LECTURE 1:

INTRODUCTION

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What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options,
etc…

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Why Derivatives Are Important
Derivatives play a key role in transferring risks in the
economy
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc.
Many financial transactions have embedded
derivatives
The real options approach to assessing capital
investment decisions has become widely accepted
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How Derivatives Are Traded
On exchanges such as the Chicago Board of
Trade (BOT) or Chicago Board Options
Exchange (CBOE)
Open outcry system to electronic trading

In the over-the-counter (OTC) market where

traders working for banks, fund managers and
corporate treasurers contact each other directly

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The OTC Market Prior to 2008
Largely unregulated
Banks acted as market makers quoting bids and
offers
Master agreements usually defined how transactions
between two parties would be handled
But some transactions were handled by central
counterparties (CCPs). A CCP stands between the
two sides to a transaction in the same way that an
exchange does
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Since 2008…
OTC market has become regulated. Objectives:
Reduce systemic risk (see Business Snapshot 1.2)
Increase transparency

In the U.S and some other countries, standardized

OTC products must be traded on swap execution
facilities (SEFs) which are similar to exchanges
CCPs must be used for standardized transactions
between dealers in most countries
All trades must be reported to a central registry
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Size of OTC and Exchange-Traded Markets

$632.6Trillion

$52.6Trillion

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market

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The Lehman Bankruptcy (Business Snapshot 1.1)
Lehman’s filed for bankruptcy on September 15, 2008. This
was the biggest bankruptcy in US history

Lehman was an active participant in the OTC derivatives

markets and got into financial difficulties because it took high
risks and found it was unable to roll over its short term
funding

It had hundreds of thousands of transactions outstanding

with about 8,000 counterparties

Unwinding these transactions has been challenging for both

the Lehman liquidators and their counterparties
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How Derivatives are Used
To hedge risks
To speculate (take a view on the future direction
of the market)
To lock in an arbitrage 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

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Foreign Exchange Quotes for GBP,
May 6, 2013
Bid Offer
Spot 1.5541 1.5545

1-month forward 1.5538 1.5543

3-month forward 1.5533 1.5538

6-month forward 1.5526 1.5532

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Forward Price
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 (as shown by
the table)

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Terminology
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

End-of-chapter problem 1.1

What is the difference between a long forward position
and a short forward position?

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Example
On May 6, 2013, the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months at an
exchange rate of 1.5532
This obligates the corporation to pay
$1,553,200 for £1 million on November 6,
2013
What are the possible outcomes?
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Profit from a Long Forward
Position (K= delivery price=forward price at
time contract is entered into)

Profit

Price of Underlying at
K Maturity, ST

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Profit from a Short Forward
Position (K= delivery price=forward price at time
contract is entered into)

Profit

Price of Underlying
K at Maturity, ST

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Futures Contracts
Agreement to buy or sell an asset for a
certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC, a
futures contract is traded on an exchange

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Options, Futures, and Other Derivatives, 9th Edition, Global Edition,
Copyright © John C. Hull 2018 17
Examples of Futures Contracts
Agreement to:
Buy 100 oz. of gold @ US$1400/oz. in December

Sell £62,500 @ 1.5500 US$/£ in March

Sell 1,000 bbl. of oil @ US$90/bbl. in April

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1. Gold: An Arbitrage Opportunity?
Suppose that:
The spot price of gold is US$1,400
The 1-year forward price of gold is US$1,500
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?

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2. Gold: Another Arbitrage Opportunity?

Suppose that:
- The spot price of gold is US$1,400
- The 1-year forward price of gold is US$1,400
- The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?

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The Forward Price of Gold
If the spot price of gold is S and the forward price
for a contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
In our examples, S = 1400, T = 1, and r =0.05 so
that
F = 1400(1+0.05) = 1470

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1. Oil: An Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$95
- The quoted 1-year futures price of oil is US$125
- The 1-year US$ interest rate is 5% per annum
- The storage costs of oil are 2% per annum
Is there an arbitrage opportunity?

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2. Oil: Another Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$95
- The quoted 1-year futures price of oil is US$80
- The 1-year US$ interest rate is 5% per annum
- The storage costs of oil are 2% per annum
Is there an arbitrage opportunity?

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Options
A call option is an option to buy a certain
asset by a certain date for a certain price (the
strike price)
A put option is an option to sell a certain
asset by a certain date for a certain price (the
strike price)

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American vs European Options
An American option can be exercised at any
time during its life
A European option can be exercised only at
maturity

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Google Call Option Prices from CBOE (May 8, 2013; Stock
Price is bid 871.23, offer 871.37);

Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer
820 56.00 57.50 76.00 77.80 88.00 90.30

840 39.50 40.70 62.90 63.90 75.70 78.00

860 25.70 26.50 51.20 52.30 65.10 66.40

880 15.00 15.60 41.00 41.60 55.00 56.30

900 7.90 8.40 32.10 32.80 45.90 47.20

920 n.a. n.a. 24.80 25.60 37.90 39.40

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Google Put Option Prices from CBOE (May 8, 2013; Stock
Price is bid 871.23, offer 871.37);

Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer
820 5.00 5.50 24.20 24.90 36.20 37.50

840 8.40 8.90 31.00 31.80 43.90 45.10

860 14.30 14.80 39.20 40.10 52.60 53.90

880 23.40 24.40 48.80 49.80 62.40 63.70

900 36.20 37.30 59.20 60.90 73.40 75.00

920 n.a. n.a. 71.60 73.50 85.50 87.40

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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

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Types of Traders
Hedgers
Speculators
Arbitrageurs

Problem 1.2
Explain carefully the difference between hedging,
speculation, and arbitrage.
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A trader is hedging when she has an
exposure to the price of an asset and takes a
position in a derivative to offset the exposure.
In a speculation the trader has no exposure
to offset. She is betting on the future
movements in the price of the asset.
Arbitrage involves taking a position in two or
more different markets to lock in a profit.

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Hedging Examples
A US company will pay £10 million for imports
from Britain in 3 months and decides to hedge
using a long position in a forward contract

An investor owns 1,000 Microsoft shares

currently worth $28 per share. A two-month put
with a strike price of $27.50 costs $1. The
investor decides to hedge by buying 10 contracts

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Value of Microsoft Shares with and
without Hedging
40,000 Value of
Holding ($)
35,000
No Hedging
30,000 Hedging

25,000

Stock Price ($)

20,000
20 25 30 35 40

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Speculation Example
An investor with $2,000 to invest feels that a
stock price will increase over the next 2
months. The current stock price is $20 and
the price of a 2-month call option with a strike
of 22.50 is $1

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Arbitrage Example
A stock price is quoted as £100 in London
and $150 in New York
The current exchange rate is 1.5300
What is the arbitrage opportunity?

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Dangers
Traders can switch from being hedgers to
speculators or from being arbitrageurs to
speculators
It is important to set up controls to ensure that
trades are using derivatives for their intended
purpose
SocGen (Business Snapshot 1.4) is an
example of what can go wrong

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Hedge Funds (Business Snapshot 1.3)
Hedge funds are not subject to the same rules as mutual
funds cannot offer their securities publicly.
Mutual funds must
disclose investment policies,

makes shares redeemable at any time,

limit use of leverage

Hedge funds are not subject to these constraints.

Hedge funds use complex trading strategies are big users
of derivatives for hedging, speculation and arbitrage

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Types of Hedge Funds
Long/Short Equities
Convertible Arbitrage
Distressed Securities
Emerging Markets
Global Macro
Merger Arbitrage

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