Derivative Securities

Derivative Markets

Derivative markets are a relatively new phenome-

non, but are one of the most rapidly growing asset
classes.
Currently, there are approximately 300 million de-
rivative contracts outstanding with a market value
of around $50 Trillion
While equity trading is centered in New York
(NYSE, NASDAQ), derivative markets are centered
in Chicago (CME, CBOT, CBOE)
What is a Derivative

A derivative is simply a contract which entitles the

holder to buy or sell a commodity at some future
date for a predetermined price.
Therefore, while a stock or a bond has intrinsic
value (a stock or a bond represents a claim to some
asset or income stream), a derivative has no intrin-
sic value. Its value is “derived” from the underlying
asset.
Futures Contracts

A futures contract is an obligation to buy/sell a specific

quantity of a specific commodity at a future date for a pre-
determined price.
The buyer of the future (long position) is required to
purchase the commodity
The seller of the future (short position) is required to de-
liver the commodity
For example, A July wheat future obligates the buyer to
purchase 5,000 bushels (FND 6/28, LTD 7/12) for a price of
293 cents/bushel between 6/28 – 7/12.
Futures Contract
4

3.5

3
Market Price
Contract Price
2.5

1.5
0 5 10 15 20 25 30

 In this example, the long position earns a profit of $.58 per bushel times
5,000 bushels equal $2,900. Note that the short position loses $2,900.
Types of Futures

Currencies Agriculture Metals & En- Financial

ergy
British Pound Lumber Copper Treasuries
Euro Milk Gold LIBOR
Japanese Yen Cocoa Silver Municipal Index
Canadian Dollar Coffee Platinum S&P 500
Mexican Peso Sugar Oil DJIA
Cotton Natural Gas Nikkei
Wheat
Cattle
Soybeans
Hedging Risk With Futures

Suppose you are a wheat farmer, your income is

strongly tied to the price of wheat
Specifically, you are concerned about falling wheat
prices
Therefore, you would like to take a short position in
wheat futures
Who will take the long position?

A flour producer would use wheat as an input to pro-

duction. Therefore a flour producer might be con-
cerned about rising wheat prices.
To hedge this risk, the flour producer would want to
take a long position in wheat futures
The dealers place orders with their pit traders, who strike a
deal.

Farmer Flour Producer

(Short Position) (Long Position)
Once the deal is made, the deal is sent to the clearing-
house, who will act as the middleman

Clearinghouse
(Long Position/Short Position)

Farmer Flour Producer

(Short Position) (Long Position)
Why is a middleman required?

Recall that, unlike stocks or bonds, derivatives have fu-

ture obligations attached to them. The clearinghouse
is just an efficient way to insure compliance with the
terms of the contract.
Settlement day

The wheat future requires delivery/purchase of

wheat upon expiration. This, however, rarely (if
ever) actually happens.
If the commodity is actually “delivered”, its simply
a question of identifying ownership.
The most common procedure would be a canceling
out of the contract by issuing an identical contract
of equal size, but opposite position at the current
spot price.
Upon settlement, the profit would be (F-S) for the
farmer, and (S-F) for the flour producer.
Hedging Interest Rate Risk

Suppose that you have purchased a 10 year T-Bond with a

face value of $100,000. What risks do you face? How can
you hedge that risk?
You bond price will fall if interest rates rise. Therefore, you
would want to take a short position in an interest rate fu-
ture.
What type of future should you sell?
Suppose you hedge with 13 Week T-Bill Futures

For every 1% rise in interest rates, you T-Bond

drops by approximately $7,500 in value (10 yr Trea-
suries have a duration of approximately 7.5)
If you take a short position in T-Bill futures (the
standard size is $1,000,000). For every 1% increase
in interest rates, you would earn $2,500 (90 day T-
Bills have a duration of .25). Therefore, you would
need to buy 3 contracts.
Further, this T-Bill hedge only protects you from
interest rate risk – not yield curve risk.
Note that your ratio of futures to forwards is 30:1.
This is no coincidence!
What should the futures price be?

As a first pass, remember that no one should expect to make profits in

the market. Therefore, the future’s price should equal the expected fu-
ture spot price; F = E(S’)
However, it is also reasonable to believe that because futures are being
used to hedge risk, the buyers/sellers would be willing to pay a pre-
mium for that hedge.
In the wheat example, the farmer should be willing to pay a future price
below the future spot price (F<E(S)) while the flour producer should be
willing to pay a price higher that the future spot price (F>E(S))
Modern portfolio theory assumes that fluctuating commodity prices
represent a source of systematic risk to financial portfolios. Therefore,
because futures can alleviate this risk, they should sell at a discount.
Pricing Futures
To price a future its important to recognize that there
are several ways to generate a given cash flow. Any two
methods that generate the same cash flow should have
the same cost!
Currency Futures
Suppose that an October 2005 contract for Euros costs
$1.25 per Euro.
By going long on this contract, you can buy Euro in one
year for $1.25 apiece. How else can you acquire Euro in
one year at a fixed price with no money up front?
Borrow money today to buy a Euro denominated asset.
Currency Futures
Suppose that the
interest rate on ECB
bonds is 4%. How much 1
would an ECB bond with  .96 E
a face value of 1 Euro 1.04
cost?
Currency Futures
If the current exchange
rate is $1.20 per euro,
we can figure out what  1.20$ 
we need to borrow .96 E    $1.15
 E 
today to buy the bond.
Currency Futures
If we borrowed this
amount at a 6% annual
interest rate, what
would you owe $1.15(1.06)  $1.22
tomorrow
This gives us the same
Euro that we could by in
the futures market for
$1.25!
Currency Futures
The general condition F
e(1  i )
can be written as (1  i*)
follows: F  Futures Price ($/E)
e  Current exchange rate ($/E)
i  US interest rate
i*  Foreign interest rate
Index/Commodity Futures
Suppose an October S&P 500 index future was selling
for $1,150 (This future allows you to buy one share of
the index).
Alternatively, suppose that you borrowed money today
to buy a bond that would pay out enough to purchase a
share of the index with certainty next year.
Index/Commodity Futures
The expected payout to
this bond would be next
year’s index value. To
get the bond’s price, we
discount by an interest P'

rate that reflects the (1  iS &P )

bond’s risk (say, the

return to the S&P 500)
Index/Commodity Futures
Now, because we
borrowed this amount
today (at the T-Bill rate),
P ' (1  i )
we will owe our loan
amount plus interest
next year. (1  iS &P )
Index/Commodity Futures
For example, if the S&P
500 index was expected
to sell for $1,250 next $1,250(1.04)
year (the average return  $1,182
on the index is 10%) and
(1.10)
the T-Bill rate was 4%,
we could buy a share of
the index today for
$1,182
Index/Commodity Futures
Again, the general
relationship can be
written as follows. P ' (1  i )
F
The more variable (1  ix )
market ‘x’ is, the larger
the interest rate
associated with market
‘x’ and, hence, the
cheaper the future price
will be.
Options vs. Futures

Recall that a futures contract is an obligation to de-

liver or purchase a specific commodity as a predeter-
mined time & price
Options vs. Futures

Recall that a futures contract is an obligation to deliver or

purchase a specific commodity as a predetermined time &
price
An option contract gives the holder the option to buy or
sell a specific commodity at a predetermined time & price
Only the purchaser (long position) of the contract gets the
option. The seller (short position) has to obligation to
buy/sell if the option is exercised.
An option, however, does have an up front cost (the price of
the option)
“Vanilla” Options

Any option is defined by four characteristics: com-

modity, size, exercise (strike) price, and term.
A call option gives the holder the option to purchase a
commodity at the strike price
 A put option fives the holder the option to to sell a
commodity at the strike price
Variations on Exercising

A European option can only be exercised upon ex-

piration
An American option may be exercised at any time
up to the expiration date of the contract
A Bermuda (Mid Atlantic) option has several po-
tential exercise dates over the life of the contract
(monthly, quarterly, etc)
Variations on Payout

Average (Tokyo) option: the payout is equal to the

average commodity price over the contract’s life-
time minus the strike price
Look back options: The strike price is equal to the
minimum (call)/maximum (put) of the underlying
commodity
Ladder options: Gains are “locked in“ once the
commodity hits predetermined price levels
“Exotic” Options

One example of an “exotic” would be a barrier option.

In addition to a strike price, a barrier option has one (single
barrier option) or two (double barrier option) “trigger”
prices.
For knock out options, if a trigger is crossed, the option is
voided
For knock in options, the option is activated once the trig-
ger price has been hit
The direction of the price change also matters: “down and
in” “down and out” , “up and in” , “up and out”
Why use options?
Why use options?

Hedging: as with futures, options can be used to in-

sure against many different types of risk
Speculation: as with futures, an option is basically a
bet as to the direction/magnitude of a commodity
price.
A Protective Put

A protective put involves the purchase of a stock and a

put on that stock in equal quantities
The combined value of the stock/put will never be
lower than the strike price of the put.
A protective put is like buying insurance against price
declines.
Protective Put
60 40
40 30
20
20 10
0 0
1 8 15 22 29 36 43 50 1 8 15 22 29 36 43 50

On the right is the payout to buying a put with a strike price of
$30.
Protective Put
60
40
20
0

Combine the put with a share of the underlying

stock.
Covered Call

A covered call involves buying a stock and selling a call

in equal proportions.
The combination of the call/stock will never rise above
the strike price of the call.
This strategy might be used to collect income of a ris-
ing stock price without paying capital gains taxes
Covered Call
60 0
40 1 8 15 22 29 36 43 50
-10
20
0 -20
1 8 15 22 29 36 43 50 -30

On the right is a the payout from selling a call with a strike
price of $30.
Covered Call
40
30
20
10
0
15

22

29

36

43

50
1

Combine the call with the stock

Straddle

A straddle involves buying a put and a call on a stock

(with equal strike prices) in equal proportions
A straddle benefits from both price increases and de-
creases, but might be quite costly
Strips and straps involve different proportions of
puts/calls
Straddle
40 30
30 20
20
10 10
0 0

On the right is a the payout from buying a call with a strike
price of $30. On the Left is the payout from buying a put with
the same strike price.
Straddle
40
30
20
10
0
1 8 15 22 29 36 43 50

Combine the two to get a straddle. Note that a straddle benefits

from both price increases and decreases, but is quite expensive.
Collar

A collar involves the simultaneous purchase of a

call and sale of a call at different strike prices
The combined value of the two calls will be
bounded above and below. Further, the cost of the
purchased call is offset by the revenues from the
written call
A swap is essentially a collar with a zero spread
Straddle
0 30
-5 20
-10 10
-15 0
-20

On the right is a the payout from buying a call with a strike
price of $30. On the Left is the payout from selling a call with a
strike price of $35.
Straddle
6
4
2
0
15

22

29

36

43

50
1

 The collar is very cheap because you use the proceeds from the sale of one
derivative to buy the other.
Put/Call Parity

Recall the protective put constructed earlier (1 stock, 1 put)

This payout can be replicated by purchasing a call option
and a Treasury in equal proportions
Because these two portfolios have the same payout, they
must have equal cost. This defines a relationship between
call prices and put prices
The put/call parity condition is written as
C + X/(1+rf)^T = S + P
Option Pricing

There is no guarantee that an option will actually be exer-

cised. This greatly complicates the pricing of these con-
tracts.
Conceptually, we know call option prices should have the
following characteristics:
 Positively related to the commodity price
 Negatively related to the strike price
 Positively related to the variance of the underlying commodity
 Positively related to the term
 Negatively related to the real interest rate
Binomial Pricing
Binomial pricing involves constructing a lattice for
possible movements of the underlying asset’s price.
At each point on the tree, it is possible to replicate the
return from a call option with a combination of stock
and a bond.
If two assets have the same returns, they should have
the same price!
Example
Suppose a share of stock is currently selling for $20. It
has an equal chance of increasing to $25 or falling to
$15 tomorrow.
There is a risk free bond selling for $1 today. If the in-
terest rate is 6%, the bond will be worth $1.06 tomor-
row.
Consider a call option with a strike price of $20.
Example
There are two states of the world State 1: $25X + $1.06Y
tomorrow: State 2: $15X + $1.06Y
State 1: State 2
S = $25 S = $15 $25X + $1.06Y = $5
C = $5 C = $0 $15X + $1.06Y = $0
B = $1.06 B = $1.06
Solving for X and Y, we get
Suppose we buy X shares of the X = .5 (1/2 Share of Stock)
stock today and Y shares of the Y = -7.08 (Borrow $7.08)
bond. What is our payout
tomorrow?
The Cost of .5 Shares today (net of
borrowing $7.08) is
We need to choose a combination
of X and Y to replicate the call .5($20) - $7.08 = $2.92
payout This is the value of the call!!
Black/Scholes (1973)

The key bit of logic behind the Black/Scholes option pric-

ing framework is that it is always possible to construct a
portfolio of call options and the underlying commodity in
such a way as to eliminate all risk
Recall that a risk free portfolio should pay the risk free rate
of return to eliminate any potential arbitrage opportunities.
This no arbitrage condition results in a relationship be-
tween the call price and the underlying fundamentals
The biggest limitation to the Black/Scholes framework is
that it can only be used to price European options
Black/Scholes (1973)
Pricing American Options

The problem with pricing American options is that they are

“path dependant”
For example, suppose that a call option on IBM stock is pur-
chased with a strike price of $85. The current Price of IBM stock
is $85. What will that option be worth in a month?
IBM stock traded at a constant $85 for the entire month and then
jumped to $90. In this case, the option would be worth around
$5.
However, if IBM stock rose to $150 and then dropped to $90, the
option would probably have already been exercised.
Therefore, its not just the stock price that matters. It also matters
how it got there.
Swaps

A swap is simply a contract in which one payment stream is

traded (swapped) for another
The most common swap is a variable/fixed rate interest
swap in which interest rate payments on a variable rate loan
are traded for interest rate payments on a fixed rate loan
Swaps can also be created for currencies, commodities,
stocks, etc.
Recall, that a swap is basically a zero spread collar. There-
fore, the same principles used for pricing options are used
for pricing swaps.
Other option combinations

The underlying commodities themselves can be deriv-

ative securities.
You can buy options on futures (i.e., the option to enter
into a futures contract)
Options on swaps are known as swaptions
Options on options are known as compound options