Introduction
• Basic derivatives contracts
– Forward contracts
– Call options
– Put Options
• Types of positions
– Long position
– Short position
• Graphical representation
– Payoff diagrams
– Profit diagrams
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Forward Contracts
• Definition: a binding agreement (obligation) to buy/sell
an underlying asset in the future, at a price set today
• Futures contracts are the same as forwards in principle
except for some institutional and pricing differences.
• A forward contract specifies
– The features and quantity of the asset to be delivered
– The delivery logistics, such as time, date, and place
– The price the buyer will pay at the time of delivery
Expiration
Today date
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The Payoff on a Forward Contract
• Payoff for a contract is its value at expiration
• Payoff for
– Long forward = Spot price at expiration – Forward price
– Short forward = Forward price – Spot price at expiration
• Example 2.1: S&R (special and rich) index:
– Today: Spot price = $1,000, 6-month forward price =
$1,020
– In six months at contract expiration: Spot price = $1,050
• Long position payoff = $1,050 – $1,020 = $30
• Short position payoff = $1,020 – $1,050 = -($30)
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Payoff Diagram for Forwards
• Long and short forward positions on the
S&R 500 index
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Call Options
• A non-binding agreement (right but not an
obligation) to buy an asset in the future, at a price
set today
• Preserves the upside potential, while at the same
time eliminating the unpleasant downside (for the
buyer)
• The seller of a call option is obligated to deliver if
asked Today Expiration date
or
at buyer’s choosing
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Examples
• Example 2.3: S&R index
– Today: call buyer acquires the right to pay $1,020 in six
months for the index, but is not obligated to do so
– In six months at contract expiration: if spot price is
• $1,100, call buyer’s payoff = $1,100 – $1,020 = $80
• $900, call buyer walks away, buyer’s payoff = $0
• Example 2.4: S&R index
– Today: call seller is obligated to sell the index for $1,020
in six months, if asked to do so
– In six months at contract expiration: if spot price is
• $1,100, call seller’s payoff = $1,020 – $1,100 = ($80)
• $900, call buyer walks away, seller’s payoff = $0
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Definition and Terminology
• A call option gives the owner the right but not the obligation
to buy the underlying asset at a predetermined price during a
predetermined time period
• Strike (or exercise) price: the amount paid by the option
buyer for the asset if he/she decides to exercise
• Exercise: the act of paying the strike price to buy the asset
• Expiration: the date by which the option must be exercised
or become worthless
• Exercise style: specifies when the option can be exercised
– European-style: can be exercised only at expiration date
– American-style: can be exercised at any time before expiration
– Bermudan-style: Can be exercised during specified periods
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Payoff/Profit of a Purchased Call
• Payoff = Max [0, spot price at expiration – strike
price]
• Profit = Payoff – future value of option premium
• Examples 2.5 & 2.6:
– S&R Index 6-month Call Option
• Strike price = $1,000, Premium = $93.81, 6-month
risk-free rate = 2%
– If index value in six months = $1100
• Payoff = max [0, $1,100 – $1,000] = $100
• Profit = $100 – ($93.81 x 1.02) = $4.32
– If index value in six months = $900
• Payoff = max [0, $900 – $1,000] = $0
• Profit = $0 – ($93.81 x 1.02) = – $95.68
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Diagrams for Purchased Call
• Payoff at expiration • Profit at expiration
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Payoff/Profit of a Written Call
• Payoff = – max [0, spot price at expiration –
strike price]
• Profit = Payoff + future value of option premium
• Example 2.7
– S&R Index 6-month Call Option
• Strike price = $1,000, Premium = $93.81, 6-month
risk-free rate = 2%
– If index value in six months = $1100
• Payoff = – max [0, $1,100 – $1,000] = – $100
• Profit = – $100 + ($93.81 x 1.02) = – $4.32
– If index value in six months = $900
• Payoff = – max [0, $900 – $1,000] = $0
• Profit = $0 + ($93.81 x 1.02) = $95.68
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Put Options
• We introduced a call option by comparing it to a
forward contract in which the buyer need not buy
the underlying asset if it is worth less than the
agreed-to purchase price.
• Perhaps you wondered if there could also be a
contract in which the seller could walk away if it is
not in his or her interest to sell.
• The answer is yes. A put option is a contract where
the seller has the right to sell, but not the
obligation.
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Put Options
• A put option gives the owner the right but not
the obligation to sell the underlying asset at a
predetermined price during a predetermined
time period
• Payoff/profit of a purchased (i.e., long) put
– Payoff = max [0, strike price – spot price at expiration]
– Profit = Payoff – future value of option premium
• Payoff/profit of a written (i.e., short) put
– Payoff = – max [0, strike price – spot price at expiration]
– Profit = Payoff + future value of option premium
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NOTE
• It is important to be crystal clear about the use of
the terms “buyer” and “seller” because there is
potential for confusion.
• The buyer of the put owns a contract giving the
right to sell the index at a set price. Thus, the
buyer of the put is a seller of the index!
• Similarly, the seller of the put is obligated to buy
the index, should the put buyer decide to sell.
• Thus, the buyer of the put is potentially a seller of
the index, and the seller of the put is potentially a
buyer of the index.
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Put Option Examples
• Examples 2.9 & 2.10
– S&R Index 6-month Put Option
• Strike price = $1,000, Premium = $74.20, 6-month
risk-free rate = 2%
– If index value in six months = $1100
• Payoff = max [0, $1,000 – $1,100] = $0
• Profit = $0 – ($74.20 x 1.02) = – $75.68
– If index value in six months = $900
• Payoff = max [0, $1,000 – $900] = $100
• Profit = $100 – ($74.20 x 1.02) = $24.32
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Profit for a Long-Put Position
• Profit table • Profit diagram
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A Few Items to Note
• A call option becomes more profitable when
the underlying asset appreciates in value
• A put option becomes more profitable when
the underlying asset depreciates in value
• Moneyness
– In-the-money option: positive payoff if exercised
immediately
– At-the-money option: zero payoff if exercised
immediately
– Out-of-the money option: negative payoff if
exercised immediately
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Option and Forward Positions: A
Summary
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