Lecture Presentation Software

to accompany

Investment Analysis and Portfolio Management

Seventh Edition by

Frank K. Reilly & Keith C. Brown

Chapter 21

Chapter 21 - An Introduction to Derivative Markets and Securities

Questions to be answered: What distinguishes a derivative security such as a forward, futures, or option contract, from more fundamental securities, such as stocks and bonds? What are the important characteristics of forward, futures, and option contracts, and in what sense can the be interpreted as insurance policies?

Chapter 21 - An Introduction to Derivative Markets and Securities

How are the markets for derivative securities organized and how do they differ from other security markets? What terminology is used to describe transactions that involve forward, futures, and option contracts? How are prices for derivative securities quoted and how should this information be interpreted?

Chapter 21 - An Introduction to Derivative Markets and Securities

What are similarities and differences between forward and futures contracts? What do the payoff diagrams look like for investments in forward and futures contracts? What do the payoff diagrams look like for investments in put and call option contracts? How are forward contracts, put options, and call options related to one another?

Chapter 21 - An Introduction to Derivative Markets and Securities

How can derivatives be used in conjunction with stock and Treasury bills to replicate the payoffs to other securities and create arbitrage opportunities for an investor? How can derivative contracts be used to restructure cash flow patterns and modify the risk in existing investment portfolios?

Derivative Instruments
Value is depends directly on, or is derived from, the value of another security or commodity, called the underlying asset Forward and Futures contracts are agreements between two parties - the buyer agrees to purchase an asset from the seller at a specific date at a price agreed to now Options offer the buyer the right without obligation to buy or sell at a fixed price up to or on a specific date

Why Do Derivatives Exist?

Assets are traded in the cash or spot market It is sometimes advantageous enter into a transaction now with the exchange of asset and payment at a future time Risk shifting Price formation Investment cost reduction

Derivative Instruments
Forward contracts are the right and full obligation to conduct a transaction involving another security or commodity - the underlying asset - at a predetermined date (maturity date) and at a predetermined price (contract price)
This is a trade agreement

Futures contracts are similar, but subject to a daily settling-up process

Forward Contracts
Buyer is long, seller is short Contracts are OTC, have negotiable terms, and are not liquid Subject to credit risk or default risk No payments until expiration Agreement may be illiquid

Futures Contracts
Standardized terms Central market (futures exchange) More liquidity Less liquidity risk - initial margin Settlement price - daily marking to market

Options
The Language and Structure of Options Markets
An option contract gives the holder the right-but not the obligation-to conduct a transaction involving an underlying security or commodity at a predetermined future date and at a predetermined price

Options
Buyer has the long position in the contract Seller (writer) has the short position in the contract Buyer and seller are counterparties in the transaction

Options
Option Contract Terms
The exercise price is the price the call buyer will pay to-or the put buyer will receive from-the option seller if the option is exercised

Option Valuation Basics

Intrinsic value represents the value that the buyer could extract from the option if he or she she exercised it immediately The time premium component is simply the difference between the whole option premium and the intrinsic component

Option Trading Markets-options trade both in overthe-counter markets and on exchanges

Options
Option to buy is a call option Option to sell is a put option Option premium - paid for the option Exercise price or strike price - price agreed for purchase or sale Expiration date
European options American options

Options
At the money:
stock price equals exercise price

In-the-money
option has intrinsic value

Out-of-the-money
option has no intrinsic value

Investing With Derivative Securities

Call option
requires up front payment allows but does not require future settlement payment

Forward contract
does not require front-end payment requires future settlement payment

Options Pricing Relationships

Call Option Stock price + Exercise price Time to expiration + Interest rate + Volatility of underlying stock price + Factor Put Option + + +

Profits to Buyer of Call Option

3,000 2,500 2,000 1,500 1,000 500 0 (500) (1,000) 40 50 60 70 80 90
Stock Price at Expiration

Profit from Strategy Exercise Price = $70 Option Price = $6.125

100

Profits to Seller of Call Option

1,000 500 0 (500) (1,000) (1,500) (2,000) (2,500) (3,000) 40 50 60 70 80 90
Stock Price at Expiration

Profit from Strategy Exercise Price = $70 Option Price = $6.125

100

Profits to Buyer of Put Option

3,000 2,500 2,000 1,500 1,000 500 0 (500) (1,000) 40 50 60 70 80 90
Stock Price at Expiration

Profit from Strategy

Exercise Price = $70 Option Price = $2.25

100

Profits to Seller of Put Option

1,000 500 0 (500) (1,000) (1,500) (2,000) (2,500) (3,000) 40 50 60 70 80 90
Stock Price at Expiration

Profit from Strategy

Exercise Price = $70 Option Price = $2.25

100

The Relationship Between Forward and Option Contracts

Put-call parity
Long in WYZ common at price of S0 Long in put option to deliver WYZ at X on T
Purchase for P0

Short in call option to purchase WYZ at X on T

Sell for C0

Net position is guaranteed contract (risk-free) Since the risk-free rate equals the T-bill rate: (long stock)+(long put)+(short call)=(long T-bill)

Creating Synthetic Securities Using Put-Call Parity

Risk-free portfolio could be created using three risky securities:
stock, a put option, and a call option

With Treasury-bill as the fourth security, any one of the four may be replaced with combinations of the other three

Adjusting Put-Call Spot Parity For Dividends

The owners of derivative instruments do not participate directly in payment of dividends to holders of the underlying stock If the dividend amounts and payment dates are known when puts and calls are written those are adjusted into the option prices (long stock) + (long put) + (short call) = (long Tbill) + (long present value of dividends)

Put-Call-Forward Parity
Instead of buying stock, take a long position in a forward contract to buy stock Supplement this transaction by purchasing a put option and selling a call option, each with the same exercise price and expiration date This reduces the net initial investment compared to purchasing the stock in the spot market

Put-Call-Forward Parity
The difference between put and call prices must equal the discounted difference between the common exercise price and the contract price of the forward agreement, otherwise arbitrage opportunities would exist

An Introduction To The Use Of Derivatives In Portfolio Management

Restructuring asset portfolios with forward contracts
shorting forward contracts tactical asset allocation to time general market movements instead of company-specific trends hedge position with payoffs that are negatively correlated with existing exposure converts beta of stock to zero, making a synthetic T-bill, affecting portfolio beta

An Introduction To The Use Of Derivatives In Portfolio Management

Protecting portfolio value with put options
purchasing protective puts keep from committing to sell if price rises asymmetric hedge portfolio insurance

Either
hold the shares and purchase a put option, or sell the shares and buy a T-bill and a call option

The Internet Investments Online

www.cboe.com www.cbot.com www.cme.com www.cme.com/educational/hand1.htm www.liffe.com www.options-iri.com

End of Chapter 21
An Introduction to Derivative Markets and Securities

Future topics Chapter 22

Forward and Futures Contracts