Introduction Chapter 1 Options Futures and Other Derivatives

Introduction Chapter 1 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 1

Over-The-Counter Markets It is a telephone- and computer-linked network of dealers Trades are usually between two financial institutions or between a financial institution and one of its clients (typically a corporate treasurer or fund manager) Briefly, two participants can enter into any mutually acceptable contract. Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 2

Exchange-Traded Markets A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange It creates an orderly market with welldefined contracts A market maker quotes a bid an offer A bid price is a price at which they are prepared to buy An offer price is a price at which they are prepared to sell Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 3

Foreign Exchange Quotes for GBP, July 20, 2007 In order to see the current spot prices you can go to: http: //finance. yahoo. com/q? s=GBPUSD=X Spot Bid 2. 0558 Offer 2. 0562 1 -month forward 2. 0547 2. 0552 3 -month forward 2. 0526 2. 0531 6 -month forward 2. 0483 2. 0489 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 4

Size of OTC and Exchange-Traded Markets (Figure 1. 1, Page 3) 550 Size of Market 500 ($ trillion) 450 OTC 400 350 300 250 200 150 100 50 0 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 5

Ways 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 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 6

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

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 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 8

Example (page 4) 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? Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 9

Profit from a Long Forward Position Profit K Price of Underlying at Maturity, ST Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 10

Profit from a Short Forward Position Profit K Price of Underlying at Maturity, ST Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 11

Futures Contracts (page 6) 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 The difference between these two will be discussed in detail in the next chapters Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 12

Exchanges Trading Futures Chicago Board of Trade Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more (see list at end of book) Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 13

Examples of Futures Contracts Agreement to: 1. Buy 100 oz. of gold @ US$ 1808. 4/oz. in December (NYMEX) http: //www. cmegroup. com/trading/metals/precious/gold. html 2. Sell £ 62, 500 @ 1. 5775 US$/£ in March (CME) http: //www. cmegroup. com/trading/fx/g 10/british-pound. html 3. Sell 1, 000 bbl. of oil @ US$ 109. 43 /bbl. in April (NYMEX) http: //www. cmegroup. com/trading/energy/crude-oil/brentcrude-oil-last-day. html Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 14

Arbitrage Involves taking positions in two or more different markets to lock in a risk-free profit A stock price is quoted as £ 100 in London and $158 in New York o The current exchange rate is 1. 5787 o What is the arbitrage opportunity? o Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 15

1. Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$1800 The 1 -year forward price of gold is US$1860 The 1 -year US$ interest rate is 3% per annum Is there an arbitrage opportunity? Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 16

2. Gold: Another Arbitrage Opportunity? Suppose that: - The spot price of gold is US$1800 - The 1 -year forward price of gold is US$1800 - The 1 -year US$ interest rate is 3% per annum Is there an arbitrage opportunity? Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 17

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 = 1800, T = 1, and r =0. 03 so that F = 1800(1+0. 03) = 1854 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 18

Options A call option is an option to buy a certain asset by a certain date for a certain price (the strike price, K) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price, K) Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 19

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 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 20

Intel Option Prices (Sept 12, 2006; Stock Price=19. 56); See Table 1. 2 page 7; Source: CBOE Strike Price Oct Call Jan Call Apr Call Oct Put Jan Put Apr Put 15. 00 4. 650 4. 950 5. 150 0. 025 0. 150 0. 275 17. 50 2. 300 2. 775 3. 150 0. 125 0. 475 0. 725 20. 00 0. 575 1. 175 1. 650 0. 875 1. 375 1. 700 22. 50 0. 075 0. 375 0. 725 2. 950 3. 100 3. 300 25. 00 0. 025 0. 125 0. 275 5. 450 Current Prices on: http: //finance. yahoo. com/q/op? s=INTC+Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 21

Exchanges Trading Options Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) and many more (see list at end of book) Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 22

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 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 23

Types of Traders • Hedgers • Speculators • Arbitrageurs 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 (See for example Barings Bank, Business Snapshot 1. 2, page 15) Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 24

Hedging Examples (pages 10 -11) 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 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 25

Value of Microsoft Shares with and without Hedging (Fig 1. 4, page 11) 40, 000 Value of Holding ($) 35, 000 No Hedging 30, 000 Hedging 25, 000 Stock Price ($) 20, 000 20 25 30 35 40 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 26

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 What are the alternative strategies? Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 27