Options, Futures, and Other Derivatives, 6

th
Edition, Copyright John C. Hull 2005
1.1
Introduction
LOS 1
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.2
Introduction
Gibson Greetings loses $19.7 million in derivatives
Proctor and Gamble takes $157 million hit on
derivatives
Metallgesellschaft derivatives losses put at $1.3
billion
Derivative losses bankrupt Barings

Such popular press accounts could easily lead us to
conclude that derivatives were not only involved in
these losses, but were responsible for them as well.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.3
Barings Bank
February 26, 1995
233 year old bank
28 year old Nick Leeson
$1.3 billion loss
bought by ING Investment for $1.5
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.4
Orange County
Bob Citron, the county treasures
$7.5 billion worth portfolio (schools, cities)
borrowed $12.5 billion, invested in 5 year notes
interest rates increased
reported at cost - big mistake!
realized a loss of $1.64 billion
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.5
Metallgesellshaft
14
th
largest industrial group in Germany
58,000 employees
offered long term oil contracts
hedge by long-term forward contracts
short term contracts were used (rolling hedge)
1993 price fell from $20 to $15
$1 billion margin call in cash
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.6
Derivatives Defined
Actually, there is no easy definition of derivatives,
although economists, accountants, lawyers, and
government regulators have all struggled to develop
a precise definition.

Although there are several competing definitions, we
define derivative as a contract that derives most of its
value from some underlying assets.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.7
Derivatives Defined
An underlying is the asset, reference rate, or index
from which a derivative inherits its principal source
of value.

Underlying assets For example
Financial assets Government bond
Commodity Gold
Another derivative Option on Futures
Stock index S&P 500
Interest rate LIBOR
And many others Weather
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.8
Derivatives: A Short History
Philosopher Thales of Miletus

Call option on oil-presses

Evidenced in Aristotles Politics.

But the modern treatment of derivative contracts has
its root in the inspired work of the Frenchman,
Louis Bachelier in 1900.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.9
Why Derivatives?
To hedge risks
To speculate (take a view on the future direction of
the market)
To lock in an arbitrage (riskless) profit
To change the nature of a liability
To change the nature of an investment without
incurring the costs of selling one portfolio and
buying another
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.10
Types of Derivatives
Types of derivatives include

Commodity derivative a derivative contract
specifying a commodity or commodity index as the
underlying.

For example, a crude oil forward contract specifies
the price, quantity, and date of a future exchange of
the grade of crude oil that underlies the forward
contract.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.11
Types of Derivatives
Financial derivative a derivative contract
specifying a financial instrument, interest rate,
foreign exchange rate, or financial index as the
underlying.

For example, a call option on IBM stock gives its
owner the right to buy the IBM shares that underlie
the option at a predetermined price.

In this course, we will discuss the major types of
financial derivatives such as forward contracts, futures
contracts, options and swap.
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.12
Forward Contracts
Forward contract is a contract between two parties
for one party to buy something from the other at a
later date at a price agreed upon today.

The parties that agree to the forward contract are
known as counterparties.

No actual transfer of ownership occurs in the
underlying asset when the contract is initiated.
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.13
Forward Contracts
The forward price for a contract is the delivery
price that would be applicable to the contract if
were negotiated today (i.e., it is the delivery price
that would make the contract worth exactly zero).

The forward price may be different for contracts of
different maturities.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.14
Forward Contracts
The party that has agreed to buy has what is termed
a long position. The party that has agreed to sell
has what is termed a short position.

Forward contracts are similar to futures except that
they trade in the over-the-counter (OTC) market.

Forward contracts are particularly popular on
currencies and interest rates. Forward contracts on
physical commodities are also commonly observed.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.15
Forward Contracts
Forward contracts on both foreign exchange and
physical commodities involve physical settlement at
maturity.

Many forward contracts, however are cash-settled
forward contracts.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.16
Example
On June 3, 2003 the treasurer of a corporation
enters into a long forward contract to buy 1
million in 6 months at an exchange rate of 1.6100.

This obligates the corporation to pay $1,610,000
for 1 million on December 3, 2003.

What are the possible outcomes?
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.17
Profit from a Long Forward
Position
Profit
Price of Underlying
at Maturity, S
T
K
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.18
Profit from a Short Forward
Position
Profit
Price of Underlying
at Maturity, S
T
K
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.19
Futures Contracts
Futures contract is a contract between two parties for
one party to buy something from the other at a later
date at a price agreed upon today; subject to a daily
settlement of gains and losses and guaranteed
against the risk that either party might default.

Similar to forward contract with a few exceptions,
such as whereas a forward contract is traded OTC, a
futures contract is traded on an exchange.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.20
Futures Contracts
Financial Futures contracts based on financial
instrument or financial index.

Foreign Currency Futures contracts calling for
the delivery of a specific amount of a foreign
currency at a specified future date in return for a
given payment of US dollars.
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.21
Futures Contracts
Interest Rate Futures take a debt instrument (T-
bill or T-bond) as their underlying financial
instrument.

Stock Index Futures that are based on the value
of an underlying stock index, such as S&P 500
index, DSE General Index, DSE-20 or CSE-30.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.22
Futures Contracts
Most futures transactions in the United States occur
through the open outcry trading process, in which
traders literally cry out their bids to go long and
offers to go short in a physical trading pit.

In recent years, there have been several attempts to
replicate the trading pit with online computer
networks.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.23
Exchanges Trading Futures
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)
LIFFE (London)
Eurex (Europe)
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see the list on Page 5 of the text)
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.24
Examples of Futures Contracts
Agreement to:

buy 100 oz. of gold @ US$400/oz. in December
(NYMEX)

sell 62,500 @ 1.5000 US$/ in March (CME)

sell 1,000 bbl. of oil @ US$20/bbl. in April
(NYMEX)
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.25
Forward Contracts Vs. Futures
Contracts
Private contract between 2 parties Exchange traded
Non-standard contract Standard contract
Usually 1 specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final cash
settlement usually occurs
Contract usually closed out
prior to maturity
FORWARDS FUTURES
Some credit risk
Virtually no credit risk
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.26
Options
Option is a contract between two parties that gives
one party (the buyer) the right to buy or sell
something from or to the other party (the seller) at a
later date at a price agreed upon today.

For example, if IBM is selling at $120 and an
investor has the option to buy a share at $100, this
option must be worth at least $20, the difference
between the price at which you can buy IBM ($100)
through the option contract and the price at which
you could sell it in the open market ($120).
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.27
Options
There are two major classes of options, such as

Call option an option to buy a certain asset by
a certain date for a certain price (the strike price).
Put option an option to sell a certain asset by a
certain date for a certain price (the strike price).

Options, like other financial derivatives, can be
written on financial instruments, interest rates,
foreign exchange rates, and financial index.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.28
American Vs. European Options
An American option can be exercised at any time
during its life.

An European option can be exercised only at
maturity.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.29
Exchanges Trading Options
Chicago Board Options Exchange (CBOE)
American Stock Exchange (Amex)
Philadelphia Stock Exchange
Pacific Exchange
LIFFE (London)
Eurex (Europe)
and many more (see the list in your textbook)
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.30
Options Vs. Futures/Forwards
A futures/forward contract gives the holder the
obligation to buy or sell at a certain price.

An option gives the holder the right to buy or sell at
a certain price.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.31
Swaps
Swap is a contract in which two parties agree to
exchange a series of cash flows.

For example, Party A might agree to pay a fixed
rate of interest on $1 million each year for 5 years
to Party B. In return, Party B might pay a floating
rate of interest on $1 million each year for 5 year.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.32
Swaps
There are five basic kinds of swaps, such as interest
rate swaps, currency swaps, equity swaps,
commodity swaps, and credit swaps.

Swaps can also be classified as plain vanilla or
flavored. An example of a plain vanilla swap is
the fixed-for-floating swap.

Swaps are privately negotiated derivatives.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.33
Swaps
Swaps trade in an off-exchange, over-the-counter
environment. Swap transactions are facilitated by
dealers who stand ready to accept either side of a
transaction (e.g., pay fixed or receive fixed)
depending on the customers demand at the time.

These dealers generally run a matched book, in
which the cash flows on numerous transactions net
to a relatively small risk exposure on one side of the
market.
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.34
Swaps
Many of these matched trades are termed customer
facilitations, meaning that the dealer serves as a
facilitating agent, simultaneously providing a swap
to a customer and hedging the associated risk with
either an offsetting swap positions or with a futures
position.

The dealer collects a fee for the service and if, the
transaction is structured properly, incurs little risk.
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.35
Swaps
When exact matching is not feasible for offsetting a
position, dealers typically lay off the mismatch risk
(also known as residual risk) of their dealing portfolio
by using other derivatives.

Because dealers act as financial intermediaries in swap
transaction, they typically must have a relatively strong
credit standing, large capitalization, good access to
information about various end users, and low costs of
managing the residual risks of an unmatched portfolio
of customer transactions.
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.36
Swaps
Swap customers, called end users, usually enter into a
swap to modify an existing or anticipated risk
exposure. Swaps have also been used to establish
unhedged positions allowing the end user an
additional means with which to speculate on future
market movements.

End users include commercial banks, investment
banks, thrifts, insurance companies, manufacturing
and other non-financial corporations, institutional
funds and government-sponsored enterprises.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.37
Types of Traders
Hedgers includes all acts aimed to reduce
uncertainty about future price movements in a
commodity, financial security or foreign currency.

Speculators involves betting on the movements
of the market and try to take advantage of the high
gearing that derivative contracts offer, thus making
windfall profits.
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.38
Types of Traders
Arbitrageurs involves riskless profits by taking
positions in two or more markets. They do not
hedge nor speculate, since they are not exposed to
any risks in the very first place.

Some of the largest trading losses in derivatives
have occurred because individuals who had a
mandate to be hedgers or arbitrageurs switched to
being speculators.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.39
Financial Engineering
The four types of derivatives forward, futures,
options and swaps serve as the financial building
blocks for building more complex derivatives.

The process of building more complex financial
derivatives from the elemental blocks is referred to as
financial engineering. Financial engineering is most
often used to create custom solutions to complex risk
management problems and to exploit arbitrage
opportunities.
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.40
Derivatives Markets
Exchange Traded Markets
Traditionally exchanges have used the open-
outcry system, but increasingly they are switching
to electronic trading.

Contracts are standardized but lack flexibility in
contract terms, virtually no credit risk.

Heavy regulation restricts the kinds of trading
that can be conducted.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.41
Derivatives Markets
Over-the-counter (OTC) Markets

A computer- and telephone-linked network of dealers
at financial institutions, corporations, and fund
managers.
Contracts can be non-standard and there is some small
amount of credit risk.
Liquidity can be very low, due to search costs in
finding trading partners.
Positions in OTC contracts can be difficult to exit
before the prescribed termination date.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.42
OTC Vs. Exchange Traded Market

Source: Bank for International Settlements. Chart shows total principal
amounts for OTC market and value of underlying assets for exchange
market
0
20
40
60
80
100
120
140
160
180
200
220
240
Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04
Size of Market ($
trillion)
OTC
Exchange
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.43
Criticisms of Derivative Markets
Speculation

Comparison to gambling
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.44
Misuses of Derivatives
High leverage

Inappropriate use
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.45
The Social Role of Financial
Derivatives
Traditionally, two social benefits have been
associated with financial derivatives, such as

Financial derivatives are useful in managing risk.
The market for financial derivatives generates
publicly observable prices containing the markets
assessment of the current and future economic
value of certain assets.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.46
Derivatives and Your Career
Financial management in a business
Small businesses ownership
Investment management
Public service
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.47
Derivative Market in Bangladesh
At present there is no derivative market in Bangladesh.
However, in a very short span of time capital market
intermediaries are bringing in infrastructure changes
such as book building, derivative and option market to
our market.

Derivatives and option market is unavailable only due to
our lack of professionals and technical weakness and
also there are no specific regulations relating to these
products.

Introduction of these products will further broaden
investment horizon and bring enhanced depth and
liquidity to our market and attract global customers.
Options, Futures, and Other Derivatives, 6
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Edition, Copyright John C. Hull 2005
1.48
Derivative Market in Bangladesh
The scarcity of diversified products in Bangladesh leads
to the decline of liquidity of the market. Introducing
option and future market can be a solution to the above
issue.

Turnover and market capital of our neighbor India grew
substantially after introducing the option and future
market.

However, the investors have to be educated properly to
reduce speculation.
Options, Futures, and Other Derivatives, 6
th
Edition, Copyright John C. Hull 2005
1.49
Derivative Market in Bangladesh
Date Derivative Contract
October,
2002
Interest Rate Cap agreement between Cibitnak N A and Khulna
Power Company Ltd., the first derivative deal completed in
Bangladesh to mitigate interest rate risk.
July, 2006 USD/JPY Zero Cost Range-Forward between SCB and a leading
corporate to hedge exchange rate risk.
April, 2008 Zero-Cost-Collar between Standard Chartered Bank (SCB) and
Square Textiles Ltd. to hedge against the volatility of cotton price
in the New York Board of Trade
May, 2008 GBP/USD Range Forward Contract between SCB and ACI Ltd. to
hedge exchange rate risk.
May, 2008 EUR/USD Zero Cost Option between SCB and Square Yarns Ltd.