = $100 ($93.81 x 1.02) = $4.32
If index value in six months = $900
Payo = max [0, $900 $1,000] = $0
Prot = $0 ($93.81 x 1.02) = $95.68
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Payo and prot after 6 months
purchased $1,000-strike S&R call option.
The option premium is assumed to be $93.81 and the
eective interest rate is 2% over 6 months.
price in 6 months call payo FV(premium) call prot
800
850
900
950
1000
1050
1100
1150
1200
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Diagrams for Purchased Call
Payoff at expiration Profit at expiration
The payoff at expiration of a purchased
S&R call with a $1000 strike price.
Profit at expiration for purchase of 6-month
S&R index call with strike price of $1000 versus
profit on long S&R index forward position.
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Payo/Prot of a Written Call
Payo = max [0, spot price at expiration strike price]
Prot = Payo + future value of option premium
Example 2.7
S&R Index 6-month Call Option
Strike price = $1,000, Premium = $93.81,
6-month risk-free rate = 2%
If index value in six months = $1100
Payo = max [0, $1,100 $1,000] = $100
Prot = $100 + ($93.81 x 1.02) = $4.32
If index value in six months = $900
Payo = max [0, $900 $1,000] = $0
Prot = $0 + ($93.81 x 1.02) = $95.68
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Put Options
A put option gives the owner the right but not the
obligation to sell the underlying asset at a predetermined
price during a predetermined time period
The seller of a put option is obligated to buy if asked
Payo/prot of a purchased (i.e., long) put
Payo = max [0, strike price spot price at
expiration]
Prot = Payo future value of option premium
Payo/prot of a written (i.e., short) put
Payo = max [0, strike price spot price at
expiration]
Prot = Payo + future value of option premium
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Put Option Examples
Examples 2.9 & 2.10
S&R Index 6-month Put Option
Strike price = $1,000, Premium = $74.20,
6-month risk-free rate = 2%
If index value in six months = $1100
Payo = max [0, $1,000 $1,100] = $0
Prot = $0 ($74.20 x 1.02) = $75.68
If index value in six months = $900
Payo = max [0, $1,000 $900] = $100
Prot = $100 ($74.20 x 1.02) = $24.32
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Prot for a Long Put Position
Prot table
Prot after 6
months from a
purchased
1000-strike
S&R put
option with a
future value of
premium of
$75.68.
S&R Index Put Future Value Put
in 6 Months Payo of Premium Prot
$800 $200 -$75.68 $124.32
850 150 -75.68 74.32
900 100 -75.68 24.32
950 50 -75.68 -25.68
1000 0 -75.68 -75.68
1050 0 -75.68 -75.68
1100 0 -75.68 -75.68
1150 0 -75.68 -75.68
1200 0 -75.68 -75.68
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A Few Items to Note
A call option becomes more protable when the
underlying asset appreciates in value
A put option becomes more protable when the
underlying asset depreciates in value
Moneyness
In-the-money option: positive payo if exercised
immediately
At-the-money option: zero payo if exercised
immediately
Out-of-the money option: negative payo if exercised
immediately
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Option and Forward Positions: A Summary
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Maximum possible prot and loss at maturity for
long and short forwards and purchased and written
calls and puts. FV(premium) denotes the future
value of the option premium
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Prot diagrams for the three basic long positions:
long forward, purchased call, and written put.
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Prot diagrams for the three basic short positions:
short forward, written call, and purchased put
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Forwards, calls, and puts at a glance: a summary of
forward and option positions.
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