Lecture 1:

Introduction to Derivatives

This lecture defines derivatives and motivates their

study with examples of forwards, futures, and options.

I. What are Derivatives?

II. The Universe of Derivatives

A. Forwards
B. Futures
C. Options
D. Other Derivatives

III. Popular Options and their Institutional Features

A. Exchange Traded Stock Options
B. Stock Index Options
C. Foreign Currency Options
D. Options on Futures
E. Embedded Options
F. OTC Options

IV. The Evolution of Derivatives

 Introduction to Derivatives

I. What are Derivatives?

A derivative or contingent claim is a financial

contract whose value depends on some underlying
or primitive variable.

These variables are often financial securities, such

as stocks, bonds, currencies, or other derivatives.
However, they can be anything.

Examples:

 Futures on the outcome of political elections and

sports trade at Tradesports.com and the IEM
(www.biz.uiowa.edu/iem/markets/)

 Derivatives on the price of raw materials (e.g.,

natural gas futures and options) trade on the New
York Mercantile Exchange (www.nymex.com)

 Derivatives on the price of precious metals

(e.g., gold, silver, and platinum) are trading at
the NYMEX or the Chicago Board of Trade
(www.cbot.com)

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 Introduction to Derivatives

 Weather indices
Record the cumulative difference between reference
temperature (65F, 18C) and average of the daily
high and low (AT).

X
T
Heating Degree Days D maxf18 ATt ; 0g
tD1

X
T
Cooling Degree Days D maxfATt 18; 0g
tD1

U.S. weather (15 monthly cities, 10 seasonal

cities) and European weather derivatives (5
monthly and seasonal cities) are traded at the
Chicago Mercantile Exchange

 In this course, we will learn how to:

– Price derivatives using no arbitrage principle.
This will enable us to determine the price
of derivatives in terms of the price of their
underlying.
– Use derivatives for hedging and speculating.

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 Introduction to Derivatives

II. The Universe of Derivatives

A. Forwards
A forward contract is an agreement between two
parties to buy/sell something at a specified price
on a specified date.
Terminology:
 The specified price is the forward price.
– Or “delivery” price.
 The party agreeing to buy the good in the future
buys a forward and has a long position.
 The party agreeing to sell the good in the future
sells a forward and has a short position.
1: Contract Specification
 Amount and quality of the good.
 Delivery or forward price, denoted K.
 Time of delivery, denoted T .
 Delivery location.
2 : Property
Net number of outstanding contracts is zero:
#Long Positions - #Short Positions = 0.

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 Introduction to Derivatives

3: Example: Hedging with Forwards

The U.S. company Apple exports iPods to
Europe. Suppose Apple expects to sell e1M
worth of iPods three months from now. Apple
wants to hedge its exposure to fluctuations in the
$/e exchange-rate.
Suppose the e spot and forward prices (in $) are:

Spot 30-days 60-days 90-days

Price (in $) 1:20311 1:20427 1:20530 1:20643

To hedge the exchange rate risk, Apple simply

enters into a forward contract to sell e1M dollars
for a price of $1.20643M in 90 days.

There are two ways to interpret this transaction:

 Apple commits to converting the e revenues
into $ at the 90-days forward rate.
 The profit/loss from the forward contract
offsets any loss/profit from exchange rate
fluctuations.

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 Introduction to Derivatives

Notation:

t D current date
T D maturity date of the derivative security
S D price of the underlying security
K D delivery price
F D forward price

At time t , the forward price F .t; T / for delivery at

T equals the delivery price K. At time  > t , the
forward price F .; T / for delivery at T fluctuates
and is no longer equal to the delivery price K.

Questions:
 Does the delivery price K of the forward
contract change as the forward price F
fluctuates?

 Suppose the 90-day $ forward price F goes up

to 1:21 $/e. Has the short position made or
lost money? How about the long position?

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4: Payoff Diagrams
We often use payoff diagrams to represent the
cash-flow from a derivative security as a function
of the price of the underlying security.

Payoff long position

K S(T)

short position

The payoff of a forward contract is:

 S.T / K for the long position.
 K S.T / for the short position.

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 Introduction to Derivatives

B. Futures

1. Contract Specification
A futures contract is like a forward contract.
However, while forwards are private arrangements
between financial institutions and/or corporations,
futures are:
- exchange traded (mostly at CBOT and CME).
- Standardized. (Why?)
- “Marked to market”. (Why?)
- Price movement limits. (Why?)

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Main types of futures

On Commodities
 Agricultural: corn, soybeans, pork bellies, cocoa,
coffee, orange juice, sugar
– this is why forward contracting originated...
... and (in this country) it was here in Chicago

and why Chicago is any sort of financial center
 Metals and energy: copper, gold, platinum, silver,
crude oil, gas, propane
On Financial Products
 Foreign currencies
 Interest rate futures: Treasury bonds, bills, and
notes, Libor, eurodollars, municipal bond index,
Australian government bond, federal funds rate
 Equity indexes: S&P 500, S&P midcap 400, NYSE
index, Value Line index, OTC, Russell 2000, Nikkei
225, FTSE index, Toronto 35
 Single stock futures: 100-odd available, for
example, at OneChicago (JV of CBOE, CBOT, and
CME)

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2. Example: Hedging with futures

Apple can also hedge with standardized futures.
– Are there advantages to hedging with futures?
– Are there disadvantages?

The Apple example, with futures

March 2005 Euro FX futures contracts are traded at
the CME. The ticker symbol is EC. Each contract is
an agreement to purchase e125;000.

To hedge the exchange rate risk, Apple sells 8 March

contracts. It thereby agrees to sell e1;000;000.

 It is off-loading Euro price risk.

The e futures prices are:

Spot March June September

Price ($) 1:2039 1:2081 1:2112 1:2149

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3. Marking to Market:

Margin Requirements: To enter into the futures

contract, Apple must deposit an initial margin of

8 contracts  $1;000=contract D $8;000

Maintenance margin is usually 75% of the initial

margin, ($6;000, in this case)

 Margin will depend on:

– The notional value of the position
– The volatility of the underlying

Now suppose on day 1 the contract closes at

$1:2100/e. Apple’s brokerage account decreases by:

.1:2100 1:2081/$/e  1M e D $1; 900:

Apple is now short 8 March Euro FX contracts with a

futures price of $1:2100/e.
 Identical to any other March Euro FX contract
 Original futures price is irrelevant to the value of
the contracts

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The margin account still contains $6;100 and Apple

does not yet get a margin call from its broker.

However, look at what could happen to the margin

account over the next few days:

March SF Gain from Add/Withdraw End-of-Day

Futures Futures to/from Margin Margin
Price Position Account Account
Day 0 1:2081$/e – $8;000 $8;000
Day 1 1:2100$/e -$1;900 $0 $6;100
Day 2 1:2095$/e
Day 3 1:2125$/e

Marking to market continues until Apple either closes

the position by buying 8 Euro FX contracts, or
delivers the 1M es at maturity.

 In practice, futures positions are usually closed

prior to delivery

Question:

What is the futures price at maturity?

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4. Payoff Diagrams

The payoff diagram of a futures contract is identical

to that of a forward contract, except that the
gains and losses from futures contracts are realized
immediately (and hence incrementally), rather than
all at once at maturity.

C. Differences pricing futures and forwards

The main difference is marking to market, or realizing
gains and losses each day rather than all at once at
expiration.
 If interest rates are constant, the timing of gains
and losses does not matter. In this case, futures
prices equal forward prices.
 If interest rates fluctuate, the timing of gains and
losses matters. In this case, these prices differ. To
determine their difference, we need a model with
fluctuating interest rates ! Fixed Income.
Intuition: If gains covary positively with interest
rates, the futures contract is more valuable than the
corresponding forward contract.

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D. Options

A call option gives its owner the right, but not the
obligation, to buy something at a specified price (the
exercise or strike price) on or before a specified date
(the maturity or expiration date).
Example:
On January 11, 2003, the Intel stock price is S.t / D
17:42 and a 2/03 Intel call with strike price K D 17:50
costs C.t / D 1:15.
A put option gives its owner the right, but not the
obligation, to sell something at a specified price on
or before a specified date.
Example continued ...
A 2/03 put with K D 17:50 costs P .t / D 1:30.

Terminology:

 The party that receives the right to buy/sell in the

future buys the option and has a long position.
 The party that gives the right to buy/sell in the
future writes the option and has a short position.

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Important:

Unlike with forward and futures contracts, the buyer

of an option is not obligated to buy or sell. This is
why we call it an option. The buyer therefore does
not exercise the right to buy or sell unless the payoff
from doing so is positive. The writer of an option, on
the other hand, is obligated to sell or buy at the strike
price if the buyer demands it.

1. Contract Specification

 The deliverable
 K = strike or exercise price.
 T = maturity or exercise date.
 Options style: European or American.

The owner of an European-style option can exercise

only on the expiration date.

The owner of an American-style option can exercise

at any time up to and including the expiration date.

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2. Properties

(A) An option is in-the-money (ITM) if it is worth

something if exercised today.
An option is out-of-the-money (OTM) if it would
costs something to exercise today.
An option is at-the-money (ATM) if the current price
of the underlying is equal to the strike price.

S.t/ < K S.t/ D K S.t/ > K

Call Out-of-the-Money At-the-Money In-the-Money
Put In-the-Money At-the-Money Out-of-the-Money

(B) The “intrinsic value” of a

call option is maxŒ0; S.t / K
put option is maxŒ0; K S.t /

(C) The payoff at maturity of a

call option is maxŒ0; S.T / K
put option is maxŒK S.T /; 0

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3. Payoff and Profit Diagrams

Payoff diagrams depict the value of the option at

maturity as a function of the price of the underlying
security at maturity.

Call Payoff at Maturity Put Payoff at Maturity

C(T) P(T)

K S(T) K S(T)

Written Call Payoff Written Put Payoff

at Maturity at Maturity
K

K S(T) K S(T)

-K

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Some textbooks use profit diagrams, which show the

option’s payoff net of cost. Hull uses both payoff and
profit diagrams. The computation of profits usually
ignores the value of time.

Call Profit Diagram Put Profit Diagram

K K S(T)

S(T) -P(t)
-C(t)

-K

Question:

What is the “break-even” price of the underlying

security at maturity, such that the buyer of a call
option makes no financial gain or loss? How about
for the seller?

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D. Other Derivatives

- LEAPS.
“Long-term Equity AnticiPation Security”

- Swaps and swaptions.

- Interest rate floors, caps, and collars.

- Structured corporate securities

Often embedded options: e.g. convertible bonds

- “Exotic” options:
* Knock-Ins or Knock-Outs
* Bermudan options
* Asian options
* Lookback options
* Binary options

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 Introduction to Derivatives

III. Common Options and their Institution Features

A. Exchange Traded Stock Options

- CBOE, PHLX, AMEX, PSE, and NYSE.

- Each contract represent 100 shares.

- Exchange-traded stock options are American style.

- Expiration cycles:
Exchange-traded stock options mature on the
Saturday following the third Friday of the contract
month. Maturity dates are based on January,
February or March expiration cycles:

Cycle Cycle Months Examples

January 1 4 7 10 IBM, Intel
February 2 5 8 11 Coke, Woolworth
March 3 6 9 12 Philip Morris, Ford

Options are traded for the two closest months and

the subsequent two months of the cycle.

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Example:
At the beginning of the year, Intel options are traded
on the CBOE for January, February, April, and July.
After the third Friday in January, options are traded
for February, March, April, and July.
After the third Friday in February, options are traded
for March, April, July, and October.

- Exercise price spacing:

$2 12 spacing for S.t / < $25.
$5 spacing for $25 < S.t / < $200.
$10 spacing for S.t / > $200.

Example:
Intel’s stock price is S.t / D 17:42 < 25.
Therefore, the available strike prices are:
K D f:::; 12:50; 15:00; 17:50; 20:00; :::g

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- Dividends and stock splits:

Exchange-traded options are generally not protected
against cash dividends. However, they are
adjusted for stock splits and stock dividends.

After an n-for-m stock split, the exercise price is

reduced to m=n of its previous value, and the claim
on the number of shares is increased by a factor of
n=m.

Example: On June 7, 1993, Intel experienced a 2-

for-1 split. At the close of trading, just before the split,
Intel was at 112 3/4. Suppose that before the split
you had one call option (representing 100 shares) on
Intel with an exercise price of 110.

 What happens to the total value of your options at

the instant the split takes place?
 What happens to the value of a call option on a
single share of Intel?
 What happens to the value of a call option at a
dividend ex-date?

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B. Stock Index Options

- All stock index options are European style, except for

the S&P 100 Index (OEX) options.

- One contract represents 100 times the index.

- Settlement is for cash.

- The most popular contracts are the options on the

S&P 100 Index and on the S&P 500 Index (SPX),
both traded at the CBOE.

Example:

If K D 915 and S.T / D 927, then the writer of a call

option pays the buyer 12  100 D $1; 200

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C. Foreign Currency Options

- Mostly traded at the PHLX.

- Both American- and European-style.

D. Options on Futures

- Based on agricultural, oil, livestock, metals, currency,

interest rate, and stock index futures.

- The most popular contracts are:

 Treasury bond futures (traded at the CBOT)
 S&P Index futures (traded at the CME)
 Eurodollar futures (also traded at the CME)

- Settlement is for a futures contract plus the difference

between the futures price and the exercise price.

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E. Embedded Options

Part of another security; the “option component” of,

e.g., a
 convertible bond,
 callable bond,
 redeemable bond, or
 securitized mortgages.

F. OTC Options

- These options are not exchange-traded.

 They are privately negotiated arrangements
between financial institutions and/or corporations.

- Personalized and not easily traded.

- Can be designed for any hedging need.

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 OTC derivatives market size (2006-2008)

– Source: BIS

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