OPTIONS, FUTURES AND

OTHER DERIVATIVES
Introduction

Patrick PILCER
[email protected]
 Objectives
• To provide a broad understanding of how
these instruments trade, how they can be
evaluated and how they should be used

• Arbitrage, valuation and hedging

• Emphasis of quantitative approach

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Grading

 Class participation
 Final exam
(closed-book, personal notes allowed)

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 Schedule
 Session 1
Introduction to derivatives / Basics of futures markets / Using futures
/ Pricing forwards and futures
 Session 2
Options fundamentals / Trading strategies / Pricing options
 Session 3
Pricing options: Arbitrage relationships / Binomial model / Black-
Scholes-Merton Model Hedging options: the Greek letters

Final exams…

References: John C. Hull books (Options, Futures and other

Derivatives, Fundamentals of Futures and Options Markets)

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Introduction to derivatives

• Products

• Markets

• Traders

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 Products
 Derivatives
What is a derivative?

A Derivative is a financial instrument whose

cash flows ( payoff) depend directly on (is
derived from) the value of another or others
financial instruments (the underlying)

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 Products
 Derivatives

Agreement between two parties

Limited lifetime

No creation of money , zero sum game (the

cash flows received by the holder of the
derivatives are paid by his counterpart

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 Products
Examples

 Futures: agreement to buy or sell an asset

at a certain time for a certain price
 Options: right to buy (call) or sell(put) a
certain asset by a certain date for a certain
price (American, European, Bermudean…)
 Swap: agreement to exchange cash flows in
the future

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• Forwards
– Contracts made between two parties that require some specific
action at a later date
– Takes the form of delivery of some underlying asset and payment for
the asset
– All contracts have
• A buyer and a seller
• A maturity or ‘expiration’ date
• A formula for exchanging payments set up when the contract is initiated that
takes effect at some later date
– Are in effect zero-sum game
– Traded OTC

• Futures Contract: forward-based derivative traded on an exchange

– Financial Futures Contract: based on a financial asset
– Commodity Futures Contract: based on a physical or ‘hard’ asset

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• Initially they were largely based on agricultural products
– Seasonality and weather conditions tend to make fluctuations severe and unpredictable
– The concept of forward buying and selling was developed to help producers and consumers
protect themselves against seasonal price fluctuations

• History
– Forward trading was introduced in the 1600s by the Japanese with rice forwards
– To-Arrive contracts: buyer and seller agreed in advance to the terms of a sale that would be
consummated when the goods arrived
– Stantardised and exchange-traded forwards (future contracts) were launched in the 1860s
– Volatile financial markets in the 1970s led to the concept of forwards being applied to
financial products such as stocks, bonds and currencies

• In recent years futures trading has grown due to

– Introduction of new contracts and exchanges in emerging markets
– Electronic trading with lower transaction costs and greater liquidity
– Increased presence of speculators and therefore more efficient prices

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• Exchange-Traded Forwards (futures contracts)
– Initially forwards were OTC contracts, with no price
transparency
– CBOT was the first organised market in 1848
– 1860s: first standardised contracts

• Importance of standardisation
– Futures contracts developed to solve some of the problems
associated with OTC forward agreement
– All trading take place in a single location via the open outcry
system
– Facilitated accurate and immediate price dissemination
– Margining system was developed to guarantee the financial
integrity of each contract
– Influx of speculators greatly improved liquidity, and efficiency

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Futures Contracts and Markets
• Futures Contract: agreement between two parties to buy or sell an asset
at some future point in time at a predetermined price

General Characteristics of Futures Contracts and Markets

• Exchange-traded futures are standardised in terms of their:
– Contract size: number of units that underlie the future contract
– Minimum tick size: smallest price increment the futures can move
– Daily Trading Limit: amount by which most futures can move up or down.
Once the limit has been reached, no trading is allowed beyond.
– Grade
– Time of delivery
– Place of delivery
– Trading hours
 except the price, al the contract terms are defined by the exchange

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Futures Contracts and Markets
• Daily settlement (daily mark-to-market): profits are credited daily to accounts
that have winning positions, and losses debited daily to accounts that have losing
positions. This process assures each party of the other’s party performance.

• Delivery Months: are set by the exchanges. The exchanges set specific deadlines
days for when trading in a contract ceases and for when the delivery period
begins and ends.

• Deliverable grade: quality of an asset that will be accepted for delivery in terms
of grade, weight or other characteristics

• Margin: the financial integrity of the futures markets is protected by requiring

that each party to a contract to post a performance bond, called the margin

• Regulation: futures markets are regulated by governmental agencies and self-

regulatory organisations

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Definition
• Futures and forwards are binding agreement to deliver
quantity of goods/assets at an agreed price on an agreed
future date at an agreed location
– No cash exchange at initiation
– Price payable Is fixed at initiation: insurance against price changes
– Anyone can buy/sell forwards/futures contracts
– ‘Buyer’ of forward/future receives goods at delivery date

• Forward contracts are oldest example of derivative contracts

– Agricultural arrangements
– Labour contracts
– Market with physical delivery established in early 20th century
– Financial futures markets developed in 1980s

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Stock Index Futures
• Based on stock market index: FTSE100, Nikkei225,
S&P500
– Index chosen by exchange as part of contract design

• Value to traders is that they offer a way of:

– Trading/speculating on future movements of the market
– Hedging market risk (beta of the index will be very close
to 1)
– Leaves position only exposed to unique risk

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Contract Specification – Index Futures
• ‘Asset’ is an index not physically traded
– Value is determined as index level x contract multiplier
– Multiplier/multiple is arbitrary value per index point

• Example
– Paris’s CAC 40 uses €10 per index point
– If index at 3,400 then the notional value of a contact is €34,000

• Almost always cash settled

– Parties exchange the cash difference between the asset’s notional value
now and at point of agreement
– A few contracts are/were physically settled, e.g. the Tokyo Nikkei future
– But, very inconvenient as delivery of basket of shares required, and very
expensive to settle

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Futures Contracts and Markets
Margin Requirements and Marking to Market

• Margin: amount of money that a customer must deposit with a broker to provide a level of
assurance that the financial obligations of the futures contract will be met
• Initial margin: required deposit when a futures contract is entered into
• Maintenance margin: minimum balance for margin required during the life of the contract

Leverage
• Leverage: is the ratio of the investment relative to the amount of capital needed to purchase

Price Loan Payment Leverage

$ 100 000,00 $ 75 000,00 $ 25 000,00 4:1

• Leverage is not inherent in a futures contract, and should be thought of as separate.

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 Markets
Exchange Traded Market OTC Market
Standardized Contracts Customized contracts (no
standard)
Centralization of bids and Computer or telephone linked
offers network of dealers and
institutions
No link between counterparts Agreement with specific
counterpart
No credit risk Credit risk
Positions can be closed out Positions held until maturity
before maturity
Electronic trading / open- Counterpart must be located
outcry system

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 Forward vs. Futures
• Forward contract is private, not designed to be traded (price, quantity,
delivery etc. are negotiated)
• Futures are traded on an organised market (e.g. CBOT, CME). All terms
except price are fixed to allow trade
• Note: many forward / OTC markets are becoming more futures-like

Forward Future
Trading Over The Counter (OTC) Exchange Traded
Transparency Private Public
Delivery Physical / Cash Usually closed out
Expiry Negotiated Fixed range
Payment At Expiry (but changing) Marked to Market
Contract Terms Negotiable Standardised

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Futures Exchanges and Clearing Houses
Clearing Houses

• Match trades submitted by clearing member firms

• Guarantees the financial obligations of every contract that it clears
• It acts as the buyer for the sellers and as the seller for the buyer
(principle of substitution)
• The obligation is not to the counterpart but to the clearing house
• Market participants need not to be concerned about the honesty
or reliability of other trading parties
• Counterparty risk is considered to be negligible: main advantage
as opposed to OTC trading

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 Futures Exchanges and Clearing Houses
Marking-to-Market and
Margin

• Day 2 : the equity of client A: BUYER B: SELLER

B is still higher than the 100 oz. December Gold Futures on NYMEX - -
maintenance margin: no Day 1: US$ 385 / oz.
Initial Margin $ 2 000,00 $ 2 000,00
deposit Maintenance Margin $ 1 500,00 $ 1 500,00
Day 2: US$ 386 / oz.

• Day 3: the equity of client Equity

Day 3: US$ 391 /oz.
$ 2 100,00 $ 1 900,00

B is under the Equity $ 2 600,00 $ 1 400,00

maintenance margin. Deposit - $ 600,00
Client B should replenish
equity at least to the
original margin level

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 Clearing Houses
• Each long (bought) position, must have a short (sold) position
– CH interposes itself between buyer and seller
• To minimise default risk, CH requires MARKING TO MARKET loser pays (via
CH) winner the day’s price change
– Seller may have to pay buyer if 𝑃𝑡 < 𝑃𝑡−1
– Drawn from VARIATION MARGIN account
– In addition, both sides pay INITIAL MARGIN = average day’s price movement
Buy from
A B

A Clearing House B

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 Futures Contracts and Markets
Reading a Futures Quotation Page

– Open interest: The total amount of contracts

outstanding
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 Options on Futures
• Options on futures
– Introduced in 1982 when the CBOT began trading on T-Bond futures
– A call option gives the holder the right to purchase a particular futures contract at a specific
price at any time during the life of the option. Most options on futures are American style
– The option premium is paid by the buyer at the time of purchase
– No margin requirement for the buyer, as the losses are limited to the extent of the option
premium. The seller must post a margin.
– Strike prices that are out-of-the-money are more popular than those that are in-the-money

• Flex option: designed to offer the flexibility of the OTC market, but with the advantages that
exchange trading brings such as price transparency and reduction in counterparty risk

• Exercise of a futures option: the buyer and writer of the option will receive a futures
position in their respective accounts the following day at the exercise price of the option

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 Traders
• Speculators
They take a bet, a position in the market
• Hedgers
They try to reduce their risks
• Arbitrageurs
They take advantage of abnormal
differences in the price of different assets
and lock in riskless profits
• Market Makers
They give bid and ask prices to the market

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Hedging with Index Futures
• Some issues may arise

1. Because the future is for a pre-determined amount, the hedge

may be incomplete
1. Suppose amount to be hedged is £450,000
2. Index now at 5,900 and point value is £10
3. Then need to buy/sell 7.6 contracts to precisely match risk
4. So either
1. Under-hedge with 7 contract, leaving £22,000 unhedged
2. Over-hedge with 8 contracts, leaving a £37,000 opposite exposure

2. Basis risk arises because index will not precisely match the
underlying exposure
3. Transaction costs

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 Example of arbitrage
Assume the underlying is a stock that delivers no
dividend, price is 100, risk free rate is 3% annual

Consider a Futures contract with a one year maturity

What if the Futures price on this stock is

100
103
110
97
90
Can you arbitrage the stock with the futures and how?

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 Example of arbitrage
You buy the stock at 100 and borrow for it at 3%. You
sell the Futures at 110
In one year you pay the interest and repay the capital:
-103
You sold the Futures at 110

Your final cash flow is +7, whatever the price of the

stock is at that date

You have built a cash and carry position

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 Example of hedging
You are long 1000 Total, this stock quotes 35
euros.

You d like to hedge your position with puts,

strike 32, maturity December, premium 2
euros.

What if at end of December, Total ends up

at 25, 30, 35, 40?

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 Long Put Payoff

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 Short Put Payoff

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 Long Call Payoff

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 Short Call Payoff

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1) The buyer of a futures contract:

a) Has the right, but not the obligation, to buy the underlying
asset at the expiry date of the contract.

b) Has the obligation to buy an amount of the underlying asset

at the expiry date for a pre-specified price.

c) Agrees to pay now but receive later an amount of the

underlying asset.

d) Advances a small deposit (the margin) to the seller to

guarantee some future trade.

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Which of the instruments below is NOT a
standardized contract traded on an exchange?

a) Forward rate agreements (FRA)

b) UK long gilt futures

c) Three-month Eurodollar futures

d) CME Euro FX futures

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In an arbitrage-free market, the listed price
of a futures contract on a stock index is:

a) Always greater than the current value of the

stock index.

b) Never greater than the current value of the

stock index.

c) The same as the current value of the stock

index.

d) Greater or less than the current value of the

stock index, depending on the fair basis.

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Which of the following is NOT an advantage
of futures contracts relative to forward
contracts?

a) They are cheaper to trade than forward

contracts.

b) They offer more flexibility on the amount

and delivery date.

c) Credit risk on the counterparty is negligible.

d) They are exchanged-listed.

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If you own 1000 shares of Vodafone, which of
the strategies below is the best hedge for your
equity risk exposure? Assume Vodafone has a
beta of 0.8 with the FTSE 100 index.

a) Sell 800 futures contract on the FTSE 100.

b) Buy 800 futures contract on the FTSE 100.

c) Sell a forward contract on 1000 Vodafone

shares.
d) Buy a forward contract on 1000 Vodafone
shares.

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Fearing that interest rates may rise in the short term,
a financial director decides to hedge his bond portfolio
with a 3x6 FRA on $10,000,000. If after 3 months the
relevant interest rate has moved down from 5% to
4.5% p.a., the hedge will result on a:

a) Profit of $12,500

b) Loss of $12,500

c) No profit or loss

d) None of the above

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Microsoft Corp. (MSFT) is currently traded for $23
and has an estimated dividend yield of 1.6% per
annum. US interest rates are flat at 5% for the next 12
months. What is the fair price of a forward contract to
buy MSFT six months from now?

a) 22.43

b) 22.61

c) 23.39

d) 23.58

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Your screen shows that you can trade $1 (one US
dollar) for $0.6000 now or lock-in a price for the same
$1 in 1-month time for $0.6100 with a forward
contract. You check your calculations and you find
that the fair one month FX rate is $0.595. How would
you set up a strategy to make a risk-free profit from
this? Assume no transaction costs.

a) Invest in a dollar-linked bank account in the UK.

b) Borrow in the UK, buy dollars, invest in the US, and
sell a forward contract on the final amount of dollars.
c) Buy Eurodollar futures contracts and sell sterling
futures contracts.
d) None of the above.

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