9/7/2021

Chapter 1
Introduction

Options, Futures, and Other Derivatives, 8th Edition,

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TERMS
Derivative: phái sinh
Forward contract: HĐ kỳ hạn
Future contract: HĐ tương lai, giao sau
Swap contract: HĐ hoán đổi
Option contract: HĐ quyền chọn
Transaction: Giao dịch
Embedded: Ghi nhận, đưa vào
Bid: giá mua, offer: giá bán, Master: chủ nhân
Central registry: Trung tâm đăng ký
Delivery price: Giá giao dịch
Long position: Vị thế mua, Short Position: Vị thế bán
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What is risk?
What all definitions [of risk] have in common is
agreement that risk has two characteristics:
Uncertainty: An event may or may not
happen.
Loss: An event has unwanted consequences
or losses

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What is the financial risk?

The probability that an actual return on an investment

will be lower than the expected return.
Financial risk is divided into the following categories:
Basic risk, Capital risk, Country risk, Default risk,
Delivery risk, Economic risk, Exchange rate risk,
Interest rate risk, Liquidity risk, Operations risk,
Payment system risk, Political risk, Refinancing risk,
Reinvestment risk, Settlement risk

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What is risk management?

Risk management is the identification, evaluation,
and prioritization of risks followed by coordinated
and economical application of resources to
minimize, monitor, and control the probability or
impact of unfortunate events or to maximize the
realization of opportunities.
In the world of finance, risk management refers to
the practice of identifying potential risks in advance,
analyzing them and taking precautionary steps to
reduce/curb the risk.

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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: forwards, futures, swaps, options,
exotics…

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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
Options Exchange (CBOE)
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, page 5)
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

(Figure 1.1, Page 5)

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 26, 2013 (See page 6)
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

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Example (page 6)
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
at Maturity, ST
K

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Futures Contracts (page 8)

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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Exchanges Trading Futures

CME Group (formed when Chicago
Mercantile Exchange and Chicago Board of
Trade merged)
NYSE Euronext (being acquired by bteh
InterContinental Exchange)
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see list at end of book)
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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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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

(ignores the gold lease rate)

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); See Table 1.2 page 9

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); See Table 1.3 page 9

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

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Exercise 1
A one-year call option on a stock with a strike
price of $40 costs $4; a one-year put option on
the stock with a strike price of $40 costs $5.
Suppose that a trader buys two call options and
one put option. The breakeven stock price above
which the trader makes a profit is

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Exercise 2
A one-year call option on a stock with a strike
price of $80 costs $6; a one-year put option on
the stock with a strike price of $80 costs $7.
Suppose that a trader buys three call options
and two put option. The breakeven stock price
below which the trader makes a profit is?

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