FINC 3340

1
FINC 3340

• Derivatives Markets

2
Understanding Forwards and Futures

• We are now entering fundamentally different
  territory. The previous chapters all dealt with
  securities that could be bought and sold for
  immediate delivery (spot). Forwards and futures
  are securities that allow contracting now for
  transactions in the future. The growth and
  development of active futures (and options)
  markets, especially for interest rate related
  contracts, has been another key component of the
  ongoing financial "revolution."

3
Understanding Forwards and futures

• KEY IDEAS
• Using forwards and futures - what is a hedge?

4
Forward and Futures Contracts

• Basic contract structures
• What are the key differences?
• How does marking to market work?

5
Forward and Futures Contracts

• A brief look at futures markets

6
Options An Overview

• A contract that allows one party to choose if the
  contract will be fulfilled (and the second party
  is required to complete the contract) is an
  option contract. There are essentially two types
  of options, depending on what the owner of the
  option has the right to do.
• CALL OPTION A contract that allows one party to
  buy an underlying asset for a fixed price on or
  before a specific time. Usually the underlying
  asset is a share of common stock in a company.
  We will later focus on financial instrument
  options.
• PUT OPTION A contract that allows one party to
  sell an underlying asset for a fixed price on or
  before a specific time.
• What is the nature of these contracts and how are
  they priced?

7
Option Pricing A Simplified Approach

• CHICAGO BOARD (November 3, 2003)
• FIRM STRIKE CALLS
  PUTS
• CLOSE PRICE NOV DEC JAN NOV DEC JAN
• Yahoo! 40 4.20 5.30
  5.90 0.25 1.90 5.80
• 44.10 45 1.00 2.25 3.00 0.85
  2.80 6.20
• 50 0.15 0.60 1.30 1.50 4.30 7.20
• Reading this data for a call option is as
  follows An individual can buy one call option
  (a contract for puchase of one hundred shares of
  Yahoo!) or buy one put option. Contracts have
  specific strike or execise prices and expiration
  dates. For example, if you wanted to buy a call
  option on Yahoo! with an expiration date in
  December (its the third Friday in December) and a
  strike of 45 per share, it would cost you 2.25
  per share or 225 (100 x 2.25). The current
  selling price of Yahoo! stock is 44.10 per
  share.

8
Option Pricing A Simplified Approach

• The intrinsic value of the contract is the
  difference between the strike price and the
  current market price. For a call option it is St
  - K (common variables are K or X). The intrinsic
  value is the price to buy and exercise the
  contract immediately.
• The key to remember here is the call is an
  option.if you don't want to exercise you don't
  have to exercise. Therefore the intrinsic value
  can never be negative. Thus for a call, the
  intrinsic value is 0 if the exercise price is
  above the strike price or St - K, whichever is
  higher. Often you may see this in mathematical
  form as
• Ct Max ( 0, St - K ).
• The same discussion works for puts but in reverse
  and the final statement is
• Pt Max ( 0, K - St ).

9
Option Pricing A Simplified Approach

• Call and Put Options are often referred to as
  in-the-money or out-of-the-money options. An
  in-the-money option simply means that for a call
  option, the current stock price is above the
  strike price. For an in-the-money put option,
  the current stock price is below the strike
  price. This means that to buy these in-the-money
  options you will have to pay at least the
  intrinsic value (and this is the lower limit of
  the option). But usually you pay more than the
  intrinsic value. For example, return to the
  Yahoo! quotes. The December 45 call sells for
  2.25, even though the intrinsic value is 0.
  The December 45 put sells for 2.80 or 1.90
  above its intrinsic value (of 0.90). We note
  two things here, the options are not symmetric,
  that is they are not selling for the same premium
  over their respective intrinsic value and the
  call is selling for a (slightly) larger premium
  (above intrinsic value). Why?

10
Option Pricing A Simplified Approach

• At times prior to an options expiration date,
  the price is above its intrinsic value, but how
  much above? The answer depends on five factors
• 1. The stock price
• 2. The strike or exercise price
• 3. The time to expiration
• 4. The risk free rate
• 5. The volatility of the stock (variance of
  price over time).

11
Swaps

• Defined a swap is a contractual agreement in
  which two parties, called counterparties, agree
  to make periodic payments to each other.
  Contained in the swap agreement is a
  specification of the notional principal, the rate
  of interest applicable to each (which may be
  fixed or floating), the timetable by which the
  payments are to be made, and any other provisions
  bearing on the relationship between the parties.

12
Swaps, continued

• The most common type of interest rate swap is a
  fixed-for-floating rate swap. In this type of
  swap, the first counterparty agrees to make
  fixed-rate interest payments to the second
  counterparty in exchange for floating-rate
  interest payments to the first counterparty by
  the second counterparty. The interest payments
  are calculated on the basis of a hypothetical
  amount of principal called notional principal.
  Only the interest payments are exchanged.

13
Swaps, continued

• What are some other kinds of swaps?
• Currency
• Credit

14
Interest Rate Caps and Floors

• Cap - a series of single European interest rate
  call options used to protect against rate moves
  above a set strike level
• Floor - a series of single European interest rate
  put options used to protect against rate moves
  below a set strike level
• Recall some basic option valuation points, and
  apply them to caps and floors