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DerivativesMarkets-Class1-.pdf
DERIVATIVES MARKETS
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Overall Objectives of This Course
FIN 430 features the state-of-the-art theories, tools/techniques, and best practices in learning and applying derivatives.
In FIN 430, we study: (i) Fundamental concepts of futures/forwards, options, and
other derivatives; (ii) Economics and institutional features of derivatives
markets; (iii) Frameworks of financial and strategic decisions that
involve pricing, trading, and hedging of derivatives; (iv) Applications of derivatives concepts and tools in various
corporate and financial market settings.
Objectives and Learning Outcomes: 1. Derivatives Theories, Applications, and Practice. 2. Financial Decision Making, Financial Innovations, Risk
Management, Financial Engineering, and Other Applications. 3. Creating, Capturing, and Reinforcing Important Values
Using Derivatives. 22
Major Contents
Part I 1. Introduction to Derivatives Markets 2. Futures and Forwards 3. Options
Part II 4. Swap 5. Credit Derivatives 6. Other Derivatives: e.g., Exotic Options, Interest rate
Derivatives, Derivatives on Non-tradeable Assets, etc.
Part III 7. Advanced Topics in Derivatives Markets 8. Real Options – Applying Options in Strategic Decisions
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Our Approach: Theory + Applications Lectures + Review Sessions + Exercise + Simulation + Research
Analytical tools, theoretical frameworks, and quantitative models integrated with real world examples and case studies.
Derivatives innovation (proposal of new derivatives). Derivatives trading simulation.
Class participation, homework, and individual research assignments are critical.
Final Grades: Class Participation and Homework 10% Individual Assignment # 1 Derivatives Innovation 20% Individual Assignment #2 Derivatives Trading Simulation 20% Midterm Exam (Class #8, Oct 10, 2019) 15% Final exam (Final Exam Week, Dec 12, 2019) 35%
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Class-by-Class Schedule 9. Options (II).
10. Options (III).
11. Options (IV). Review Session (IV).
12. Options (V).
13. Swaps. Credit Derivatives.
14. Other Derivatives, Advanced Issues. Real Options (I). Review Session (V).
15. Real Options (II). Final Review Session.
16. Final Exam.
1. Introduction to Derivatives. Derivatives Markets.
2. Futures/Forwards (I). Review Session (I).
3. Futures/Forwards (II).
4. Futures/Forwards (III).
5. Futures/Forwards (IV). Review Session (II).
6. Futures/Forwards (V).
7. Options (I). Review Session (III).
8. Mid-term Exam.
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Important Concepts We’ll Learn Derivatives Markets, Options, Futures, and Other Derivatives:
Economics of derivatives markets Mechanics, hedging, risk management, arbitrage and trading strategies.
Futures, Forwards and Option markets: Institutional features of derivatives markets.
Nature of Risk, Risk Management, Financial Engineering and Innovation: Risk drivers; risk management consistent with value propositions. Financial engineering; financial innovation.
Hedging, Speculation and Arbitrage: Hedging: investors and companies use derivatives to hedge different types of risks
such as interest rate, currency risk, commodity price risk, etc. Speculation: derivatives traders use futures contracts to bet on the future direction
of prices; speculators can also use options to bet on the volatility of the underlying asset.
Arbitrage: concept of arbitrage and implications on derivative trading and pricing. Economic function of derivatives markets:
Price discovery and information efficiency. Market Valuation and Arbitrage-Free Price:
Determining the arbitrage-free price (law of one price). Theoretical (risk neutral and no-arbitrage) valuation of options:
• Binomial Option Pricing Models. • The Black-Scholes-Merton Option Pricing Model. • Greek letters; implied volatilities, VIX.
Other Derivatives: Swaps; credit derivatives; exotic options; interest rate derivatives. Real Options: Application of options into real strategic-dynamic decisions.
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Powerful Derivatives Tools We’ll Learn Futures and Forwards
Options
Swaps
Options on Stock Indices, Currencies, and Futures
Option Implied Volatility (VIX)
Credit Derivatives; Credit Default Swaps (CDS)
Interest Rate Derivatives
Other Derivatives and Exotic Options
Derivatives on Commodities and Non-tradeable Assets
Financial Innovation and Proposed New Derivatives
Derivatives Trading Strategies
Real Options 7
Derivatives as Your Career! Derivatives experts are in great demand:
Traders, arbitrageurs, large/small speculators, innovators in financial markets, etc.
“Quants” (“rocket scientists”), analysts, traders and market makers in different markets: options, futures, currency, commodities, etc.
Investment management and institutional investors.
Policy makers in stock and options/futures exchanges and markets.
Business decision makers (e.g., CEO, CFO, managers, entrepreneurs, farmers, etc.) who use derivatives to manage exposures to interest rate risk, currency risk, weather risk, etc.
Managers who apply knowledge/insights of derivatives: derivatives markets, hedging and risk management, valuation of firm value and securities, real options, etc.
Public policy makers and regulators in financial markets.
Individuals who make dynamic decisions under risks and uncertainties.
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Major Financial Events of Our Times Global Financial Markets:
Financial innovations. Rising importance of financial engineering and risk management
using derivatives. Global interdependence and contagion. Emerging markets.
Financial Market Volatility, Institutions, and Governance: Volatility is volatile (e.g., VIX). Rise of hedge funds and derivatives. Risk arbitrage. Fall of LTCM (1998). Enron-mania. The Sarbanes-Oxley Act (2002).
Important Financial Events: Decimalization (2001). Dividend tax cut (2003). Mutual funds scandal (2003). Hedge funds mania (2005). Housing Bubble (2001-2005). NYSE went public (2006). Penny Pilot Program of Option Exchanges (2007). CME Group created (2007) – CME and CBOT merged. CME Group acquired New York Mercantile Exchange (NYMEX)
(2008). CBOE went public (2010). 9
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Major Corporate Events of Our Times… Financial Crises and Emerging Issues:
2007 Hedge fund losses; Subprime Mortgage Crisis. 2008 Société Générale trading loss incident (losses of $6.9 billion USD). 2007-2009 “Global Financial and Economic Crises”, including regulatory
concerns over CDS market and collapses of Bear Sterns, Lehman Brothers, AIG, among others.
In Oct 2008, the Troubled Asset Relief Program (TARP) provided public bailouts to firms, banks, and institutions. TARP fund receiving financial institutions issued warrants (option-like securities) to the government.
2010 European Sovereign Debt Crisis. In July 2010, the US Congress passed the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank Act), which created the Consumer Financial Protection Bureau (CFPB) to promote finance education and literacy.
Other recent events: S&P downgrades US credit rating (2011); JPMorgan Chase’s trading losses from $2 billion to $4.4 billion, and then $5.8 billion (as of July 2012); Facebook IPO and option listing (2012), etc.
Regulatory changes to over-the-counter (OTC) derivatives markets - Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act; the regulatory framework for the governance of the OTC derivatives markets and vests oversight authority in the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC).
Other ongoing/emerging issues: market manipulation, controversies over high frequency trading; cryptocurrency, Bitcoin derivatives (CME and CBOE launched Bitcoin futures), among others.
Notorious Derivatives “Disasters” In 1994, Procter and Gamble lost $150 million in an interest-rate swap.
In 1994, Orange County, California reported a loss of $1.7 billion on interest rate derivatives.
In 1995, Barings Bank lost more than $2 billion in Nikkei index futures and options. It suffers large losses of 1.3 billion due to speculative trading by a 28-year-old former clerk name Nick Lesson in its Singapore office .
In 1996, Sumitomo Corporation lost $2.6 billion (10% of Sumitomo’s annual sales) in copper derivatives.
Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether, Myron Scholes and Robert Merton. LTCM folded in 1998, losing $4.6 billion in less than four months. At the beginning of 1998, it had off-balance sheet derivative positions amounting to $1.25 trillion, most of which were in interest rate derivatives.
In 2006, Amaranth Advisors lost $6 billion in natural gas futures.
During 2007-2008 financial crisis, Morgan Stanley lost $9 billion in Credit Default Swap (CDS). In September 2008, the bankruptcy of Lehman Brothers caused a total of about $400 billion payable to the CDS buyer. Meanwhile, AIG (seller of CDS) required a federal bailout because of potential losses over $100 billion.
In July 2012, the estimated derivative trading loss of JPMorgan Chase was $5.8 billion.
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Current Financial Crisis (information provided as of Nov 2008)
1yr change
5yr change
10yr change
VIX 128.04% 117.89% 40.34%
House Pi -9.56% 12.88% 34.29%
GDP 3.37% 26.36% 49.57%
S&P -36.91% -11.60% -17.63%
CPI 4.82% 16.73% 29.14%
Volume 16.54% 116.78% 175.18%
Crash index 87%
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SPY vis-à-vis CBOE Implied Volatility Index (VIX)
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Useful sources of information and data: CBOE VIX: (http://www.cboe.com/micro/VIX/vixintro.asp) VIX historical price data: (http://www.cboe.com/micro/VIX/historical.aspx) SPY (http://finance.yahoo.com/quote/SPY/history?ltr=1)
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100
150
200
250
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VIX Close SPY Poly. (VIX Close) Poly. (SPY)
Derivatives and Financial Markets during Financial Crisis
Futures Market
ETF-CME 2b contracts Quadrillion dollars of value (15 0’s) 1.15 Trillion on Lehman Bro – no default
CDS Market Total Gross Notional = 33,557,901,575,685 (33.55Trillion as of Oct 31 2008) # Contracts = 2,449,192
Equity Market
Since 1 January, 2008, equity loss: Oct - losses 4-5 Trillions Nov - $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion.
Mortgage market
The U.S. mortgage market is at $12 trillion (9.2% in foreclosure through August 2008). During 2007, nearly 1.3 million properties subject to foreclosure, up 79% in 2006.
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Class 1 Introduction to Derivatives
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Overview of Class 1:
Introduction to derivatives: Fundamental Concepts
Brief history of derivatives
Uses of derivatives
Economics and roles of derivative markets
Different types of financial derivatives
Introduction to Futures, Forwards, and Options
Economics of exchange-traded and OTC derivatives markets
Criticisms and rebuttals of derivatives
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1. What are Derivatives?
Derivatives are defined as financial instruments (or contracts) whose values depend on (derive from) the values (incorporating risk drivers, time and uncertainty) of other, more basic, underlying variables. The underlying variables are often the prices of traded assets.
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1.1. Understanding the Concepts of Derivatives
Derivatives markets can be characterized by the interactions between derivative and spot markets: dissemination and transmission of information, risk transfer/sharing, price discovery, pricing and valuation – derivatives are essential for all agent’s decision making even for managers with no anticipated need to transact in the capital markets.
Derivatives are “synthetics”, which involve a form of pretending an ownership in the benchmark source and reaping the same economic consequences from a real transaction.
Derivatives trade in “zero net supply” markets, where each buyer has a matching seller.
Derivatives are “zero-sum games” - one trader’s gain is the other’s loss.
Derivatives feature the approach of “contingent claim” analysis: range from pricing of complex financial derivatives/securities to financial and strategic decisions.
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1.2. Understanding Derivatives... Spectrum of derivatives: standardized vs. customized, simple vs. complex,
financial vs. real, etc.
Since the Nobel Prize-winning work by Black and Scholes (1973) and Merton (1973), options and derivatives have been understood as (high- frequency) trading activities linking the underlying asset markets and the derivatives markets – determined by “No Arbitrage” condition.
Arbitrage is one of the most important and powerful concepts (wisdom) in finance and derivatives – Arbitrage means riskless profits (or “free lunch”) with no investment. The principle of “No Arbitrage” has important implications from corporate finance (the M-M theorem), investment (market efficiency), to “Arbitrage-Free” price of derivatives (the law of one price).
In practice Arbitrage involves comparing the estimated intrinsic value of a underlying asset to the value of a replicating asset. Intrinsic value is estimated by determining the amount, timing, and risk of
the underlying asset and then applying a valuation methodology. The value of the replicating asset, a traded asset, or portfolio of traded
assets, whose cash flows exactly match those of the underlying asset, is its market price. 19
1.3. Understanding Derivatives... Derivatives and Financial Innovations:
“Derivatives are at the core of financial innovation, for better or for worse” (Jarrow and Chatterjea (2013)). There are 2 major economic motives for financial innovations: (i) Regulatory Constraints (e.g. taxes); and
(ii) Transaction Costs. Trading activities move to financial markets
where transaction costs and regulatory constraints are minimized.
On the one hand, derivatives can help to enhance firm value, to support corporate financial management and investments, to create wealth for individuals, to provide risk management, hedging, and financial engineering for corporations and financial institutions, to advance financial innovations, and to create new trading strategies.
On the other hand, derivatives are associated with extreme large losses, and even financial crisis. There are misuses of derivatives and notorious “derivatives disasters”.
In FIN 430, we shall provide a better understanding of the nature, intricacies, and economic insights of derivatives. 20
1.4. The “Big Picture”
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Exhibit 1. Interrelationships between Spot and Derivative Markets
Underlying Assets Markets Derivatives Markets
Equities, Indices Futures, Forwards Interest Rates, Exchange Rates Trading, Price Options Commodities , Energy Info, Risks Swaps Others: Volatilities, Credit Risk Exotic Options Weather, Non-Tradeable Assets Other Derivatives
Valuation and Pricing
(No Arbitrage)
2. History of Derivatives In Genesis Chapter 29 (about 1700 B.C.), Jacob purchased an option costing
him seven years of labor (derivative contract) that granted him the right to marry Laban's daughter Rachel.
Aristotle (about 2400 years ago): a philosopher named Thales, who forecasted the weather and used his money to corner the olive press market. When the harvest produced a bumper crop, olive press is in high demand and Thales made a fortune.
Legend of South Sea Island archipelago whose inhabitants settled their interisland trade not with gold but with carved boulders hauled on rafts. One day, a sudden storm sunk the raft of the debtor (including the boulder). The island high priest, happened to be the central banker, pointed to the bottom of the lagoon, where the boulder could be clearly see, and direct the completion of the trade.
The origins of derivatives traced back to India (about 2000 B.C.), to ancient Babylonia (1894–1595 B.C.) and Roman merchants who traded grains with Egypt.
The first exchange for trading derivatives are traced to the Royal Exchange in London, for forward contracting. The celebrated Dutch Tulip bulb mania was characterized by forward contracting around 1637. The first futures contracts are generally traced to the Yodoya rice market in Japan around 1650. 22
2.1. History of Derivatives… The creation of the Chicago Board of Trade (CBOT) in 1848 (due to its
prime location on Lake Michigan, and major center for the storage, sale, and distribution of Midwestern grain). In 1925 the first futures clearinghouse was formed.
During 1922-1950s, options, futures and various derivatives continued to be banned from time to time, from countries to countries. In 1950s, there was the ban on onion futures, and an old saying "you can create futures contracts on anything but onions.”
In 1972 the Chicago Mercantile Exchange (CME) created the International Monetary Market for trading in currency futures. In 1973, the creation of both the Chicago Board Options Exchange (CBOE).
In 1975, the CBOT created the first interest rate futures contract. In 1977, the CBOT created the T -bond futures contract. In 1982 the CME created the Eurodollar contract. In 1982, the first stock index futures and contract on the S&P 500 index were launched.
In 1983, the CBOE created an option on an index of stocks; swaps and other derivatives (e.g., exotic) are increasingly popular ever since.
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3. Uses of Derivatives Derivatives can be used as risk management tools or
as investment opportunities.
Uses of derivatives: (1) Derivatives as basis for financial innovation and
engineering (changing risk-return profile, replicating returns, hedge portfolio), and a convenient substitute/efficient medium for investments (risk and return unchanged).
(2) Derivatives to hedge, reduce risk, and manage risks inherent in business (decrease risk with costs).
(3) Derivatives as speculation to increase risk and reward through leverage (increase risk).
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3.1. Ways Derivatives are Used To Hedge and Manage Risks.
To Speculate (take a view on the future direction of the market).
To Arbitrage.
To provide Financial Innovations and Financial Engineering. – e.g., changing the nature (risk profile) of a liability/ investment without
incurring the costs of selling one portfolio and buying another. – e.g., Use of derivatives for adjusting portfolio proportions; changing Equity
exposure using Index Futures.
The Basel Committee’s Risk Management Guidelines for Derivatives (July 1994,10–17) identified the following risks in connection with an institution’s derivative activities: – (1) Market (or price) risk, which includes commodity price risk, equity
price risk, interest rate risk, and foreign currency price risk; – (2) Credit risk (including settlement risk); – (3) Liquidity risk; and – (4) Operational (or operations) risk. – See Jarrow and Chatterjea (2013) for further details and examples.
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4. Examples of Derivatives Futures Contracts (exchanged-traded)
Forward Contracts (OTC)
Options (exchange-traded and OTC)
Swaps (OTC – going to have more exchange-traded features?)
Other types of derivatives include hybrids: e.g., they are created from financial innovations and financial engineering. Examples are: Options on Futures; Options on Swaps; Options on Options, etc.
Exotic Options Examples are: Compound Options, Chooser Options, Barrier
Options, Binary Options, Lookback Options, Asian Options, etc.
Note: The Underlying Asset is also know as the Underlying. A derivative derives its value from the underlying.
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5. Economic Functions of Derivatives Markets
Risk Management and Financial Engineering Hedging vs. speculation Derivatives provide opportunity to (re-)configure risk-and-return tradeoff. Firms can transfer risks (e.g., interest rate risk, currency risks) to speculators at
a price using derivatives. Hedging can enhance corporate strategy. Risk management and financial engineering with value propositions can add value to the firm.
Price Discovery (Active and Informative) derivative trading may enhance the price discovery
process of the underlying assets. The information content of derivative prices can be used as predictor of the spot market prices.
Forward / futures markets provide forecasts of spot market prices in the future, whereas option markets provide information on volatility.
Operational Advantages Transaction costs; market liquidity (important); ease of short selling (leveraged
transactions).
Market efficiency The economic linkage between spot and derivatives prices and low transaction
cost facilitate informed trading, rapid price adjustments (“synchronous markets”), and informational efficiency.
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6. Futures Contracts
A Futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price.
In contrast, a Spot contract is an agreement to buy or sell the asset immediately (or within a very short period of time).
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6.1. Futures Price The Futures Price for a particular contract is the price at
which you agree to buy or sell later
Important insight: “Contract Now, Transact Later”.
Futures price is determined by supply and demand in the same way as a spot price.
Futures Price and Spot Price are determined in different (but related) markets:
• Futures Price is determined in the Futures Market.
• Spot price is determined in the Spot Market.
Terminology of Futures Positions: The party that has agreed to buy has a long position. The party that has agreed to sell has a short position.
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6.2. Future Exchanges: Examples
Examples of Futures Exchanges in U.S. Chicago Mercantile Exchange (CME)
Group, which includes Chicago Board of Trade (CBOT) and New York Mercantile Exchange (NYMEX)
Chicago Board Options Exchange (CBOE) Group
Chicago Butter and Egg Board, precursor to the CME
International Monetary Market (IMM), part of the CME
Commodity Exchange (COMEX), part of the CME
Kansas City Board of Trade (KCBT), acquired by CME
Chicago Climate Exchange Minneapolis Grain Exchange (MGEX) New York Board of Trade (NYBOT),
unit of ICE.
Examples of Future Exchanges around the Globe: Eurex Exchange Euronext (merged with NYSE to
form NYSE Euronext in 2007) European Climate Exchange International Petroleum Exchange
(IPE) London International Financial
Futures and Options Exchange (LIFFE), precursor to Euronext.liffe
London Metal Exchange (LME) National Stock Exchange of India Korea Exchange Taiwan Futures Exchange (TAIFEX) TIFFE (in Toyko) Hong Kong Exchanges and
Clearing (HKEx) BM&F, now B3 (in Brazil)
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Futures trades on exchange-traded markets – organized exchanges that provide regulations for buyers and sellers to trade a “homogeneous product.” The federal Commodity Futures Trading Commission (CFTC) and the industry’s National Futures Association (NFA) regulate commodity exchanges in the U.S..
6.3. CBOT and Price Discovery: Open Outcry and the “Pits”
Open outcry occurs in the “Pits” – sunken, polygonal rings, vary in size (trading volume), inside with brokers and exchange employees (like lifeguard), surrounded by trading desks and arbitrage (arb.) clerks. Orders flow to the trading “Pits” via verbal indication AND hand signals or floor clerk (“runner”). See “Circle of Trade” below.
Price of exchange memberships (privilege to trade on the floor): often > $1 million. See (http://www.cmegroup.com/company/membership/membership-pricing- cbot.html). CBOE seat changed hands for $2.8 million in Oct 2009. A record $3.3 million was paid for a CBOE membership on June 18, 2008 (source: Bloomberg).
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Trade occurs at trading floor
“Pit” reporter records data
Traders, getting informed, call to place an order
Data/Info. transmitted to priceboards
Data/info. distributed around the world futures markets
Figure 6.3. Circle of Trade
6.4. Electronic Trading Traditionally futures contracts have been traded using the open outcry
system where traders physically meet on the floor of the exchange. Advantages of open outcry include: efficiency mean of price discovery; market making ability (the “edge”); reputation; high cost of trading seat, etc.
Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers.
Q: Which is better? Open Outcry vis-à-vis Electronic Trading.
Merton Miller’s Critique: Open outcry trading pits: a cheap way of handling transactions in large
volume at great speed and frequency in setting of high price volatility. Electronic trading: more efficient in order routing, data processing,
surveillance, etc. Exchange provides other critical functions: clearing and settlement,
guarantees of contract performance, record-keeping, and audit trails, and collection and dissemination of price information.
Best from both worlds? See, e.g., CBOE Hybrid that combines both the electronic trading and open outcry.
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6.5. Process of Futures Contracts
Marking-to-Market (Exchange-Traded Futures)
Closed/Offset Position before Delivery
Transact Later Long Futures Delivery Short
Today Delivery Date
Contract Now Futures Price Quantity Delivery Date Other Specifications
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6.6. Payoff to Long Forward Position
Payoff to Long Forward
Price of Underlying at Delivery, STK
(Delivery Price in Forward Contract)
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6.7. Payoff to Short Forward Position
Payoff to Short Forward
Price of Underlying at Delivery, STK
(Delivery Price in
Forward Contract)
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7. Forward Contracts Forward contract:
Similar to futures, a forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price.
In other words, forward contract locks in a price today for a future transaction — “Contract Now, Transact Later”.
Forward contracts are similar to futures except that they trade in the over-the-counter (OTC) markets (with less regulatory requirements but higher risk of default).
Forward contracts are popular on currencies and interest rates.
Useful Insight: we may view futures as a standardized forward or forward as a customized futures.
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7.1. Over-the Counter (OTC) Markets The over-the counter (OTC) market is an important alternative to
exchanges. It is a telephone and computer-linked network of dealers who do not physically meet. Trades are usually made between financial institutions, corporate treasurers, and fund managers.
The OTC markets have been growing significantly in terms of scale and scope (source: International Swaps and Derivatives Association (ISDA) Market Survey). Since the financial crisis, the OTC derivatives markets have experienced important structural and regulatory changes.
o In the second half of 2017, the total combined notional amount of outstanding OTC derivatives contracts was $532 trillion. The largest share is interest rate derivatives, followed by foreign exchange derivatives, credit derivatives, and equity derivatives. In the second half of 2018 , the total combined notional amount of outstanding OTC derivatives contracts was $544 trillion.
o The gross market value of OTC derivatives (reflecting market and counterparty credit risks) declined to $11 trillion in 2017 and $9.7 trillion in 2018 (lowest level since 2007) from the peak of $35 trillion in 2008.
o Source: “OTC derivatives statistics at end-December 2017,” and “OTC derivatives statistics at end-December 2018,” BIS (Bank for Internal Settlements).
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8. Options
A call option is an option (but not an obligation) to buy a certain asset by a certain date for a certain price (the strike price).
A put option is an option (but not an obligation) to sell a certain asset by a certain date for a certain price (the strike price).
Note: an option contract gives the buyer of the option contract the right (again, an option but not an obligation) to buy or sell an asset for a predetermined strike price in the future. A call option provides the buyer of the call option contract the right to buy in the future. In contrast, a put option provides the buyer of the put option contract the right to sell in the future.
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8.1. Process of Options Contracts Closed/Offset Position before Maturity
Early Exercise Opportunity (American Options)
Transact Later Long Options Exercising Options (Call or Put) Short
Today Maturity Date
Contract Now Call or Put Strike Price Quantity Maturity Date Option Exercise (European or American Options) Option Premium Other Specifications
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8.2. Profit to Long Call Options
Profit to Long Call Option
Price of Underlying at Maturity, ST
K (Strike Price in Option Contract)
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8.3. Profit to Long Put Options
Profit to Long Put Option
Price of Underlying at Maturity, ST
K (Strike Price in Option Contract)
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8.4. Exercising Policy: American vs. European Style Options
The main difference is option exercising policy:
a) An American option can be exercised at any time during its life.
b) A European option can be exercised only at maturity.
c) A Bermudan option is a hybrid of American and European options.
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8.5. Options vs. Futures/Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price in the future.
An option gives the holder the right (the exercising flexibility, but not the obligation) to buy or sell at a certain price in the future.
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9. Types of Traders in Derivatives Markets
Jarrow and Chatterjea (2013) argue that different types of derivatives traders can be categorized in terms of their trading strategies:
Hedgers: traders who try to reduce risk by trading securities.
Speculators: traders who take calculated risks in their pursuit of profits; they may be classified in term of their trading frequency (from highest to lowest frequency): (i) scalpers (e.g. floor traders, market makers, liquidity traders); (ii) day traders; or (iii) position traders (trend followers) on the basis of how long they hold their trades.
Arbitrageurs: traders who exploit price discrepancies among securities, seek arbitrage opportunities in inefficient markets, and attempt to extract riskless arbitrage profits.
However, some of the largest trading losses in derivatives markets occurred when some hedgers or arbitrageurs switched to become speculators (See, e.g., Barings Bank, Enron, etc.).
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Useful Readings and Concepts for This Class Important concepts learned in Class #1:
1. Definitions and Concepts of Derivatives
2. Characteristics of Derivatives Markets – Interrelationships between Derivatives and Spot Markets
3. Notion of Arbitrage and Importance of “No-Arbitrage” in Pricing Derivatives
4. Basics of Futures and Options contracts – how do they work; how do they differ; who should consider futures and/or options.
Important Readings: Jarrow and Chatterjea (2013):
Ch. 1 (focus on: 1.1, 1.2, 1.3, 1.4, 1.8)
Ch. 4 (focus on 4.1, 4.2, 4.3, 4.4, 4.5)
Ch. 5 (focus on 5.1, 5.2)
Ch. 6 (focus on 6.1, 6.2, 6.3, 6.5, 6.6)
Useful (Additional/Optional) Reference: Hull (7th or 8th edition):
Ch. 1 (focus on: 1.1-1.2 futures contracts; 1.3 OTC market; 1.4 Forward Contracts; 1.5-1.6 Options; 1.7-1.9 Types of Traders; 1.11 Dangers).
Ch. 25 (focus on: 25.1).
Note: references above are equivalent to Hull (6th edition): Ch. 1, 23. 45
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