FINA2322ABC Tutorial 1
THE UNIVERSITY OF HONG KONG
HKU BUSINESS SCHOOL
FINA2322ABC – DERIVATIVES
FIRST SEMESTER, 2024-2025
Tutorial 1 – Introduction to Derivatives, Forward and Options
General Information
Instructor: Dr. Jiaheng Yu Email: yujh@[Link]
Tutor: Hermione Oi Ching KWOK Email: oichingk@[Link]
Tutor: Jason Che Hin TSE Email: jasontch@[Link]
Email: fina2322hku@[Link]
Office: Room 1026, KKL Building Phone: 2857 8514
Office Hours: Refer to Moodle, making appointment in advance is required
Tutorial Schedule
Session Time Venue Tutor
1 Monday 11:30 - 12:20 KK925 Hermione
2 Monday 12:30 - 13:20 KK925 Hermione
3 Monday 16:30 - 17:20 KK1010 Hermione
4 Thursday 15:30 - 16:20 KK925 Hermione
5 Thursday 16:30 - 17:20 KK925 Hermione
6 Tuesday 16:30 - 17:20 KK1010 Jason
7 Tuesday 17:30 - 18:20 KK1010 Jason
8 Wednesday 10:30-11:20 KK925 Jason
9 Wednesday 11:30-12:20 KK925 Jason
10 Thursday 11:30-12:20 KK828 Jason
11 Thursday 12:30-13:20 KK828 Jason
FINA2322ABC Tutorial 1
Quick Review on Lecture 1&2: Introduction to Derivatives,
Forward and Options
✓ What is Derivatives?
• An agreement between two parties which has a value determined by the price of
something else.
• Common elements in derivatives:
- Underlying asset
- Predetermined price
- Maturity
- Contract Size
✓ Measures of Market Size
• Open interest
• Trading Volume
• Market Value
• Notional Value
✓ Uses of Derivatives
• Risk management
• Speculation
• Reduced transaction costs
• Regulatory arbitrage
✓ Compounding
• Two formats of interest rate
i. Effective interest rate
𝐹𝑉 = 𝑃𝑉(1 + 𝑟)
E.g. A 6-month effective interest rate of 2%
ii. APR interest rate (compounding frequency needed)
𝑟 𝑚𝑇
𝐹𝑉 = 𝑃𝑉 (1 + )
𝑚
E.g. Interest rate is 4% p.a., compounded semi-annually
E.g. The 6-month interest rate is 4% p.a.
E.g. The continuously compounded interest rate is 3.96% p.a.
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FINA2322ABC Tutorial 1
✓ More to note…
• Payoff VS Profit?
• Settlement method: Cash or physical delivery?
✓ Summary of forward payoff
Positions Long forward Short forward
Right / Obligation
Example: If ST is… Payoff is… If ST is… Payoff is…
Assume the 30 30
forward exercise 40 40
price is $50 50 50
60 60
70 70
Payoff Diagram
Profit Diagram
Cost
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FINA2322ABC Tutorial 1
✓ Futures Contract
• Standardized, with specified delivery dates, locations, procedures
• Mark to market – earnings and losses are marked to market daily
• Initial deposit in margin account
- Excess equity above the initial margin can be withdrawn
- Margin call will be issued if account balance is below maintenance margin
• Difference with forward contract: liquid, marked to market, small credit risk,
price limit, cannot be customized
✓ Cross Hedging
• Use the forward contract of an underlying (e.g. index) to hedge the return of
another underlying (e.g. stock)
• If stock and index are perfectly correlated …
- Number of contracts
𝛽 × (𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑙𝑢𝑒)
=
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑖𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒 × (𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑠𝑖𝑧𝑒)
• If stock and index are not perfectly correlated…
𝜌𝜎
- 𝑜𝑝𝑡𝑖𝑚𝑎𝑙 ℎ𝑒𝑑𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 ℎ = 𝜎 𝑆 , the optimal proportion of the portfolio that
𝐹
should be hedged
ℎ×(𝑝𝑜𝑟𝑡𝑓𝑙𝑖𝑜 𝑠𝑖𝑧𝑒 (𝑢𝑛𝑖𝑡𝑠))
- optimal number of contracts = 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑠𝑖𝑧𝑒 𝑜𝑓 ℎ𝑒𝑑𝑔𝑖𝑛𝑔 𝑖𝑛𝑠𝑡𝑟𝑢𝑚𝑒𝑛𝑡 (𝑢𝑛𝑖𝑡𝑠)
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FINA2322ABC Tutorial 1
Tutorial Exercise
Question 1 (Commission Charges)
Suppose you short-sell 300 shares of XYZ stock at $30.19 with a commission charge of
0.5%. How much profit have you made if you close the short-sale at a price of $29.87?
Supposing you pay commission charges for purchasing the security to cover the short-
sale, and the interest rate in the market is 0%.
Question 2 (Payoff diagram of Stock)
Suppose XYZ stocks has a price of $50 and pays no dividends. The effective annual interest
rate is 10%.
(a) Draw payoff and profit diagrams for a long position in the stock. Verify that profit
is 0 at a price in 1 year of $55.
(b) Draw payoff and profit diagrams for a short position in the stock. Verify that profit
is 0 at a price in 1 year of $55.
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FINA2322ABC Tutorial 1
Question 3 (cross hedging)
A seller of apples expects to sell 200 tons of apples in 3 months and decides to use 3-month
orange futures for hedging. Based on the historical data, it is given that the price of apple
per ton, 𝑆 𝐴 , has a standard deviation of 𝜎𝐴 = 0.03, and the price of orange per ton, 𝑆 𝑂 , has
a standard deviation of 𝜎𝑂 = 0.02. uurthermore, the correlation coefficient eetween 𝑆 𝐴
and 𝑆 𝑂 is 𝜌𝐴𝑂 = 0.8.
𝐴 𝑂 𝑂
(a) What is the hedged profit, in terms of 𝑆0.25 , 𝑆0.25 and 𝐹0,0.25 (the 3-month orange
futures price today) in three months, if you enter today into a short position of 3-
month orange futures price with each orange contract has 200 tons of orange as the
underlying asset?
(b) What is the variance minimizing hedge ratio ℎ∗ ?
(c) Suppose each orange futures contract now is on 100 tons of orange. What is the
numeer of contracts 𝐻 ∗ that minimizes the variance of hedged profit?
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FINA2322ABC Tutorial 1
Appendix of Lecture Note 2
