Topic 1 Introduction To Derivatives

Basics

A derivative (or derivative security) is a financial instrument whose value depends upon the value of other, more basic, underlying variables. Some common examples include things such as stock options, futures, and forwards. It can also extend to something like a reimbursement program for college credit. Consider that if your firm reimburses 100% of costs for an A, 75% of costs for a B, 50% for a C and 0% for anything less.
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Basics

Your right to claim this reimbursement, then is tied to the grade you earn. The value of that reimbursement plan, therefore, is derived from the grade you earn. We also say that the value is contingent upon the grade you earn. Thus, your claim for reimbursement is a contingent claim. The terms contingent claims and derivatives are used interchangeably.

Basics

So why do we have derivatives and derivatives markets?

Because they somehow allow investors to better control the level of risk that they bear. They can help eliminate idiosyncratic risk. They can decrease or increase the level of systematic risk.

A First Example

There is a neat example from the bond-world of a derivative that is used to move non-diversifiable risk from one set of investors to another set that are, presumably, more willing to bear that risk. Disney wanted to open a theme park in Tokyo, but did not want to have the shareholders bear the risk of an earthquake destroying the park.

They financed the park through the issuance of earthquake bonds. If an earthquake of at least 7.5 hit within 10 km of the park, the bonds did not have to be repaid, and there was a sliding scale for smaller quakes and for larger ones that were located further away from the park.
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A First Example

Normally this could have been handled in the insurance (and re-insurance) markets, but there would have been transaction costs involved. By placing the risk directly upon the bondholders Disney was able to avoid those transactions costs.

Presumably the bondholders of the Disney bonds are basically the same investors that would have been holding the stock or bonds of the insurance/reinsurance companies. Although the risk of earthquake is not diversifiable to the park, it could be to Disney shareholders, so this does beg the question of why buy the insurance at all.

This was not a free insurance. Disney paid LIBOR+310 on the bond. If the earthquake provision was not it there, they would have paid a lower rate.
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A First Example

This example illustrates an interesting notion that insurance contracts (for property insurance) are really derivatives! They allow the owner of the asset to sell the insured asset to the insurer in the event of a disaster. They are like put options (more on this later.)

Basics

Positions In general if you are buying an asset be it a physical stock or bond, or the right to determine whether or not you will acquire the asset in the future (such as through an option or futures contract) you are said to be LONG the instrument. If you are giving up the asset, or giving up the right to determine whether or not you will own the asset in the future, you are said to be SHORT the instrument.

In the stock and bond markets, if you short an asset, it means that you borrow it, sell the asset, and then later buy it back. In derivatives markets you generally do not have to borrow the instrument you can simply take a position (such as writing an option) that will require you to give up the asset or determination of ownership of the asset. Usually in derivatives markets the short is just the negative of the long position
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Basics

Commissions Virtually all transactions in the financial markets requires some form of commission payment.

The size of the commission depends upon the relative position of the trader: retail traders pay the most, institutional traders pay less, market makers pay the least (but still pay to the exchanges.) The larger the trade, the smaller the commission is in percentage terms.

Bid-Ask spread Depending upon whether you are buying or selling an instrument, you will get different prices. If you wish to sell, you will get a BID quote, and if you wish to buy you will get an ASK quote.
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Basics

The difference between the bid and the ask can vary depending upon whether you are a retail, institutional, or broker trader; it can also vary if you are placing very large trades. In general, however, the bid-ask spread is relatively constant for a given customer/position. The spread is roughly a constant percentage of the transaction, regardless of the scale unlike the commission. Especially in options trading, the bid-ask spread is a much bigger transaction cost than the commission.
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Basics

The point of the preceding slide is to demonstrate that the bid-ask spread can be a huge factor in determining the profitability of a trade.

Many of those option positions require at least a 10% price movement before the trade is profitable.

Many trading strategies that you see people propose (and that are frequently demonstrated using real data) are based upon using the average of the bid-ask spread. They usually lose their effectiveness when the bid-ask spread is considered.

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Basics

Market Efficiency We normally talk about financial markets as being efficient information processors.

Markets efficiently incorporate all publicly available information into financial asset prices. The mechanism through which this is done is by investors buying/selling based upon their discovery and analysis of new information. The limiting factor in this is the transaction costs associated with the market. For this reason, it is better to say that financial markets are efficient to within transactions costs. Some financial economists say that financial markets are efficient to within the bid-ask spread. Now, to a large degree for this class we can ignore the bid-ask spread, but there are some points where it will be particularly relevant, and we will consider it then.

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Basics

Before we begin to examine specific contracts, we need to consider two additional risks in the market:

Credit risk the risk that your trading partner might not honor their obligations.

Familiar risk to anybody that has traded on ebay! Generally exchanges serve to mitigate this risk. Can also be mitigated by escrow accounts.

Margin requirements are a form of escrow account.

Liquidity risk the risk that when you need to buy or sell an instrument you may not be able to find a counterparty.

Can be very common for outsiders in commodities markets.

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Basics

So now we are going to begin examining the basic instruments of derivatives. In particular we will look at (tonight):

Forwards Futures Options

The purpose of our discussion tonight is to simply provide a basic understanding of the structure of the instruments and the basic reasons they might exist.

We will have a more in-detail examination of their properties, and their pricing, in the weeks to come.

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Forward Contracts
A forward contract is an agreement between two parties to buy or sell an asset at a certain future time for a certain future price.

Forward contracts are normally not exchange traded. The party that agrees to buy the asset in the future is said to have the long position. The party that agrees to sell the asset in the future is said to have the short position. The specified future date for the exchange is known as the delivery (maturity) date.

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Forward Contracts
The specified price for the sale is known as the delivery price, we will denote this as K.

Note that K is set such that at initiation of the contract the value of the forward contract is 0. Thus, by design, no cash changes hands at time 0. The mechanics of how to do this we cover in later lectures.

As time progresses the delivery price doesnt change, but the current spot (market) rate does. Thus, the contract gains (or loses) value over time.

Consider the situation at the maturity date of the contract. If the spot price is higher than the delivery price, the long party can buy at K and immediately sell at the spot price ST, making a profit of (ST-K), whereas the short position could have sold the asset for ST, but is obligated to sell for K, earning a profit (negative) of (K-ST).

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Forward Contracts

Example:

In this example you were the long party, but what about the short party? They have agreed to sell wheat to you for $4.00/bushel on December 14. Their payoff is positive if the market price of wheat is less than $4.00/bushel they force you to pay more for the wheat than they could sell it for on the open market.

Indeed, you could assume that what they do is buy it on the open market and then immediately deliver it to you in the forward contract.

Their payoff is negative, however, if the market price of wheat is greater than $4.00/bushel.

They could have sold the wheat for more than $4.00/bushel had they not agreed to sell it to you.

So their payoff function is the mirror image of your payoff function:

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Forward Contracts

Clearly the short position is just the mirror image of the long position, and, taken together the two positions cancel each other out:

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Futures Contracts

A futures contract is similar to a forward contract in that it is an agreement between two parties to buy or sell an asset at a certain time for a certain price. Futures, however, are usually exchange traded and, to facilitate trading, are usually standardized contracts. This results in more institutional detail than is the case with forwards. The long and short party usually do not deal with each other directly or even know each other for that matter. The exchange acts as a clearinghouse. As far as the two sides are concerned they are entering into contracts with the exchange. In fact, the exchange guarantees performance of the contract regardless of whether the other party fails.
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Futures Contracts

The largest futures exchanges are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). Futures are traded on a wide range of commodities and financial assets. Usually an exact delivery date is not specified, but rather a delivery range is specified. The short position has the option to choose when delivery is made. This is done to accommodate physical delivery issues.

Harvest dates vary from year to year, transportation schedules change, etc.
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Futures Contracts

The exchange will usually place restrictions and conditions on futures. These include:

Daily price (change) limits. For commodities, grade requirements. Delivery method and place. How the contract is quoted.

Note however, that the basic payoffs are the same as for a forward contract.

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Options Contracts

Options on stocks were first traded in 1973. That was the year the famous Black-Scholes formula was published, along with Mertons paper - a set of academic papers that literally started an industry. Options exist on virtually anything. Tonight we are going to focus on general options terminology for stocks. We will get into other types of options later in the class. There are two basic types of options:

A Call option is the right, but not the obligation, to buy the underlying asset by a certain date for a certain price. A Put option is the right, but not the obligation, to sell the underlying asset by a certain date for a certain price.

Note that unlike a forward or futures contract, the holder of the options contract does not have to do anything - they have the option to do it or not.
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Options Contracts

The date when the option expires is known as the exercise date, the expiration date, or the maturity date. The price at which the asset can be purchased or sold is known as the strike price. If an option is said to be European, it means that the holder of the option can buy or sell (depending on if it is a call or a put) only on the maturity date. If the option is said to be an American style option, the holder can exercise on any date up to and including the exercise date. An options contract is always costly to enter as the long party. The short party always is always paid to enter into the contract

Looking at the payoff diagrams you can see why

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Options Contracts

Lets say that you entered into a call option on IBM stock:

Today IBM is selling for roughly $78.80/share, so lets say you entered into a call option that would let you buy IBM stock in December at a price of $80/share. If in December the market price of IBM were greater than $80, you would exercise your option, and purchase the IBM share for $80. If, in December IBM stock were selling for less than $80/share, you could buy the stock for less by buying it in the open market, so you would not exercise your option.

Thus, your payoff diagram is:

Thus your payoff to the option is $0 if the IBM stock is less than $80 It is (ST-K) if IBM stock is worth more than $80

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Options Contracts

What if you had the short position? Well, after you enter into the contract, you have granted the option to the long-party. If they want to exercise the option, you have to do so. Of course, they will only exercise the option when it is in there best interest to do so that is, when the strike price is lower than the market price of the stock.

We can thus write your payoff as:

payoff = min(0,ST-K), which has a graph that looks like:

So if the stock price is less than the strike price (ST<K), then the long party will just buy the stock in the market, and so the option will expire, and you will receive $0 at maturity. If the stock price is more than the strike price (ST>K), however, then the long party will exercise their option and you will have to sell them an asset that is worth ST for $K.

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Options Contracts

Recall that a put option grants the long party the right to sell the underlying at price K. Returning to our IBM example, if K=80, the long party will only elect to exercise the option if the price of the stock in the market is less than $80, otherwise they would just sell it in the market. The payoff to the holder of the long put position, therefore is simply payoff = max(0, K-ST)

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Options Contracts

The short position again has granted the option to the long position. The short has to buy the stock at price K, when the long party wants them to do so. Of course the long party will only do this when the stock price is less than the strike price. Thus, the payoff function for the short put position is: payoff = min(0, ST-K) And the payoff diagram looks like:

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Options Contracts

Traders frequently refer to an option as being in the money, out of the money or at the money.

An in the money option means one where the price of the underlying is such that if the option were exercised immediately, the option holder would receive a payout.

An at the money option means one where the strike and exercise prices are the same. An out of the money option means one where the price of the underlying is such that if the option were exercised immediately, the option holder would NOT receive a payout.

For a call option this means that St>K For a put option this means that St<K

For a call option this means that St<K For a put option this means that St>K.

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Options Contracts

We will come back to put-call parity in a few weeks, but it is well worth keeping this diagram in mind. So who trades options contracts? Generally there are three types of options traders:

Hedgers - these are firms that face a business risk. They wish to get rid of this uncertainty using a derivative. For example, an airline might use a derivatives contract to hedge the risk that jet fuel prices might change. Speculators - They want to take a bet (position) in the market and simply want to be in place to capture expected up or down movements. Arbitrageurs - They are looking for imperfections in the capital market.
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