Академический Документы
Профессиональный Документы
Культура Документы
Market
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the nature and characteristics of forward contract, futures
contract and options;
2. Analyse the factors that influence the price of options;
3. Differentiate between options and futures contract;
4. Justify the importance of hedging in managing risk; and
5. Evaluate how derivatives are priced using the basic Binomial Pricing
theorem and the Black-Scholes pricing model.
X INTRODUCTION
Among the most innovative and most rapidly growing markets to be developed
in recent years are the markets for financial futures and options. Futures and
options trading are designed to protect the investor against interest rate risks,
exchange rate risks and price risks. In the financial futures and options markets,
the risk of future changes in the market prices or yields of securities are
transferred to someone (an individual or an institution) who is willing to bear
that risk. Financial futures and options are used in both short-term money
markets and long-term capital markets to protect both borrowers and lenders
against the risks involved.
Although financial futures and options are relatively new in the field of finance,
risk protection through futures and options trading is an old concept in
marketing commodities. As far back as the Middle Ages, traders in farm
commodities developed contracts calling for futures delivery of farm products at
TOPIC 8
a guaranteed price. Trading in rice futures began in Japan in 1697. In the United
States, the Chicago Board of Trade established a futures market in grain in 1848.
More recently, the Chicago Board developed futures and options markets for
financial instruments. The Malaysian first derivatives exchange was established
in July 1993 under the name Kuala Lumpur Options and Financial Futures
Exchange (KLOFFE). In October 1995, the Malaysian Derivatives Clearing House
(MDCH) was established for both KLOFFE and the Commodity and Monetary
Exchange of Malaysia (COMMEX), and the Malaysian Derivative Exchange
(MDEX) is the only derivative exchange in Malaysia. MDEX in now known as
Bursa Malaysia Derivatives Berhad (BMD) and it operates under the supervision
of Securities Commission.
8.1
The underlying asset may be a share, Treasury Bill, foreign currency or even
another derivative security. For example:
(a)
The value of a share option depends upon the value of the share on which it
is written.
(b)
The value of a Treasury Bill futures contract depends upon the price of the
underlying Treasury Bill.
(c)
The value of a foreign currency forward contract depends upon the foreign
currency forward rates.
(d)
The value of a swap depends upon the value of the underlying swap
contract.
Two types of derivative security, futures and options, are actively traded on
organised exchanges. These contracts are standardised with regard to a
description of the underlying asset, the right of the owner, and the maturity date.
Forward contracts, on the other hand, are not standardised; each contract is
customised to its owner, and they are traded in what is called over-the-counter.
Options can be found embedded in other securities, convertible bonds and
extendible bonds being two such examples. A convertible bond contains a
provision that gives an option to convert the security into common share. As
extendible bond contains a provision that gives an option to extend the maturity
of the bond.
8.2
FORWARD CONTRACT
K(t)
T
Delivery date
Let S(t) denote the spot exchange rate (RM/USD) at date t. When the contract
matures at date T, the spot exchange rate is denoted by S(T). This spot exchange
rate is unknown when the forward contract is initiated. It is called a random
TOPIC 8
variable. The value of the forward contract at the delivery date, date T, to the
long position initiated at date t for one currency is:
S(T) K(t)
Note that the argument t in the delivery price refers to the date the contract was
initiated. The value of the forward contract at delivery equals the value of the
foreign currency, S(T), less the delivery price paid, K(t). As illustrated in the
above example, the value of the forward contract at delivery can be either
positive or negative. A graph of the possible values is shown below.
The delivery price K(t) equals the forward price f(t, T) when the contract is
initiated.
If the spot exchange rate at the delivery date is less than the delivery price S(T) <
K(t), then the value of the forward contract is negative; otherwise, it is zero or
positive. The delivery price equals the prevailing forward price, K(t) = f(t, T),
when the contract is initiated. Once the contract is written, the delivery price is
fixed over the life of the contract. The forward price, which represents the
delivery price of newly written contracts, of course can change. If you contracted
with a financial institution tomorrow, date t + 1, about buying USD for delivery
date T, in general there would be a new delivery price or forward price, K(t + 1)
= f(t + 1, T).
This completes the institutional description of a forward contract. We will return
to these contracts when we analyse pricing and hedging.
ACTIVITY 8.1
List at least three examples of forward contracts available in the
Malaysian market. You can refer to the Malaysian Investor website at
http://www.min.com.my under products, and other resource
materials such as business newspapers and magazines. Also list the
advantages and disadvantages of a forward contract.
8.3
FUTURES CONTRACT
(b)
Futures contracts are standardised with respect to the quality and the
quantity of the asset underlying the contract, the delivery date or period,
and the delivery place if there is physical delivery. In contrast, forward
contracts are customised on all these dimensions to meet the needs of the
two counterparties.
(c)
Futures contracts are settled through a clearing house. The clearing house
acts as a middleman. This minimises credit risk as the second party to a
futures contract is always the clearing house.
(d)
TOPIC 8
8.3.1
2.30
[2.30 f ]
2.30 (1 + 0.04 u 0.25)
f 2.30(1 + 0.04 u0.25)
Clearing House
This intervention of the clearing house means that the futures market has no
counterparty risk. If A plans to buy futures and B plans to sell futures, both
parties will refer to the clearing house to fulfil their intentions. The clearing
house is thus the counter party to every contract. In this case, B is not the counter
party to A.
The clearing house must have reserves to guarantee that its contracts are
executed and are considered risk-free. It actually accepts that the counterparty
may default on the contract and for this it charges a small fee for each contract
executed. Further, the clearing house only accepts contracts from recognised
traders and sets a margin account. In margin accounts, investors are required to
maintain or keep some amount of money. In Malaysia, the clearing house
derivatives is the Malaysian Derivative Exchange (MDEX). Please note that if the
net payoff is not equal to zero, then arbitrage profit is possible.
The functions of the Clearing House can be summarised as shown in Figure 8.2.
8.3.2
Settlement Price
8.3.3
Daily Margin
When a person enters into a futures contract, the individual is required to deposit
funds in an account with the broker. This account is called the margin account.
The exchange sets the minimum amount of margin required, but brokers can
increase the margin if they feel that the risk of the investors default is increased.
This margin account may or may not earn interest. The economic role of the
margin account is to act as collateral to minimise the risk of default by either
party in the futures contract.
Since the price of futures is marked-to-market, the gain or loss on the futures
contract will also change on a daily basis. Thus the margin needs to be adjusted
to reflect these changes. These changes are reflected in what is known as the
maintenance margin. This will ensure that a minimum amount is kept in the
margin account with respect to the changes in gain or loss.
Lets look at an example of the initial margin and the maintenance margin.
Consider A, who on 3 March enters into a futures contract to buy 100 troy ounces
of gold at the futures price of RM365 per troy ounce. The initial margin for the
contract is set at RM2,000 and the maintenance margin is set at 75% of the initial
margin, or RM1,500.
Table 8.1 below shows the calculation that reflects the changes in the margin
when the daily price changes. We observe that on 5 March, the price drops to
RM359 and a cash flow of RM300. This reduces the initial margin to RM1,400
which is below the maintenance margin of RM1,500. At this point, A has to topup the margin account back to the original RM2,000. Thus, A has to withdraw or
put in RM600 into the margin account. We assume that A will withdraw any
excess margin (in excess of RM2,000).
TOPIC 8
Futures Price
Cash Flow
3/3
4/3
5/3
6/3
7/3
8/3
365
362
359
364
365
367
0
300
300
+500
+100
+200
8.3.4
Cash Deposit/
Withdrawal
2000
0
600
500
100
200
Ending Margin
2000
1700
2000
2000
2000
2000
Basis
Let F(t, T) denote the futures price at date t, for delivery at time T. Let the
contract be written on an underlying asset, with spot price S(t). In a wellfunctioning and efficient market, the futures price equals the price of the
underlying asset at the delivery date. Figure 8.3 shows that F(t, T) = S(T).
s(t)
S(T)
t
F(t, T)
T
Figure 8.3: F(t, T) = S(T)
In fact, the futures price at T for immediate delivery should be equal to S(T). That
is F(T, T) = S(T). The difference between the futures price and the spot price is
known as the basis. Thus, the basis at time t is;
Basist = F(t, T) S(t).
In the forward or futures contracts investment, the risk involved is represented
by the change in the value of the basis. Thus, when the change in the basis is
relatively large, the risk involved in that investment is also large. This is
important when we consider the use of forward or futures contracts to hedge, for
instance, our investment in the cash market. We will consider this idea later in
the topic.
A typical graph of the basis with respect to maturity is shown in Figure 8.4.
In the graph above, we see that the basis is positive. However, this is not always true.
Basis can also be negative. What is important is that the graphs should converge.
8.3.5
Futures are usually used to hedge our investment or lock the price of the
underlying asset. Thus with hedging, we can construct a portfolio consisting of
assets on both the spot and the derivatives markets. It is important to understand
that in the spot market, we are dealing with the price risk whereas in the futures
market, we are faced with the basis risk. If basis0 = basisT, then we should be able
to use perfect hedging, which means the value of the underlying asset at time 0
and time T are equal.
Hedging is easier to understand by using examples. Lets look at examples where
futures are used for hedging. Be sure to follow the example and understand what
happens to the value of our portfolio when basis0 basisT.
We will assume that as the price in the spot market increases, the price in the
futures market will also increase. This is to say that the two prices are closely
TOPIC 8
correlated, which is what we usually observe. Suppose you sell one unit of
futures and buy one unit of the underlying asset. Thus, your portfolio is (S F).
At time t, your portfolio is worth (S(t) F(t)), and at time T, it is worth (S(T)
F(T)).
Thus, the change in spot price is (S(T) S(t)) and the change in the futures price is
(F(T) F(t)). To see how the value of our portfolio changes, refer to the following
formula.
(S(t) F(t))
If there is no change in the basis, then the value of our portfolio remains the
same, thus we have locked in the value of the portfolio. The result would be
different if the values of the basis are not constant.
Now, lets look at the mechanism in using futures for hedging using two companies,
Gold Mining Company and Jewellery Company. The Gold Mining Company
expects to sell 1,000 ounces of gold next month and the Jewellery Company expects
to buy 1,000 ounces of gold next month. However, to hedge against the risk of
changes in the price of gold in a months time, both companies want to lock in
todays price. Assume that todays price for gold is $352.40 per ounce and the
current futures price is $397.80. Each futures contract is for 100 ounces.
You are advised to carefully study Tables 8.2 8.5 on the next page to understand
the mechanism of using futures in hedging. Attention should be given to what
happens to hedging when the basis at the time the contract is initiated is not equal
to the basis when the futures mature. This will explain the basis risk which will
ultimately influence the gain or loss when futures are used. We also note that since
the Gold Mining Company wishes to sell gold in the future, then it will short or
sell futures when the contract is initiated. Similarly, the Jewellery Company will
long or buy futures since it wishes to buy gold in the future.
Table 8.2: Hedging Price That Locks Gold Spot Price: Spot Price Decrease
Assumption
Spot price when hedging is made
Futures price when hedging is made
Spot price when hedging expires
Futures price when hedging expires
Number of ounces hedged
Number of ounces in one futures contract
Number of futures contract used
$352.40
397.80
304.20
349.60
1000
100
10
per oz.
per oz.
per oz.
per oz.
Futures market
Basis
Sell 10 contracts:
10 x 100 x $397.80 = $397,800
Buy 10 contracts:
10 x 100 x $349.60 = $349,600
Futures market
Basis
Buy 10 contracts:
10 x 100 x $397.80 = $397,800
Sell 10 contracts:
10 x 100 x $349.60 =$349,600
TOPIC 8
Table 8.3: Hedging Price That Locks Gold Spot Price: Spot Price Increase
Assumption
Spot price when hedging is made
Futures price when hedging is made
Spot price when hedging expires
Futures price when hedging expires
Number of ounces hedged
Number of ounces in one futures contract
Number of futures contract used
$352.40
397.80
392.50
437.90
1000
100
10
per oz.
per oz.
per oz.
per oz.
Futures market
Basis
Sell 10 contracts:
10 x 100 x $397.80 = $397,800
Buy 10 contracts:
10 x 100 x $437.90 = $437,900
Futures market
Basis
Buy 10 contracts:
10 x 100 x $397.80 = $397,800
Sell 10 contracts:
10 x 100 x $437.90 = $437,900
$352.40
397.80
304.20
385.80
1000
100
10
per oz.
per oz.
per oz.
per oz.
Futures market
Basis
Sell 10 contracts:
10 x 100 x $397.80 = $397,800
Buy 10 contracts:
10 x 100 x $385.50 = $385,800
Futures market
Basis
Buy 10 contracts:
10 x 100 x $397.80 = $397,800
Sell 10 contracts:
10 x 100 x $437.90 = $385,800
TOPIC 8
Table 8.5: Hedging Price That Locks Gold Spot Price: Spot Price Increase Basis Increase
Assumption
Spot price when hedging is made
Futures price when hedging is made
Spot price when hedging expires
Futures price when hedging expires
Number of ounces hedged
Number of ounces in one futures contract
Number of futures contract used
$352.40
397.80
392.50
474.10
1000
100
10
per oz.
per oz.
per oz.
per oz.
Sh
hort (sell) hedging by Gold Mining Company
Cash market
Futures market
Basis
Sell 10 contracts:
10 x 100 x $397.80 = $397,800
Buy 10 contracts:
10 x 100 x $474.10 = $474,100
Futures market
Basis
Buy 10 contracts:
10 x 100 x $397.80 = $397,800
Sell 10 contracts:
10 x 100 x $474.10 = $474,100
EXERCISE 8.1
1. Suppose you bought a share at time t at RM4.70, and the price of
the futures on the share is RM4.60. At time T, the price of the
share drops to RM3.90 and the price of the futures drop to
RM4.00. If you short (sell) the futures at time t, what is the value
of your share at time T?
2. Consider a forward contract written on a non-dividend paying
asset. The current spot price is RM65. The maturity of the
contract is 90 days and the simple interest rate for this period is
4.50% per annum.
(a)
(b)
8.4
OPTIONS
By giving the right, the writer will receive a fee called the price of the options or
the options premium.
TOPIC 8
Either the buyer of the call options has the right to buy something or the
buyer of put options has the right to sell something.
(b)
(c)
(d)
Expiration date.
(e)
Either the buyer of the options can exercise anytime during a specified
duration (for American options) or at a specific time (European options).
(ii)
Clearing house can function in the options market similar to that in the
futures market.
(iii) The transaction cost is much lower compared with the options traded overthe-counter.
Usually institutional options buyers need a specific or a tailor-made option that
matches their needs. This usually happens in portfolio management of fixed
income securities. In fact, in portfolio management of fixed income securities like
bonds, over-the counter trading is more popular because the risk in the cash
market can be hedged by using the options.
8.4.1
Options Moneyness
Options moneyness describes the relationship between the options stated price
and the price of the underlying asset and determines if it is a profitable
transaction.
Remarks
In-the-money
(ITM)
An option is said to be
in-the-money if it is
profitable
to
immediately exercise.
At-the-money
(ATM)
An option is said to be
at-the-money if it does
not
matter
if
immediately exercised.
Out-of-the
-money (OTM)
An option is said to be
out-of-the-money if it is
not
profitable
to
immediately exercise.
8.4.2
There are some fundamental differences between futures and options. They are:
(a)
Only the sellers (not the buyers) are obliged to buy or sell. The buyers of
options need not buy or sell the underlying. In the futures contract, the
buyers and sellers are obliged to buy or sell. Thus, the main advantage of
options is where the holder or the buyer of options will benefit from an
upside benefit while limiting a downside loss.
TOPIC 8
(b)
The buyer of options must pay a fee or the price of the options to the seller
to get the right. In the futures contract, there is no exchange of money when
the contract is initiated.
(c)
The buyer of the options will decide on the price of the options to buy (for
call options) or to sell (for put options) but can take the opportunity if the
price of the options is low. In the futures contract, the price is already fixed
and the parties to the contract cannot obtain profit or suffer losses from any
price movement.
SELF-CHECK 8.1
In the earlier section, we discussed the definition of options and futures
contracts. We also discussed the characteristics of each security. Based
on your understanding, what is the main difference between options
and futures contracts?
8.4.3
There are four basis positions in options contracts. Most other options contracts
are some combinations of the four basis positions. The four basic options
contracts are:
(a)
(b)
(c)
(d)
The buyer of an option can seize opportunities to make a profit from the
movement of the price of the underlying asset. However, they must pay a fee for
this. The maximum profit for the seller of options is the price of the options itself.
At the same time, the seller of options is also exposed to the risk of loss from the
movement of the price of the underlying asset. Figures 8.6 8.9 show the gain or
loss incurred by the seller (writer) or the buyer of the respective options with the
following assumptions:
Price of options
Exercise price (x)
C
+ C
P
+ P
S
+ S
=
=
=
=
=
=
=
=
$3
$100
sell call options
buy call options
sell put options
buy put options
sell share
buy share
The following graphs show what happens to the profit or value of options
when the price of the underlying asset changes. A full understanding of the
graphs is very important as they are used in more exotic options portfolios, since
the concept is similar. For instance, in understanding put-call parity, all we need
to do is add the relevant linear graphs to look at the profit or the value of our
options portfolio.
TOPIC 8
To understand the options transactions (buy and sell) better, let us look at the
following example.
Suppose that todays price of a MAS share is RM5.00. A European three-month
call option on the MAS share is quoted as RM4.90 MAS @ 0.30. (i.e. the price of
this call option is RM0.30). This means that in three months time the buyer of the
call option can exercise or buy a MAS share at RM4.90, at whatever the price
MAS shares will be. Based on this information:
Price of MAS in 3 months time
Exercise
Profit/Loss
Exercise (buy)
Exercise (buy)
Dont exercise
0.30
Using the same information given above, except that instead of a call option, the
option is a put option. Then we will have:
Price of MAS in 3 months time
Exercise
Dont exercise
0.30
Dont exercise
0.30
Exercise (sell)
8.4.4
Profit/Loss
Put-Call-Parity
TOPIC 8
Price > X
Put
(X S)
Call
(S X)
Profit for S + P C
Share
We observe that whatever the value of the underlying asset is, it always equals to
X, the exercise price. It should be clear that the graph in Figure 8.10 gives the
same result. Thus, we can plot the profit of a portfolio of options by using
S + P C) is a
either graphs or calculations similar to the above. The portfolio (S
riskless portfolio and should earn a riskless rate of return (Rf ).
S+P-C=
X
1+R f
This formula is known as the put-call parity and it explains the relationship
between the price of call and put options.
8.4.5
The diagram below shows the time diagram between time 0 and T, where we
include the relevant variables that affect the price of options. Then we will
tabulate to see how they affect the price of options.
where:
c
C
p
P
S0
ST
K
D
T
r
:
:
:
:
:
:
:
:
:
:
:
c
+
?
+
?
r
D
+
C
+
+
+
+
+
+
TOPIC 8
Where:
+ means the variable and the option move in the same direction (for example
+
if r increases then c will also increase);
means the variable and the option move in opposite directions (for example
if D increases then c will decrease); and
?? means it depends on our expectations regarding the price of the
underlying asset.
8.5
We will look at how options are priced by considering the Binomial Pricing
Model and the Black-Scholes model. First, we will explain the Binomial Pricing
Model, followed by the Black-Scholes model, for which we will only state the
formula. The derivations of Black-Scholes model is beyond the scope of this
module.
8.5.1
(b)
(c)
(d)
(e)
We will now consider both the cash and the options markets. Assume that if the
market goes up, the price will increase by 20% and if the market goes down, it
will decrease by 20%. Thus, if the initial price of the share is S0, it will be
S0(1 + 0.20) if the market goes up and S0(1 0.20) if the market goes down. Here,
we assume that we only need one call option (in reality, we need to first calculate
the number of options needed).
Since the portfolio is a riskless portfolio, 1.20S0 fu = 0.80S0 fd. Thus we can
find the value of C by considering the formula below (assuming the maturity of
the portfolio is T);
TOPIC 8
S0 C =
1.20S 0 fu
1+R f
or
S 0 C
0.8S 0 fu
1 R f T
S0
1.20S 0 fu
1 R f T
It should be noted that S0, Rf and T are known when the contract is initiated.
Thus, we are left with the prices of call and put. If we know the price of the call,
we can find the price of the put, and vice-versa.
8.5.2
p
where:
d1
d2
K e rT N d 2 S 0 N d 1
In S 0 IK r V 2 I 2 T
V T
In S 0 IK r V 2 I 2 T
V T
d1 V T
N(d1), N(d2), = the cumulative probability density. The value for N(.) is obtained
from a normal distribution that is tabulated in most statistics textbooks.
c
P
S0
ST
K
T
R
=
=
=
=
=
=
=
=
EXERCISE 8.2
1. Consider a European call option on an asset with price S(t), strike
price K, and maturity T.
(a)
(b)
(c)
(b)
TOPIC 8
(b)
(c)
(d)
All options are written on the same share and mature at the same
time. Without the aid of diagrams, describe the total value of the
portfolio when the options mature.
Derivatives are usually used to hedge the risk that exists in the cash markets.
It should be understood that when we discuss hedging, we are concerned
with reducing or transferring risk in the cash market.
The common derivatives used are the forward, the futures and the options.
Factors influencing the options are the price of the underlying asset, the
maturity, the exercise price, interest rate, dividend and the variance of the
price of the underlying.
The prices of call and put options are related through the put-call parity. This
means that once we know the price of call options, we can theoretically find
the price of put options.