Options, Futures, and Other Derivatives

Chapter 1 – Introduction
A derivative is a financial instrument whose value depends on the values of other more basic variables.
For example, a stock option is a derivative whose value is dependent on the value of the stock.

1.1 Exchange-Traded Markets

A derivative exchange is a market where individuals trade standardized contracts that have been defined
by the exchange. For example, trader A agrees to buy 100 ounces of gold from trader B in a year for
$1,250/lb. The price is set in stone no matter what happens to the actual price of 1lb of gold.

1.2 Over-the-Counter Market

1. Once a trade has been agreed, the two parties can either present it to a central counterparty or clear
the trade bilaterally.
2. Standardized OTC derivatives between two financial institutions in the US must be traded on what are
referred to as swap execution facilities. In SEF’s, participants can post bid and offer quotes and can
trade by accepting the quotes.
3. All trades must be reported to a central repository.
4. The volume of business in OTC is much larger than in the exchange-traded market.

1.3 Forward Contracts

1. It is an agreement to buy or sell an asset at a certain future time for a certain price. It can be contrasted
with a spot contract, which is an agreement to buy or sell an asset immediately.
2. It is traded in the OTC market (usually between two financial institutions).
3. There are two positions in a forward contract: long position and short position.
a. Long position is the party that agrees to buy the asset on a certain future date for a certain
price.
b. Short position is the party that agrees to sell the asset.
4. A forward contract is a binding commitment.
5. If the spot exchange rate increases, the long position ends up winning, but if the rate decreases, the
short position ends up winning.
6. Long Position Payoff
St – K; where St is the spot price of the asset at maturity of the contract and K is the
delivery price.
7. Short Position Payoff
K – St = where St is the spot price of the asset at maturity of the contract and K is the
delivery price.

Forward Prices and Spot Prices

Consider a stock that pays no dividend and is worth $60. You can borrow the money for 1 year at 5%.
What should be the 1-year forward price of the stock be?
1.4 Future Contracts

1. Future contracts are normally traded on an exchange. The exchange specifies certain standardized
features of the contract.
2. Suppose that on September 1st, the December future price for gold is quoted as $1,380. This is the
price at which traders can agree to buy or sell gold for December delivery.
3. If there are more buyers than sellers, then the prices go up.
4. If there are more sellers than buyers, the prices go down.

1.5 Options

1. Traded both on OTC market and exchanges. There are two main types of options: call option and put
option.
a. A call option gives the holder the right to buy the asset by a certain date for a certain
price.
b. A put option gives the holder the right to sell the asset by a certain date for a certain
price.
2. The price in the contract is known as strike price, and the date in the contract is the expiration date
or maturity.
a. Strike Price = What I predict the stock price of a company could be on maturity date.
b. Premium = the initial cost to buy 1 option.
3. American options can be exercised at any time up to maturity.
4. European options can be exercised only at maturity.
5. One contract is usually an agreement to buy or sell 100 shares.
6. The holder has the right to sell or buy, but he doesn’t have to exercise his right.
7. The price of a call option decreases as the strike price increases.
8. The price of a put option increases as the strike price increases.

Call Option Example

There is a Google strike price of $700 and a maturity date of December with a bid of $52.50/share.

I want to buy one December call option contract on Google with a strike price of $700.

It will cost me $5,250 to buy 100 Google Shares (100 shares = 1 call option). If Google’s strike price doesn’t
rise above $700, I would not exercise my option and I will only lose the premium ($5,250).

However, if the strike price goes up to $900, then I would exercise my option and sell the shares for $900
each. The profit would be $20,000 - $5,250 = $14,750.
Put Option Example

I want to sell one September put option contract with a strike price of $660 and at the bid price of
$24.20/share. It will cost me $2,420 as the premium.

If the Google stock price stays above $660, the option is not exercised and I will make a profit of $2,420.

If the Google stock price drops to $600 and the option is exercised, there is a loss. I must buy 100 shares
for $660 each and sell them for just $600. Total loss would be of -$6000 + $2,420 = -$3,580.

1.6 Hedgers
Hedgers use derivatives to reduce the risk that they face from potential future movements in a market
variable.

Hedging Using Forward Contracts

It is May 2016, and Google knows that it will have to pay $10 million on August 2016 for goods it has
purchased from a British supplier. The USD-GBP exchange rate for a 3-month forward is 1.4551. If Google
decides to hedge its risk by buying GBP from the financial institution in the 3-month forward market, then
Google will have the obligation to pay $14,551,000 by maturity ($10,000,000 * 1.4551).

NOTE: A company might do better if it chooses not to hedge than if it chooses to hedge. Alternatively, it
might do worse. There is no guarantee that the outcome with hedging will be better than the outcome
without hedging.

Hedging Using Options

I own 1,000 shares of Google as of May 2019. The share price is $28/share. I am worried that the share
price will decline in the next two months, and I want protection. I will buy ten July put option contracts
(10 put options = 1,000 shares) with a strike price of $27.50. So, I have the right to sell a total of 1,000
shares for the price of $27.50. Hedging will cost me $1,000 assuming that the option price is $1.

If the market price drops below $27.50, I will exercise the option to get $27,500 - $1,000 = $26,500.
However, if the market price stays above $27.50, I will not exercise the option and it will expire worthless.

1.7 Speculators
Speculators use derivatives to bet on the future direction of a market variable.

Speculation Using Futures

It is February, I think that the GBP will strengthen through April, and I will back that hunch with $250,000.
Assume that current exchange rate is 1.4540 and April’s is 1.4543.
There are two options:
1. Buy $250,000 GBP in the spot market and hope that I can sell it later at a higher price.
2. Take a long position in four April futures contracts on GBP.

Option 1 – Purchase 250,000 units for $1.4540/lb. in February and sold at $1.500/lb. in April, so the profit
would be (1.500 – 1.4540) * 250,000 = $11,500. Buying $250,000 GBP in the spot market on February
requires an up-front payment of $363,500 (250,000 * 1.4540).

Option 2 – If the exchange rate turns out to be 1.5000/lb. in April, the futures contract enables me to
realize a profit of (1.500 – 1.4543) * $250,000 = $11,425. This option requires a small amount of cash to
be deposited by the speculator known as margin account.

Speculation Using Options

It is October and I consider that Google stock is likely to increase in value through December. The current
stock price is $20, and a 2-month call option with a strike price of $22.50 is selling at $1. I am willing to
invest $2,000 (premium)

If Stock Price Rises:

Option 1 – Purchase 100 shares. If stock price does go above $22.50 and reaches $27 by December, then
my profit would be $700 [100 shares * ($27- $20)].

Option 2 – Purchase of 2,000 call options (20 call option contracts). Since the strike price is $22.50 and
the stock price is $27, then it gives a payoff of $4.50. In other words, I am buying the share at $22.50 when
its price is $27. The total payoff from the 20 call option contracts is $7,000
[(2,000 shares * 4.50) - $2,000 premium)].

If Stock Price Falls

Option 1 - Purchase 100 shares. If stock price goes below $22.50 and reaches $15 by December, then my
loss would be $500 [100 shares * ($20 – $15)].

Option 2 – Since the stock price of $15 remained below the strike price ($22.50), the option would not
be exercised and I will lose only the premium ($2,000).

NOTE: Speculations through Futures imply larger gains and larger losses.

1.8 Arbitrageurs
Arbitrageurs take offsetting positions in two or more instruments to lock in a profit. To arbitrage is to lock
in a profit in a riskless environment by entering into transactions in two or more markets.
Chapter 2 – Futures Markets and Central Counterparts
It is June 5th, I will like to buy 5,000 bushels of corn for delivery on September. So, I will get 1 September
corn contract (1 corn contract = 5,000 bushels). At the same time, my friend wants to sell 5,000 bushels
of corn for September delivery. A price would be determined and the deal would be done.
I have a long future position (I am the buyer), and my friend has a short future position (he is the
seller). The price agreed is known as future price (600 cents/bushel).

2.1 Specification of a Futures Contract

1. Asset: The more specific the asset, the better.

2. Contract Size: If the contract size is too large, many traders who wish to hedge relatively small
exposures will be unable to use the exchange.
3. Delivery Arrangements: The price received by the party with the short position is sometimes
adjusted according to the location chosen by the party.
4. Delivery Months: The exchange specifies when trading in a particular month’s contract will begin
and will end.
5. Price Quotes: the units that will be used to quote the items.
6. Price and Position Limits: If in a day the price moves down from the previous day’s close by an
amount equal to the daily price limit, the contract is said to be limit down. The purpose of daily
price limits is to prevent large price movements from occurring.

2.2 Convergence of Futures Price to Spot Price