Chapter 9Chapter 9
AN INTRODUCTION TO DERIVATIVE INSTRUMENTS
1.2Investments Chapter 9
Chapter 9 Questions
What 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?
What 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?
What are the relationships among the prices of puts, calls, and futures?
1.3Investments Chapter 9
Derivative Instruments
Value is determined by, or derived from, the value of another investment vehicle, called the underlying asset or security
Forward 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 now
Futures contracts are similar, but are standardized and traded on an organized exchange
1.4Investments Chapter 9
Derivative Instruments
Options 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 date
Buyer is long in the contract Seller or “writer” is short the contract The price at which the transaction would we made is the
exercise or strike price The profit or loss on an option position depends on the
market price
1.5Investments Chapter 9
Why Do Derivatives Exist?
Assets are traded in the cash or spot market Sometimes 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
1.6Investments Chapter 9
Potential Benefits of Derivatives
Risk shiftingEspecially 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-priced
Investment cost reductionTo hedge portfolio risks more efficiently and less costly than
would otherwise be possible
1.7Investments Chapter 9
Forward Contracts
An agreement between two parties to exchange an asset at a specified price on a specified date
Buyer is long, seller is short; symmetric gains and losses as price changes, zero sum game
Contracts trade OTC, have negotiable terms, and are not liquid
Subject to credit risk or default risk Value realized only at expiration Popular in currency exchange markets
1.8Investments Chapter 9
Futures Contracts
Like forward contracts…Buyer is long and is obligated to buySeller is short and is obligated to sell
Unlike forward contracts…Standardized – traded on exchangeMore liquidity - can “reverse” a position and offset the future
obligation, other party is the exchangeLess credit risk - initial margin required Additional margin needs are determined through a daily
“marking to market” based on price changes
1.9Investments Chapter 9
Futures Contracts
Chicago Board of Trade (CBOT)Grains, Treasury bond futures
Chicago Mercantile Exchange (CME)Foreign currencies, Stock Index futures, livestock futures,
Eurodollar futures New 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
1.10Investments Chapter 9
Futures Contracts
Futures QuotationsOne 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 assetCents per bushel (grains)Value of the index
Value of one contract is price x contract amountSettle is the closing price from the previous day
1.11Investments Chapter 9
Futures Contracts
Example: Suppose you bought (go long) the most recent (Sept.) S&P 500 contract at the settle price (see Exhibit 17.4).
What was the original contract value?Value = $250 x 1095.20 = $273,800 What is your profit if you close your position (sell a contract)
for 1120.00?Value = $250 x 1120.00 = $280,000Profit = $280,000 - $273,800 = $6,200
1.12Investments Chapter 9
Options
Option Terminology Option to buy is a call option Option to sell is a put option Option premium – price paid for the option Exercise price or strike price – the price at which
the asset can be bought or sold under the contract
1.13Investments Chapter 9
Options
Intrinsic Value of OptionsCall Option Intrinsic Value = Max [0, V-X]Put Option Intrinsic Value = Max [0, X-V]
V = Stock ValueX = Strike Price
Option values cannot be negative since they need not be exercised if it is not in the owner’s interest to do so
1.14Investments Chapter 9
Options
Option Terminology Expiration date
European: can be exercised only at expirationAmerican: exercised any time before expiration
In-the-money: option has positive intrinsic value, would be exercised if it were expiring
Out-of-the-money: option has zero intrinsic value, would not be exercised if expiringIf not expiring, could still have value since it could later
become in-the-money
1.15Investments Chapter 9
Options
Example: 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 an intrinsic value of zeroYou would not exercise your right to buy something for $30
that you can buy for $20!
1.16Investments Chapter 9
Options
Example: 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 $30 If the stock price is $40 (out-of-the-money):
Your option has no intrinsic valueYou would not exercise your right to sell something for $30
that you can sell for $40!
1.17Investments Chapter 9
Options
Chicago Board Options Exchange (CBOE)Centralized facility for trading standardized option contractsClearing 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 contractsOffer options on almost 1,400 stocks and also index options
1.18Investments Chapter 9
Options
Stock Option QuotationsOne contract is for 100 shares of stockQuotations give:
Underlying stock and its current priceStrike priceMonth of expirationPremiums per share for puts and callsVolume of contracts
Premiums are often smallA small investment can be “leveraged” into high profits (or
losses)
1.19Investments Chapter 9
Options
Example: Suppose that you buy a January $30 call option on Microsoft (see Exhibit 17.9).
What is the cost of your contract? Cost = $.95 x 100 = $95
Is your contract in-the-money?
No. The current stock price is $28.48, so the intrinsic value is $0 per share.
1.20Investments Chapter 9
Options
Example (cont.): What is your dollar profit (loss) if, at expiration, Microsoft is
selling for $25?
Out-of-the-money, so Profit = ($95)
Is your percentage profit with options?
Return = (0-.95)/.95 = (100%)
What if you had invested in the stock?
Return = (25-28.48)/28.48 = (12.22%)
1.21Investments Chapter 9
Options
Example (cont.): What is your dollar profit (loss) if, at expiration, Microsoft is
selling for $30.50?
Profit = 100(30.5-30) – 95 = ($45)
Is your percentage profit with options?
Return = (30.50-30-.95)/.95 = (47.37%)
What if you had invested in the stock?
Return = (30.50-28.48)/28.48 = 7.09%
1.22Investments Chapter 9
Options
Example (cont.): What is your dollar profit (loss) if, at expiration, Microsoft is
selling for $35?
Profit = 100(35-30) – 95 = $405
Is your percentage profit with options?
Return = (35-30-.95)/.95 = 426.32%
What if you had invested in the stock?
Return = (35-28.48)/28.48 = 22.89%
1.23Investments Chapter 9
Options
Payoff diagramsShow payoffs at expiration for different stock prices (V) for a
particular option contract with a strike price of XFor calls:
if the V<X, the payoff is zeroIf V>X, the payoff is V-XPayoff = Max [0, V-X]
For puts:if the V>X, the payoff is zeroIf V<X, the payoff is X-VPayoff = Max [0, X-V]
1.24Investments Chapter 9
Option Trading Strategies
There are a number of different option strategies:
Buying call options
Selling call options
Buying put options
Selling put options
Option spreads
1.25Investments Chapter 9
Buying Call Options
Position 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 Premium
Note that profits on an option strategy include option payoffs and the premium paid for the option
The following diagram shows different total dollar profits for buying a call option with a strike price of $70 and a premium of $6.13
1.26Investments Chapter 9
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 = $70
Option Price = $6.13
Profit from Strategy
Stock Price at Expiration
1.27Investments Chapter 9
Selling Call Options
Bet that the price will not increase greatly – collect premium income with no payoff
Can be a far riskier strategy than buying the same options
The 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
1.28Investments Chapter 9
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 = $70
Option Price = $6.13
Stock Price at Expiration
Profit from Uncovered Call Strategy
1.29Investments Chapter 9
Buying Put Options
Position 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 Premium
Protective 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
1.30Investments Chapter 9
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 = $70
Option Price = $2.25
Profit from Strategy
Stock Price at Expiration
1.31Investments Chapter 9
Selling Put Options
Bet that the price will not decline greatly – collect
premium income with no payoff
The 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)
1.32Investments Chapter 9
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 = $70
Option Price = $2.25
Stock Price at Expiration
Profit from Strategy
1.33Investments Chapter 9
Option Spreads
Many other option strategies can be crafted using combinations of option positions
Price 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
1.34Investments Chapter 9
Option Spreads
Bullish spreads Buy a higher priced option and sell a lower priced option on
the same stock Bearish spreads
Sell a higher priced option and buy a lower priced option on the same stock
StraddleCombination of a purchasing (long) or selling (short) a put
and a call on the same expirationBetting on a large price movement (long straddle) or little
price movement (short straddle)
1.35Investments Chapter 9
Option Spreads
StrangleCombination of a call and put with the same expiration but
different exercise prices (long or short)Similar to straddle strategies
Butterfly spreadCombination strategy with 4 options, similar to straddles and
strangles, but with less risk of large losses The number of different strategies is potentially limitless
1.36Investments Chapter 9
Put/Call Parity
Premiums for puts and calls are not completely independent otherwise arbitrage opportunities would exist
Two investments with equally risky payoffs should have similar costs
Parity relationships exist between options, also between options and futures, options and spot prices, and futures and spot prices