Economics 122

FINANCIAL ECONOMI CS (DE RIVATI VES )

M. DE BUQUE - G ONZ ALES
AY2014 -201 5

SOURCE: BODIE ET AL. (2009), ROSS ET AL., LO (2008)

Derivatives
 Provide payoffs that depend on the values of other assets (called the
underlying) such as commodity prices, bond and stock prices, or market index
values.
 For this reason, called derivative assets, or contingent claims (i.e., values derive
from or are contingent on the values of other assets)
 Includes options, futures and swaps.
Options
Options – frequently traded derivative securities
 Call option: Gives its holder the right to buy an asset for a specified
price, called the exercise or strike price, on or before a specified
expiration date  (‘bet  on  a  price  increase’).
 Ex. A December call option on a stock with an exercise price of $50
entitles its owner to purchase that stock for a price of $50 at any time
up to and including the expiration date in December (American-type
option). * European: @Expiration Date
* American: On or Before Expiration Date
Call option
 Holder of the call need not exercise the option (profitable to exercise only if the
market value of the asset that may be purchased exceeds the exercise price).
 If not exercised before the expiration date of the contract, the option simply
expires and no longer has value.
 Note:
o Prices of call options decrease as the exercise price increases (the right to buy a
share at a lower exercise price is more valuable).
o Options prices increase with time until expiration.
Put option
 Put option: Gives its holder the right to sell an asset for a specified
exercise price on or before a specified expiration date (‘bet  on  a  
price  fall’)
o Ex. A December put on a stock with an exercise price of $50 thus entitles its
owner to sell that stock to the put writer at a price of $50 at any time before
expiration in December (American-type option), even if the market price of
the stock is lower than $50
o Whereas profits on call options increase when the asset increases in value,
profits on put options increase when the asset value falls
Put option
 Hence, put options profitable in bearish conditions, while call options
profitable in bullish environments
 Again, need not exercise the option (the put is exercised only if its holder
can deliver an asset worth less than the exercise price in return for the
exercise price)
 Note:
o Prices of put options increase as the exercise price increases (the right
to sell a share at a higher exercise price is more valuable)
o Options prices increase with time until expiration
Options
 Investor who wants to hold an option has to pay a premium to the seller
(writer) of the option
 Each option contract is for the purchase of 100 shares, but quotations are
made on a per-share basis
 American type option: if the buying/selling is done at any time before the final
time (maturity)
 European type option: if the exchange is done only at maturity
Sample problems
 Which security should sell at a greater price?
o A 3-month maturity call option with an exercise price of $40 versus a 3-month call
on the same stock with an exercise price of $35
• The call with the lower exercise price ($35)
o A 6-month maturity put option with an exercise price of $55 versus a 6-month put
on the same stock with an exercise price of $50
• The call with the higher exercise price ($55)
o An option with an exercise price of $40 and with a December expiration versus an
option with an exercise price of $40 and a June expiration
• The option that expires on a later date
o A put option on a stock selling at market at $50, or a put option on another stock
selling at $60 (all other relevant features of the stocks and options may be assumed
to be identical, e.g., same exercise price)
• The put on the lower priced stock
Sample problems
 Suppose you buy a November expiration call option with exercise price $40
o Suppose the stock price in November is $42. Will you exercise your call? What are
the profit and rate of return on your position?
o What if you had bought the November call with exercise price $42.50?
o What if you had bought a November put with exercise price $42.50?
 Both a call and a put currently are traded on stock X; both have strike prices of
$50 and expirations of 6 months.
o What will be the profit to an investor who buys the call for $4 in the following
scenarios for stock prices in 6 months? What will be the profit in each scenario to
an investor who buys the put for $6? (For scenarios: a. $40 b. $45 c. $50 d. $55 e.
$60)
Futures
Futures
 Contracts that allow buying the underlying at a predetermined
price at maturity
 Calls for delivery of an asset (or in some cases, its cash value) at a
specified delivery or maturity date for an agreed-upon price, called
the futures price, to be paid at contract maturity
Futures
Example: Futures
 Say you enter a contract at a futures price of $5.5 per unit at
maturity date. Suppose the price, at maturity date, rises to $5.75
(i.e., sold at market at this price)
◦ If you made a commitment to buy (took a long position), you would profit
(since you would pay the agreed-upon price of $5.5 for the underlying
asset)
◦ If the contract calls for delivery of 1,000 units, your profit would be
1,000*($5.75-$5.5)
 Suppose you had made a commitment to sell (took a short
position). What would happen?
Futures
Terminology:
 Long position – held by the trader who commits to purchase the asset on
the delivery date
o The trader holding the long position profits from price increases
o The trader holding the long position loses from price decreases
 Short position – taken  by  trader  who  commits  to  deliver  (“sell”)  the  asset  
at contract maturity
o The trader holding the short position profits from price decreases
o The trader holding the short position loses from price increases
Options vs. futures
 The right to purchase the asset at an agreed-upon price, as opposed
to the obligation, distinguishes call options from long positions in
futures contracts.
o A futures contract obliges the long position to purchase the asset at the
futures price.
o The call option, in contrast, conveys the right to purchase the asset at the
exercise price (purchase will be made only if it yields a profit).
o Clearly, a holder of a call has a better position than the holder of a long
position on a futures contract with a futures price equal to the option's
exercise price.
Options vs. futures
 This advantage comes at a price:
o Call options must be purchased, while futures contracts may be entered into
without cost
o Purchase price of an option is called the premium, which represents the
amount the purchaser of the call must pay for the ability to exercise the
option only when it is profitable to do so
 Similarly, the difference between a put option and a short futures
position is the right, as opposed to the obligation, to sell an asset at an
agreed-upon price
Derivatives markets
OPTIONS FUTURES

Basic Positions Basic Positions

◦ Call (Buy) ◦ Long (Buy)
◦ Put (Sell) ◦ Short (Sell)
Terms Terms
◦ Exercise Price ◦ Delivery Date
◦ Expiration Date ◦ Assets
◦ Assets
 Other Derivatives
 Swaps – enable two parties to exchange two different cash flows, e.g. a
cash flow associated with a fixed interest rates and a cash flow
associated with a floating interest rate
 Special mention: Non-deliverable forwards and FX swaps
 NDFS
o Used by currency speculators, and said to have heavily contributed to
AFC: Most peso collapse (then virtually fixed) in 1997, during the AFC.
countries'
exchange rates o Agreements to "buy" or "sell" foreign exchange at an agreed upon
were fixed future rate, but without physical delivery of the currency.
-Thai Baht
collapse o Only the differential between the spot rate (the prevailing exchange
rate) and the agreed upon rate is settled, and in dollar form.
o Investing in NDFS virtually tax-free at the time.
 Other derivatives
 FX swaps
o Adopted by the BSP as an additional tool for sterilized intervention,
with swap points based on differences in returns on currencies and in
IMF Site: views regarding currency movements
Positions
o This type of sterilized intervention involves a spot dollar purchase
followed by an FX swap.
o The swap consists of a spot sale (which reverses the original market
purchase) and a forward (repurchase) leg.
o Such measures naturally reduce profitability of the central bank.
 Note: Mortgage-backed securities and callable bonds can also be
considered as derivative instruments
Sample problems
 Which security should sell at a greater price?
o A 3-month maturity call option with an exercise price of $40 versus a 3-month call
on the same stock with an exercise price of $35
• The call with the lower exercise price ($35)
o A 6-month maturity put option with an exercise price of $55 versus a 6-month put
on the same stock with an exercise price of $50
• The call with the higher exercise price ($55)
o An option with an exercise price of $40 and with a December expiration versus an
option with an exercise price of $40 and a June expiration
• The option that expires on a later date
o A put option on a stock selling at $50, or a put option on another stock selling at
$60 (all other relevant features of the stocks and options may be assumed to be
identical, e.g., same exercise price)
• The put on the lower priced stock
Sample problems
 Suppose you buy a November expiration call option with exercise
price $40
o Suppose the stock price in November is $42. Will you exercise your call?
What are the profit and rate of return on your position?
o What if you had bought the November call with exercise price $42.50?
o What if you had bought a November put with exercise price $42.50?
 Both a call and a put currently are traded on stock X; both have
strike prices of $50 and expirations of 6 months.
o What will be the profit to an investor who buys the call for $4 in the
following scenarios for stock prices in 6 months? What will be the profit in
each scenario to an investor who buys the put for $6? (For scenarios: a.
$40 b. $45 c. $50 d. $55 e. $60)