Warm Up

Yuna Heo

Yuna Heo 1.1

 Derivatives?
A derivative is an instrument whose value
depends on the values of other more basic
underlying assets.

Underlying assets: stocks, bonds, currencies,

interest rates, commodities, electricity,
weather, etc...

Yuna Heo 1.2

 Examples of Derivatives

Futures Contracts
Forward Contracts
Swaps
Options
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 How do we decide the price of
(underlying) assets?
• The financial markets in which we can borrow or lend money
allows us to exchange consumption between the present and
the future.
Consumption
Next Period Lend

E1
Borrow

E0 Consumption
Now
• So, now we know how to derive the price.
• But, markets are perfect?
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 In reality:

Markets are not perfect, although most theoretical

models typically assume that markets are perfect.

Ex post everything seems much clearer than it did

ex ante.
It is easy to spot anomalies ex post.

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 Ways Derivatives are Used
• Hedgers: to hedge risks

• Speculators: to speculate
(take a view on the future direction of the market)

• Arbitrageurs: to lock in an arbitrage profit

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

Yuna Heo 1.6

 • Trading example

1. Hedge

2. Speculation

3. Arbitrage

Yuna Heo 1.7

 1. Hedge

• An investor owns 1,000 Microsoft shares

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

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 1. Hedge
40,000 Value of
Holding ($)

35,000

No Hedging
30,000 Hedging

25,000

Stock Price ($)

20,000
20 25 30 35 40

Value of Microsoft Shares with and without Hedging

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 2. Speculation

• An investor with $4,000 to invest feels that

Amazon.com’s stock price will increase
over the next 2 months. The current stock
price is $40 and the price of a 2-month call
option with a strike of 45 is $2

Yuna Heo 1.10

 3. Arbitrage
• Arbitrage opportunities when forward
price is out of line with spot price for asset
providing no income
Asset price = $40
interest rate = 5%
maturity = 3 month

if forward price is $43?

if forward price if $39?

Yuna Heo 1.11

 Examples of Derivatives

Futures Contracts
Forward Contracts
Swaps
Options
Yuna Heo 1.12
 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

Yuna Heo 1.13

 1. Futures
• A futures contract is an agreement to buy or
sell an asset at a certain time in the future for a
certain price

• The futures prices for a particular contract is

the price at which you agree to buy or sell

• It is determined by supply and demand in the

same way as a spot price

Yuna Heo 1.14

 1. Futures
<Example>
• January: an investor enters into a long
futures contract on COMEX to
buy 100 oz of gold @ $300 in April

• April: the price of gold $315 per oz

What is the investor’s profit?

Yuna Heo 1.15

 1. Futures
• Traditionally futures
contracts have been traded
using the open outcry
system where traders
physically meet on the
floor of the exchange

• Increasingly this is being

replaced by electronic
trading where a computer
matches buyers and sellers
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 2. Forward
• Forward contracts are popular on currencies
and interest rates

• Forward contracts trade in the over-the-

counter market

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 2. Forward
• The over-the counter market is an important
alternative to exchanges

• It is a telephone and computer-linked network

of dealers who do not physically meet
(see, for example, the movie “Margin Call”)

• Trades are usually between financial

institutions, corporate treasurers, and fund
managers

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 2. Forward
The size of the over the counter market
200 Size of Market ($
trillion)
150

OTC
100 Exchange

50

0
Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03

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

Yuna Heo 1.19

 2. Forward
Example:
Foreign Exchange Quotes for GBP
Bid Offer
Spot 1.6281 1.6285

1-month forward 1.6248 1.6253

3-month forward 1.6187 1.6192

6-month forward 1.6094 1.6100

Yuna Heo 1.20

 3. Options

• A call option is an option to buy a certain

asset by a certain date for a certain price
(the strike price)

• A put option is an option to sell a certain

asset by a certain date for a certain price
(the strike price)

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 3. Options
>> American vs. European Options

• An American option can be exercised at any

time during its life

• A European option can be exercised only at

maturity

For example,
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 Discussion
“Options and futures are zero-sum games.”

What do you think is meant by this

statement?

Proof.

Yuna Heo 1.23