Chapter 1

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Introduction to Introduction to DerivativesDerivatives

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 2

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 3

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 4

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Ways Derivatives are UsedWays Derivatives are Used

A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties. Ex, An SBI stock option is a derivative because its value depends on the price of SBI stock

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Forward PriceForward Price

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On July 20, 2007 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 2.0489

This obligates the corporation to pay $2,048,900 for £1 million on January 20, 2008

What are the possible outcomes? If pound appreciate to 2.05 or depreciate to 2.039

If you plan to grow 500 bushels of wheat next year, you could sell your wheat for whatever the price is when you harvest it, or you could lock in a price now by selling a forward contract that obligates you to sell 500 bushels of wheat to, say, Mr A after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On the other hand, if prices rise later, you will get only what your contract entitles you to.

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Profit from aProfit from aLong Forward PositionLong Forward Position

Profit

Price of Underlying at Maturity, STK

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Profit from a Profit from a Short Forward PositionShort Forward Position

Profit

Price of Underlying at Maturity, STK

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Futures ContractsFutures Contracts

Agreement to buy or sell an asset for a certain price at a certain time

Similar to forward contractWhereas a forward contract is traded OTC, a

futures contract is traded on an exchange. Maturity date, contract size ,strike price all

are fixed in advance.

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Exchanges Trading FuturesExchanges Trading Futures

Chicago Board of TradeChicago Mercantile ExchangeLIFFE (London)Eurex (Europe)BM&F (Sao Paulo, Brazil)TIFFE (Tokyo)NSE/BSE(India)

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OptionsOptions

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)

Buyers of CallSellers of CallBuyers of PutSellers of Put

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 14

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American vs European OptionsAmerican vs European Options

An American option can be exercised at any time during its life

A European option can be exercised only at maturity

◦Stock Price◦Strike Price◦Value of Option◦Contract Lot

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Exchanges Trading OptionsExchanges Trading Options

Chicago Board Options ExchangeAmerican Stock Exchange-NASDAQPhiladelphia Stock ExchangePacific ExchangeLIFFE (London)Eurex (Europe)

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Options vs Futures/ForwardsOptions 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 TradersTypes of Traders

• Hedgers

• Speculators

• ArbitrageursFacts: Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators

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Hedging using futureHedging using future

Company A: must pay 1 million pound in Sept for imports from Britain

Company B: will receive 3 million pound in Sept from Exports to Britain

Quotes:◦Current exchange Rate $1.6920= 1pound◦September Future price $ 1.6850= 1 pound◦Size of Future contract: pound 62,500

Company A hedging strategy?Company B hedging strategy?

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Hedging using optionsHedging using options

An investor owns 500 IBM shares and wants protection against possible decline in the share price over the next two months.

Quotes:◦Current IBM share= $52◦ IBM October 50 put= $4◦Size of Put: 100 shares

The Investor’s strategy if price fall below or above 52?

Outcome?

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Speculation using futureSpeculation using future

An investor feels that sterling with strengthen relative to the US dollar over the next two months and would like to take a speculative position

Quotes:◦Current exchange Rate $1.6470= 1pound◦April Future price $ 1.6410= 1 pound◦Size of Future contract: pound 62,500

Investor speculative strategy if exchange rate is 1.7000 or 1.6000?

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Speculation using optionsSpeculation using options

A speculator with $7,800 to invest thinks that the price of Exxon will increase in the next three months and has obtained the following quotes:

Quotes:◦Current stock price= $78◦Exxon December call with an $80 strike price =

$3◦The speculator has $ 7800 to invest

Investor speculative strategy of price $90 or $70?

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ArbitrationArbitration

A stock is traded on both the New York Stock Exchange and LSE.

Quotes:◦New York SE= $172 per share◦LSE = pound 100 per share◦Value of 1 pound= $1.7500

Investor arbitrage strategy?

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Welcome to DerivativesWelcome to Derivatives