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Chapter 11 AN INTRODUCTION TO DERIVATIVE SECURITIES
Chapter 11
AN INTRODUCTION TO DERIVATIVE SECURITIES
Chapter 11 QuestionsWhat are the basic features of forward contracts, futures contracts, and options contracts?Why do derivative securities exist? How do they help meet investor needs and increase market efficiency?What are the similarities and differences between forward contracts and futures contracts?
Chapter 11 QuestionsWhat terminology do we use to describe option contracts?What does a payoff diagram show?What are the risks and potential returns from option positions such as buying and writing calls; buying and writing puts; owning long and short positions in spreads, straddles, strangles, or butterfly spreads?
Chapter 11 QuestionsWhat are the relationships among the prices of puts, calls, and futures?What are some uses of derivatives in investment analysis and portfolio management?
Derivative InstrumentsValue is determined by, or derived from, the value of another instrument vehicle, called the underlying asset or securityForward contracts are agreements between two parties - the buyer agrees to purchase an asset, the seller agrees to sell the asset, at a specific date at a price agreed upon nowFutures contracts are similar, but are standardized and traded on an organized exchange
Derivative InstrumentsOptions offer the buyer the right, but not the obligation, to buy or sell and underlying asset at a fixed price up to or on a specific dateBuyer is long in the contractSeller or “writer” is short the contractThe price at which the transaction would we made is the exercise or strike priceThe profit or loss on an option position depends on the market price
Why Do Derivatives Exist?Assets are traded in the cash or spot marketSometimes have one’s fortunes dependent on spot price movements leads to considerable riskVarious derivatives markets have evolved
that allow some investors to manage these risks, while also creating opportunities for speculators to invest in the same contracts
Potential Benefits of Derivatives
Risk shifting Especially shifting the risk of asset price changes
or interest rate changes to another party willing to bear that risk
Price formation Speculation opportunities when some investors
may feel assets are mis-pricedInvestment cost reduction To hedge portfolio risks more efficiently and less
costly than would otherwise be possible
Forward ContractsAn agreement between two parties to exchange an asset at a specified price on a specified dateBuyer is long, seller is short; symmetric gains and losses as price changes, zero sum gameContracts are OTC, have negotiable terms, and are not liquidSubject to credit risk or default riskValue realized only at expirationPopular in currency exchange markets
Futures ContractsLike forward contracts… Buyer is long and is obligated to buy Seller is short and is obligated to sell
Unlike forward contracts… Standardized – traded on exchange More liquidity - can “reverse” a position and offset
the future obligation, other party is the exchange Less credit risk - initial margin required Additional margin needs are determined through a
daily “marking to market” based on price changes
Futures ContractsChicago Board of Trade (CBOT) Grains, Treasury bond futures
Chicago Mercantile Exchange (CME) Foreign currencies, Stock Index futures, livestock
futures, Eurodollar futuresNew York Mercantile Exchange (NYMEX) Crude oil, gasoline, heating oil futures
Development of new contracts Futures exchanges look to develop new contracts
that will generate significant trading volume
Futures ContractsFutures Quotations One contract is for a fixed amount of the
underlying asset 5,000 bushels of corn (of a certain grade) $250 x Index for S&P 500 Index Futures (of a certain
maturity) Prices are given in terms of the underlying asset
Cents per bushel (grains) Value of the index
Value of one contract is price x contract amount Settle is the closing price from the previous day
Futures ContractsExample: Suppose you bought (go long) the
most recent (Sept.) S&P 500 contract at the settle price (see Exhibit 11.5).What was the original contract value?
Value = $250 x 1180.80 = $295,200What is your profit if you close your position (sell a contract) for 1250.00?
Value = $250 x 1250.00 = $312,500Profit = $312,500 - $295,200 = $17,300
OptionsOption Terminology
Option to buy is a call optionOption to sell is a put optionOption premium – price paid for the optionExercise price or strike price – the price at which the asset can be bought or sold under the contract
OptionsOption Terminology
Expiration date European: can be exercised only at expiration American: exercised any time before expiration
In-the-money: the option has intrinsic value, and would be exercised if it were expiringOut-of-the-money: the option has no intrinsic value, would not be exercised if expiring If not expiring, could still have value since it could
later become in-the-money
OptionsExample: Suppose you own a call option with
an exercise (strike) price of $30.If the stock price is $40 (in-the-money): Your option has an intrinsic value of $10 You have the right to buy at $30, and you can
exercise and then sell for $40.If the stock price is $20 (out-of-the-money): Your option has no intrinsic value You would not exercise your right to buy
something for $30 that you can buy for $20!
OptionsExample: Suppose you own a put option with
an exercise (strike) price of $30.If the stock price is $20 (in-the-money): Your option has an intrinsic value of $10 You have the right to sell at $30, so you can buy
the stock at $20 and then exercise and sell for $30If the stock price is $40 (out-of-the-money): Your option has no intrinsic value You would not exercise your right to sell
something for $30 that you can sell for $40!
OptionsChicago Board Options Exchange (CBOE) Centralized facility for trading standardized option
contracts Clearing Corporation is the opposite party to all
trades, allowing buyers and sellers to terminate positions prior to expiration with offsetting trades
Standardized expiration dates, exercise prices, and contract sizes
Secondary market with standardized contracts Offer options on almost 1,400 stocks and also
index options
OptionsStock Option Quotations One contract is for 100 shares of stock Quotations give:
Underlying stock and its current price Strike price Month of expiration Premiums per share for puts and calls Volume of contracts
Premiums are often small A small investment can be “leveraged” into high
profits (or losses)
OptionsExample: Suppose that you buy a
January $60 call option on Microsoft (see Exhibit 11.10).What is the cost of your contract?
Cost = $9 x 100 = $900Is your contract in-the-money?
Yes. The current stock price is $63.20, so the intrinsic value is $3.20 per share.
OptionsExample (cont.):
What is your dollar profit (loss) if, at expiration, Microsoft is selling for $50?
Out-of-the-money, so Profit = ($900)Is your percentage profit with options?
Return = (0-9)/9 = (100%)What if you had invested in the stock?
Return = (50-63.20)/63.20 = (20.89%)
OptionsExample (cont.):
What is your dollar profit (loss) if, at expiration, Microsoft is selling for $65?
Profit = 100(65-60) – 900 = ($400)Is your percentage profit with options?
Return = (65-60-9)/9 = (44.44%)What if you had invested in the stock?
Return = (65-63.20)/63.20 = 2.85%
OptionsExample (cont.):
What is your dollar profit (loss) if, at expiration, Microsoft is selling for $85?
Profit = 100(85-60) – 900 = $1,600Is your percentage profit with options?
Return = (85-60-9)/9 = 177.78%What if you had invested in the stock?
Return = (85-63.20)/63.20 = 34.49%
OptionsPayoff diagrams Show payoffs at expiration for different stock prices (V)
for a particular option contract with a strike price of X For calls:
if the V<X, the payoff is zero If V>X, the payoff is V-X Payoff = Max [0, V-X]
For puts: if the V>X, the payoff is zero If V<X, the payoff is X-V Payoff = Max [0, X-V]
Option Trading StrategiesThere are a number of different option
strategies:Buying call optionsSelling call optionsBuying put optionsSelling put optionsOption spreads
Buying Call OptionsPosition taken in the expectation that the price will increase (long position)Profit for a purchasing a Call Option:
Per Share Profit =Max [0, V-X] – Call PremiumNote that profits on an option strategy include option payoffs and the premium paid for the optionThe following diagram shows different total dollar profits for buying a call option with a strike price of $70 and a premium of $6.13
Buying Call Options
40 50 60 70 80 90 100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise Price = $70Option Price = $6.13
Profit from Strategy
Stock Price at Expiration
Selling Call OptionsBet that the price will not increase greatly – collect premium income with no payoffCan be a far riskier strategy than buying the same optionsThe payoff for the buyer is the amount owed by the writer (no upper bound on V-X)Uncovered calls: writer does not own the stock (riskier position)Covered calls: writer owns the stock
Selling Call Options
40 50 60 70 80 90 100
(1,000)
(1,500)
(2,000)
(500)
0
500
1,000
(2,500)
(3,000)
Exercise Price = $70Option Price = $6.13
Stock Price at Expiration
Profit from Uncovered Call Strategy
Buying Put OptionsPosition taken in the expectation that the price will decrease (short position)Profit for purchasing a Put Option:
Per Share Profit = Max [0, X-V] – Put PremiumProtective put: Buying a put while owning the stock (if the price declines, option gains offset portfolio losses)The following diagram shows different total dollar profits for buying a put option with a strike price of $70 and a premium of $2.25
Buying Put Options
40 50 60 70 80 90 100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise Price = $70Option Price = $2.25
Profit from Strategy
Stock Price at Expiration
Selling Put OptionsBet that the price will not decline greatly – collect premium income with no payoffThe payoff for the buyer is the amount owed by the writer (payoff loss limited to the strike price since the stock’s value cannot fall below zero)
Selling Put Options
40 50 60 70 80 90 100
(1,000)
(1,500)
(2,000)
(500)
0
500
1,000
(2,500)
(3,000)
Exercise Price = $70Option Price = $2.25
Stock Price at Expiration
Profit from Strategy
Option SpreadsMany other option strategies can be crafted
using combinations of option positionsPrice spread (vertical spread) Buying and selling options on the same stock with
the same expiration, but with different strike prices
Time spread (horizontal or calendar spread) Buying and selling options on the same stock with
the same strike price, but with different expirations
Option SpreadsBullish spreads Buy a higher priced option and sell a lower priced
option on the same stockBearish spreads Sell a higher priced option and buy a lower priced
option on the same stockStraddle Combination of a purchasing (long) or selling (short) a
put and a call on the same expiration Betting on a large price movement (long straddle) or
little price movement (short straddle)
Option SpreadsStrangle Combination of a call and put with the same
expiration but different exercise prices (long or short) Similar to straddle strategies
Butterfly spread Combination strategy with 4 options, similar to
straddles and strangles, but with less risk of large losses
The number of different strategies is potentially limitless
Put/Call ParityPremiums for puts and calls are not completely independent otherwise arbitrage opportunities would existTwo investments with equally risky payoffs should have similar costsParity relationships exist between options, also between options and futures, options and spot prices, and futures and spot prices
