Chapter 9 AN INTRODUCTION TO DERIVATIVE INSTRUMENTS.

Chapter 9Chapter 9

AN INTRODUCTION TO DERIVATIVE INSTRUMENTS

1.2Investments Chapter 9

Chapter 9 Questions

What are the basic features of forward contracts, futures contracts, and options contracts?

Why do derivative securities exist? How do they help meet investor needs and increase market efficiency?

What are the similarities and differences between forward contracts and futures contracts?

What terminology do we use to describe option contracts? What does a payoff diagram show? What are the risks and potential returns from option

positions such as buying and writing calls; buying and writing puts; owning long and short positions in spreads, straddles, strangles, or butterfly spreads?

What are the relationships among the prices of puts, calls, and futures?


Derivative Instruments

Value is determined by, or derived from, the value of another investment vehicle, called the underlying asset or security

Forward contracts are agreements between two parties - the buyer agrees to purchase an asset, the seller agrees to sell the asset, at a specific date at a price agreed upon now

Futures contracts are similar, but are standardized and traded on an organized exchange


Derivative Instruments

Options offer the buyer the right, but not the obligation, to buy or sell and underlying asset at a fixed price up to or on a specific date

Buyer is long in the contract Seller or “writer” is short the contract The price at which the transaction would we made is the

exercise or strike price The profit or loss on an option position depends on the

market price


Why Do Derivatives Exist?

Assets are traded in the cash or spot market Sometimes have one’s fortunes dependent on spot

price movements leads to considerable riskVarious derivatives markets have evolved that allow

some investors to manage these risks, while also creating opportunities for speculators to invest in the same contracts


Potential Benefits of Derivatives

Risk shiftingEspecially shifting the risk of asset price changes or interest

rate changes to another party willing to bear that risk Price formation

Speculation opportunities when some investors may feel assets are mis-priced

Investment cost reductionTo hedge portfolio risks more efficiently and less costly than

would otherwise be possible


Forward Contracts

An agreement between two parties to exchange an asset at a specified price on a specified date

Buyer is long, seller is short; symmetric gains and losses as price changes, zero sum game

Contracts trade OTC, have negotiable terms, and are not liquid

Subject to credit risk or default risk Value realized only at expiration Popular in currency exchange markets


Futures Contracts

Like forward contracts…Buyer is long and is obligated to buySeller is short and is obligated to sell

Unlike forward contracts…Standardized – traded on exchangeMore liquidity - can “reverse” a position and offset the future

obligation, other party is the exchangeLess credit risk - initial margin required Additional margin needs are determined through a daily

“marking to market” based on price changes


Futures Contracts

Chicago Board of Trade (CBOT)Grains, Treasury bond futures

Chicago Mercantile Exchange (CME)Foreign currencies, Stock Index futures, livestock futures,

Eurodollar futures New York Mercantile Exchange (NYMEX)

Crude oil, gasoline, heating oil futures Development of new contracts

Futures exchanges look to develop new contracts that will generate significant trading volume


Futures Contracts

Futures QuotationsOne contract is for a fixed amount of the underlying asset

5,000 bushels of corn (of a certain grade)$250 x Index for S&P 500 Index Futures (of a certain maturity)

Prices are given in terms of the underlying assetCents per bushel (grains)Value of the index

Value of one contract is price x contract amountSettle is the closing price from the previous day


Futures Contracts

Example: Suppose you bought (go long) the most recent (Sept.) S&P 500 contract at the settle price (see Exhibit 17.4).

What was the original contract value?Value = $250 x 1095.20 = $273,800 What is your profit if you close your position (sell a contract)

for 1120.00?Value = $250 x 1120.00 = $280,000Profit = $280,000 - $273,800 = $6,200


Options

Option Terminology Option to buy is a call option Option to sell is a put option Option premium – price paid for the option Exercise price or strike price – the price at which

the asset can be bought or sold under the contract


Options

Intrinsic Value of OptionsCall Option Intrinsic Value = Max [0, V-X]Put Option Intrinsic Value = Max [0, X-V]

V = Stock ValueX = Strike Price

Option values cannot be negative since they need not be exercised if it is not in the owner’s interest to do so


Options

Option Terminology Expiration date

European: can be exercised only at expirationAmerican: exercised any time before expiration

In-the-money: option has positive intrinsic value, would be exercised if it were expiring

Out-of-the-money: option has zero intrinsic value, would not be exercised if expiringIf not expiring, could still have value since it could later

become in-the-money


Options

Example: Suppose you own a call option with an exercise (strike) price of $30.

If the stock price is $40 (in-the-money):Your option has an intrinsic value of $10 You have the right to buy at $30, and you can exercise and

then sell for $40. If the stock price is $20 (out-of-the-money):

Your option has an intrinsic value of zeroYou would not exercise your right to buy something for $30

that you can buy for $20!


Options

Example: Suppose you own a put option with an exercise (strike) price of $30.

If the stock price is $20 (in-the-money):Your option has an intrinsic value of $10 You have the right to sell at $30, so you can buy the stock at

$20 and then exercise and sell for $30 If the stock price is $40 (out-of-the-money):

Your option has no intrinsic valueYou would not exercise your right to sell something for $30

that you can sell for $40!


Options

Chicago Board Options Exchange (CBOE)Centralized facility for trading standardized option contractsClearing Corporation is the opposite party to all trades,

allowing buyers and sellers to terminate positions prior to expiration with offsetting trades

Standardized expiration dates, exercise prices, and contract sizes

Secondary market with standardized contractsOffer options on almost 1,400 stocks and also index options


Options

Stock Option QuotationsOne contract is for 100 shares of stockQuotations give:

Underlying stock and its current priceStrike priceMonth of expirationPremiums per share for puts and callsVolume of contracts

Premiums are often smallA small investment can be “leveraged” into high profits (or

losses)


Options

Example: Suppose that you buy a January $30 call option on Microsoft (see Exhibit 17.9).

What is the cost of your contract? Cost = $.95 x 100 = $95

Is your contract in-the-money?

No. The current stock price is $28.48, so the intrinsic value is $0 per share.


Options

Example (cont.): What is your dollar profit (loss) if, at expiration, Microsoft is

selling for $25?

Out-of-the-money, so Profit = ($95)

Is your percentage profit with options?

Return = (0-.95)/.95 = (100%)

What if you had invested in the stock?

Return = (25-28.48)/28.48 = (12.22%)


Options


selling for $30.50?

Profit = 100(30.5-30) – 95 = ($45)


Return = (30.50-30-.95)/.95 = (47.37%)


Return = (30.50-28.48)/28.48 = 7.09%


Options


selling for $35?

Profit = 100(35-30) – 95 = $405


Return = (35-30-.95)/.95 = 426.32%


Return = (35-28.48)/28.48 = 22.89%


Options

Payoff diagramsShow payoffs at expiration for different stock prices (V) for a

particular option contract with a strike price of XFor calls:

if the V<X, the payoff is zeroIf V>X, the payoff is V-XPayoff = Max [0, V-X]

For puts:if the V>X, the payoff is zeroIf V<X, the payoff is X-VPayoff = Max [0, X-V]


Option Trading Strategies

There are a number of different option strategies:

Buying call options

Selling call options

Buying put options

Selling put options

Option spreads


Buying Call Options

Position taken in the expectation that the price will increase (long position)

Profit for a purchasing a Call Option:

Per Share Profit =Max [0, V-X] – Call Premium

Note that profits on an option strategy include option payoffs and the premium paid for the option

The following diagram shows different total dollar profits for buying a call option with a strike price of $70 and a premium of $6.13


Buying Call Options

40 50 60 70 80 90 100

1,000

500

0

1,500

2,000

2,500

3,000

(500)

(1,000)

Exercise Price = $70

Option Price = $6.13

Profit from Strategy

Stock Price at Expiration


Selling Call Options

Bet that the price will not increase greatly – collect premium income with no payoff

Can be a far riskier strategy than buying the same options

The payoff for the buyer is the amount owed by the writer (no upper bound on V-X)

Uncovered calls: writer does not own the stock (riskier position)

Covered calls: writer owns the stock


Selling Call Options

40 50 60 70 80 90 100

(1,000)

(1,500)

(2,000)

(500)

0

500

1,000

(2,500)

(3,000)




Profit from Uncovered Call Strategy


Buying Put Options

Position taken in the expectation that the price will decrease (short position)

Profit for purchasing a Put Option: Per Share Profit = Max [0, X-V] – Put Premium

Protective put: Buying a put while owning the stock (if the price declines, option gains offset portfolio losses)

The following diagram shows different total dollar profits for buying a put option with a strike price of $70 and a premium of $2.25


Buying Put Options

40 50 60 70 80 90 100

1,000

500

0

1,500

2,000

2,500

3,000

(500)

(1,000)






Selling Put Options

Bet that the price will not decline greatly – collect

premium income with no payoff

The payoff for the buyer is the amount owed by the

writer (payoff loss limited to the strike price since

the stock’s value cannot fall below zero)


Selling Put Options

40 50 60 70 80 90 100

(1,000)

(1,500)

(2,000)

(500)

0

500

1,000

(2,500)

(3,000)






Option Spreads

Many other option strategies can be crafted using combinations of option positions

Price spread (vertical spread) Buying and selling options on the same stock with the same

expiration, but with different strike prices Time spread (horizontal or calendar spread)

Buying and selling options on the same stock with the same strike price, but with different expirations


Option Spreads

Bullish spreads Buy a higher priced option and sell a lower priced option on

the same stock Bearish spreads

Sell a higher priced option and buy a lower priced option on the same stock

StraddleCombination of a purchasing (long) or selling (short) a put

and a call on the same expirationBetting on a large price movement (long straddle) or little

price movement (short straddle)


Option Spreads

StrangleCombination of a call and put with the same expiration but

different exercise prices (long or short)Similar to straddle strategies

Butterfly spreadCombination strategy with 4 options, similar to straddles and

strangles, but with less risk of large losses The number of different strategies is potentially limitless


Put/Call Parity

Premiums for puts and calls are not completely independent otherwise arbitrage opportunities would exist

Two investments with equally risky payoffs should have similar costs

Parity relationships exist between options, also between options and futures, options and spot prices, and futures and spot prices

Chapter 9 AN INTRODUCTION TO DERIVATIVE INSTRUMENTS.

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Transcript of Chapter 9 AN INTRODUCTION TO DERIVATIVE INSTRUMENTS.