Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.1
Introduction
Chapter 1
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.2
The Nature of Derivatives
A derivative is an instrument whose
value depends on the values of other
more basic underlying variables
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.3
Examples of Derivatives
? Forward Contracts
? Futures Contracts
? Swaps
? Options
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.4
Derivatives Markets
? Exchange traded
– Traditionally exchanges have used the open-
outcry system,but increasingly they are switching
to electronic trading
– Contracts are standard there is virtually no credit
risk
? Over-the-counter (OTC)
– A computer- and telephone-linked network of
dealers at financial institutions,corporations,and
fund managers
– Contracts can be non-standard and there is some
small amount of credit risk
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.5
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,5th edition ? 2002 by John C,Hull
1.6
Forward Contracts
? A forward contract is an agreement to buy
or sell an asset at a certain time in the future
for a certain price (the delivery price)
? It can be contrasted with a spot contract
which is an agreement to buy or sell
immediately
? It is traded in the OTC market
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.7
Foreign Exchange Quotes for
GBP on Aug 16,2001 (See page 3)
Bid Offer
Spot 1.4452 1.4456
1-month forward 1.4435 1.4440
3-month forward 1.4402 1.4407
6-month forward 1.4353 1.4359
12-month forward 1.4262 1.4268
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.8Forward 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,5th edition ? 2002 by John C,Hull
1.9
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,5th edition ? 2002 by John C,Hull
1.10
Example (page 3)
? On August 16,2001 the treasurer of a
corporation enters into a long forward
contract to buy ￡1 million in six months
at an exchange rate of 1.4359
? This obligates the corporation to pay
$1,435,900 for ￡1 million on February
16,2002
? What are the possible outcomes?
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.11
Profit from a
Long Forward Position
Profit
Price of Underlying
at Maturity,STK
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.12
Profit from a
Short Forward Position
Profit
Price of Underlying
at Maturity,STK
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.13
Futures Contracts
? 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
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.14
Examples of Futures Contracts
? Agreement to:
–buy 100 oz,of gold @ US$300/oz,
in December (COMEX)
–sell ￡62,500 @ 1.5000 US$/￡ in
March (CME)
–sell 1,000 bbl,of oil @ US$20/bbl,
in April (NYMEX)
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.151,Gold,An Arbitrage
Opportunity?
? Suppose that:
- The spot price of gold is US$300
- The 1-year forward price of gold is
US$340
- The 1-year US$ interest rate is 5%
per annum
? Is there an arbitrage opportunity?
(We ignore storage costs and gold lease rate)?
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.16
2,Gold,Another Arbitrage
Opportunity?
? Suppose that:
- The spot price of gold is US$300
- The 1-year forward price of gold
is US$300
- The 1-year US$ interest rate is
5% per annum
? Is there an arbitrage opportunity?
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.17
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 = 300,T = 1,and r =0.05 so
that
F = 300(1+0.05) = 315
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.18
1,Oil,An Arbitrage
Opportunity?
Suppose that:
- The spot price of oil is US$19
- The quoted 1-year futures price of
oil is US$25
- The 1-year US$ interest rate is
5% per annum
- The storage costs of oil are 2%
per annum
? Is there an arbitrage opportunity?
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.19
2,Oil,Another Arbitrage
Opportunity?
? Suppose that:
- The spot price of oil is US$19
- The quoted 1-year futures price of
oil is US$16
- The 1-year US$ interest rate is
5% per annum
- The storage costs of oil are 2%
per annum
? Is there an arbitrage opportunity?
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.20
Exchanges Trading Options
? Chicago Board Options Exchange
? American Stock Exchange
? Philadelphia Stock Exchange
? Pacific Stock Exchange
? European Options Exchange
? Australian Options Market
? and many more (see list at end of book)
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.21
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 is an
option to sell a
certain asset by
a certain date
for a certain
price (the strike
price)
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.22
Long Call on Microsoft (Figure 1.2,Page 7)
Profit from buying a European call option on Microsoft,
option price = $5,strike price = $60
30
20
10
0
-5
30 40 50 60
70 80 90
Profit ($)
Terminal
stock price ($)
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.23
Short Call on Microsoft (Figure 1.4,page 9)
Profit from writing a European call option on Microsoft,
option price = $5,strike price = $60
-30
-20
-10
0
5
30 40 50 60
70 80 90
Profit ($)
Terminal
stock price ($)
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.24
Long Put on IBM (Figure 1.3,page 8)
Profit from buying a European put option on IBM,
option price = $7,strike price = $90
30
20
10
0
-7 90807060 100 110 120
Profit ($)
Terminal
stock price ($)
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.25
Short Put on IBM (Figure 1.5,page 9)
Profit from writing a European put option on IBM,
option price = $7,strike price = $90
-30
-20
-10
7
0 90
807060
100 110 120
Profit ($) Terminal
stock price ($)
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.26Payoffs from Options
What is the Option Position in Each Case?
K = Strike price,ST = Price of asset at maturity
Payoff Payoff
ST STK
K
Payoff Payoff
ST STK
K
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.27
Types of Traders
? Hedgers
? Speculators
? Arbitrageurs
Some of the large trading losses in
derivatives occurred because individuals
who had a mandate to hedge risks switched
to being speculators
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.28
Hedging Examples (page 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 $73 per share,A
two-month put with a strike price of $65
costs $2.50,The investor decides to
hedge by buying 10 contracts
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.29
Speculation Example
? An investor with $4,000 to invest feels
that Cisco’s 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 25 is
$1
? What are the alternative strategies?
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
1.30
Arbitrage Example (pages 12-13)
? A stock price is quoted as ￡100 in
London and $172 in New York
? The current exchange rate is 1.7500
? What is the arbitrage opportunity?