Terminology and Payoff Diagrams

Derivatives – An Overview

Forwards and futures are examples of derivative securities.

A derivative security is a financial security (asset, claim) whose value is derived from other
(more primitive) variables such as:

✓ Stocks

✓ Currencies (exchange rates)

✓ Interest rates

✓ Indexes

✓ Commodities
 Derivatives – An Overview

This course will primarily examine two basic (plain vanilla) classes of derivative securities:

✓ Forwards and futures

✓ Options (calls and puts)

The principles behind the valuation techniques are general. A key concept used in derivatives
valuation is no arbitrage pricing.
 Derivatives – An Overview

Markets and exchanges

Over-the-counter (OTC) markets

✓ A market where traders working for banks, fund managers and corporate treasurers contact
each other directly.

✓ The OTC market has become more regulated since the final crisis in 2008.

Exchange-traded markets

✓ A market where trades are in standardised contracts that have been defined by the
exchange.

✓ For example the Chicago Board Options Exchange (CBOE).

 Introduction to Forwards and Futures

A forward contract is an obligation (agreement) to buy/sell a certain quantity of the underlying

asset at a:

✓ Specified price (forward price)

✓ Specified time (maturity or expiration date)

The buyer and seller of a forward contract are involved in a forward transaction where the:

✓ Price is agreed today.

✓ Transaction occurs at maturity.

 Introduction to Forwards and Futures

Forwards tend to have the following characteristics:

✓ They are generally bilaterally agreed contracts, often described as ‘over the counter’ or OTC
and thus not exchange traded.

✓ At inception, the forward delivery price ie, the price at which the exchange is to occur in the
future, is set such that the value of the contract is zero and, thus, no money changes hands
on the inception date.

A futures contract is the same as a forward contract, except that:

✓ It is typically standardized and traded on an exchange.

✓ Gains and losses are settled daily (marked to market).

 Introduction to Forwards and Futures

Examples

Obligation to:

✓ Buy 1000 barrels of crude oil at $45.89/barrel on September 20, 2027.

✓ Sell 15000 lbs of orange juice at 182.35 cents/lb on November 9, 2027.

✓ Buy the S&P500 at $2179.75 on December 16, 2029.

▪ one unit of the contract traded on the CME (Chicago Mercantile Exchange) is worth
$250 times the S&P500 index
 Long Position in a Forward Contract

The individual contracted to purchase the asset is said to have a long position in the forward
while the individual selling the asset has a short position.

Long payoff

✓ The individual holding the long-side has agreed today, time 0 to buy the specified asset at
price F0,T at future time T.

✓ Clearly, if the market price for the asset at T exceeds the price they have promised to pay
then they have made a profit equal to the difference between the market price and the
forward price.

✓ If at T, the market price is lower than the forward price then the long side makes a loss equal
to the difference between forward price and market price.
 Long Position in a Forward Contract
Payoff

F0,T ST
- F0,T

The payoff to the long-side of the forward contract is given by

ST − F0,T

where ST is the market price of the underlying asset at the maturity date, T.
 Short Position in a Forward Contract
Payoff

F0,T

F0,T ST

The payoff to the short-side of the contract is obviously the negative of the payoff of the long
side. Thus the payoff to the short-side of the contract is given by:

F0,T − ST
 Settlement

In many cases, forwards and futures are cash-settled:

✓ The forward transaction does not take place.

✓ The buyer and seller settle their gains and losses through cash.

Settlement of forward contracts occurs at maturity whereas the settlement of futures contracts
occurs daily (marked to market).
Forwards and Futures Comparison
The End
Pricing Forwards
 Pricing Derivatives – Absence of Arbitrage

✓ When pricing derivatives we will use the same underlying pricing principle - absence of
arbitrage pricing - for all of our examples.

✓ We assume that investors are smart enough to see any arbitrage opportunities and take
them.

✓ These smart investors, or arbitrageurs as they are sometimes known, will be buying cheap
assets and selling expensive assets in their exploitation of the arbitrage opportunity.

✓ This will tend to raise the prices of the cheaper assets and reduce those of the expensive
securities and thus reduce the scope for arbitrage.

✓ Only when the arbitrage opportunity has completely disappeared will the asset prices have
no tendency to move upwards or downwards.
 Pricing Derivatives – Absence of Arbitrage

Pricing of forwards is based on no-arbitrage:

✓ Two portfolios with the same cash flows must have the same market value.

✓ To apply no-arbitrage, we will construct a portfolio that synthetically replicates the payoff of a
forward contract.

The underlying asset for a forward/futures contract can be broadly classified as follows:

✓ Investment Assets.

▪ No income

▪ Known fixed cash income

▪ Known yield
 Pricing Forwards

✓ Commodities.

▪ Investment assets

▪ Consumption assets

In this course we will concentrate on the most basic pricing equation, pricing a forward on an
underlying investment asset that has no income.
 Pricing Forwards – Notation

F0,T = Forward price

T = Maturity (expiration date)
S0 = Current price of the underlying asset (time 0)
ST = Price of the underlying asset at maturity (time T)
rT = T-year spot rate (risk-free effective annual rate)

We will ignore the differences in the timing of cash flows between futures and forwards and treat
forwards and futures as being identical for the purpose of pricing.
 Pricing Forwards on Investment Assets with No income

Portfolio One

Enter into a long forward contract at t = 0 to buy one unit of asset S for an amount F0,T to be
paid at time T.

Portfolio Two

Buy the asset S today, time 0.

Also at time 0 borrow the present value of F0,T at the risk-free rate until time T.

From analysing the cash flows of these two portfolios we can determine the forward price using
the principle of no arbitrage.
Pricing Forwards on Investment Assets with No income

Cash flows at t = 0 Cash flows at t = T

Portfolio One
0 ST − F0,T
Long forward
ST − F0,T

Portfolio Two
Identical
Buy asset S − S0 ST cash flows
at t = T for
Borrow PV of F0,T F0,T both
− F0,T
(1 + r ) portfolios
T
at risk-free rate
rf

ST − F0,T
 Pricing Forwards on Investment Assets with No income

Since portfolios one and two have the exact same future cash flows at time T, the cost of each
portfolio must be the same at t = 0 else there would be an arbitrage opportunity.

The cash flow of portfolio one at t = 0 is zero since we know that for a forward contract no cash
flows are exchanged at the date on which the contract is struck.

The cash flow of portfolio two at t = 0 is

F0,T
− S0 + .
(1 + r )
T
rf
 Pricing Forwards on Investment Assets with No income

By no arbitrage arguments the cash flows at t = 0 associated with constructing portfolios one
and two must be the same:

F0,T
− S0 + =0
(1 + r )
T
rf

Therefore by rearranging the above equation the price of a forward contract on an investment
asset that pays no income is

( )
T
F0,T = S0 1 + rrf .
The End
Terminology and Payoff Diagrams
 Options - An Overview

Options are among the most liquid financial instruments. In order to understand their usefulness
and features let’s start with the definition of a standard option contract.

An option gives its owner the right, but not the obligation, to buy or sell a given quantity of a
specified asset at some particular future date for a pre-determined price, known as the strike
price or exercise price.

So, we have 5 fundamental things to specify in the contract terms:

✓ Underlying asset
✓ Quantity
✓ Maturity date
✓ Strike price
✓ Whether the owner of the option can buy or sell
 Options - An Overview

An individual who has purchased an option contract is said to be long the option and an
individual who has sold an option contract is said to have written the option.

We can fundamentally distinguish two types of option according to whether they give the right to
buy or sell the underlying asset.

European Call Option - Gives the owner the right, but not the obligation, to buy the underlying
asset at a:

▪ specified price (strike or exercise price)

▪ specified time (maturity or expiration date)
 Options - An Overview

European put option - Gives the owner the right, but not the obligation, to sell the underlying
asset at a:

▪ specified price (strike or exercise price)

▪ specified time (maturity or exercise date)

An American option is like a European option except it can also be exercised at any time prior
to maturity.
 Options - An Overview

Call value at maturity

✓ Exercise when ST > K, CT = ST − K, in-the-money

✓ Do nothing when ST < K, CT = 0, out-of-the-money

✓ Hence, call payoff at maturity:

CT = max  0, ST − K  =  ST − K 
+
 Options - An Overview

Put value at maturity

✓ Exercise when ST < K, PT = K - ST, in-the-money

✓ Do nothing when ST > K, PT = 0, out-of-the-money

✓ Hence, put payoff at maturity:

PT = max  0, K − ST  =  K − ST 
+
 Payoff Diagrams

Long (buy) one call option – based on one unit of the underlying

CT = max  0, ST − K  =  ST − K 
+

Payoff/position diagram

Payoff Gradient = 1

0
K Stock price at T
Exercise price
(strike price)
 Payoff Diagrams

Short (sell/write) one call option – based on one unit of the underlying

CT = − max  0, ST − K  = −  ST − K 
+

Payoff/position diagram

Payoff

0
K Stock price at T
Exercise price
(strike price)
Gradient = -1
 Payoff Diagrams

Long (buy) one put option - based on one unit of the underlying

PT = max  0, K − ST  =  K − ST 
+

Payoff/position diagram

Gradient = -1
Payoff

0
K Stock price at T
Exercise price
(strike price)
 Payoff Diagrams

Short (sell/write) one put option - based on one unit of the underlying

Payoff/position diagram
PT = − max  0, K − ST  = −  K − ST 
+

Payoff

0
K Stock price at T

Exercise price
Gradient = 1
(strike price)

-K
The End
Put-Call Parity
 Put-Call Parity

Consider a call and a put option on the same underlying asset, with the same strike price K,
and the same exercise date T.

Theorem (put-call parity) - suppose the underlying asset pays no dividends. Then, the price of
the call and the put are related by:

C0 + PV ( K ) = S0 + P0

K
C0 + = S0 + P0
(1 + rrf )T
 Put-Call Parity

We can rearrange this formula to find the price of a call or the price of a put conditional on
knowing either the value of one of the put or call ie, one equation with one unknown. Option
pricing methods to originally find the value of either the call or put will be covered later in the
Binomial Option Pricing slides.
The present value of the exercise
price , PV(K), at time 0 where the
Price of the call
exercise price K is for stock S.
option on stock
S at time 0. K
C0 + = S0 + P0 Price of the put
(1 + rrf )T
option on stock S
at time 0.
The stock
price at time 0.

The put and call options both relate to the same stock and both have the same exercise price
and exercise date.
 Put-Call Parity

Where does this parity relationship come from?

Think of the following scenario:

1. Buy stock S at time t = 0.

2. Buy a put option on the same stock S at time t = 0 with an exercise price of K, exercise date T.
Payoff at exercise date T
ST < K ST ≥ K

Long stock ST ST

Long put K – ST 0

Net payoff K ST

We can also represent this payoff on a payoff diagram.

 Put-Call Parity

Payoff/position diagram Net payoff from strategy

Gradient = 1
Payoff
K

Payoff for long stock

Payoff for long put

0
K Stock Price at T
Exercise price
(strike price)
 Put-Call Parity
Think of the another scenario:
1. Buy a call option on the same stock S at time t = 0 where the exercise price is K, exercise
date T.
2. Invest an amount of money equal to the PV(K) in a government bond where it will earn the
risk-free rate. The risk-free rate for the period is rrf and T is the number of time periods time
between t = 0 and the exercise date.
Payoff at exercise date
ST ≤ K ST > K

Long call 0 ST - K

Invest K/(1+ rrf)T K K

at risk-free rate

Net payoff K ST
We can also represent this payoff on a position diagram.
 Put-Call Parity

Payoff/position diagram
Net payoff from strategy
Gradient = 1
Payoff
K
Payoff from
investment at
risk-free rate

Payoff from long call

0
K Stock price at T
Exercise price
(strike price)
 Put-Call Parity
Payoff at exercise date
ST ≤ K ST > K

Long call 0 ST - K

Invest K/(1+ rrf)T K K Notice both strategies give the

at risk-free rate exact same payoffs. Under no
arbitrage pricing where the
Net payoff K ST payoffs are the same the price
to construct the two strategies
ST ≤ K ST > K at t = 0 should be the same.

Long stock ST ST

Long put K - ST 0

Net payoff K ST
 Put-Call Parity
Cash flow at t = 0

Buy stock -S0

Buy put -P0

Buy call -C0

Invest at risk-free rate é ù
K
-ê ú
ê
( ) ú
T

êë 1 + rrf úû
Therefore since both strategies give the same payoff the price of each strategy under no
arbitrage arguments should be the same. Hence the put-call parity relationship written in terms
of value/cost rather than cash flows is:

K
C0 + = S0 + P0
(1 + r )
T
rf
 Put-Call Parity

If the put-call parity does not hold we can generate arbitrage profits. For example if:

K
P0 > C0 + - S0
1 + rrf

Short the left-hand side. Go long the right-hand side.

This implies: This implies:

Short the put Long the call

Invest PV of K at risk-free rate
Short the stock

This strategy will result in a net cash inflow today and cash flows that sum to zero in the future
ie, arbitrage.
 Put-Call Parity

t=0 Exercise date T

Cash flow at t = 0 Cash flow at t = T

ST ≤ K ST > K

Short put P0 ST - K 0

Long call -C0 0 ST - K

Invest PV(K) -K/(1+rrf)T K K
Short stock S0 -ST -ST

Net cash flow >0 K 0 0

Since P0 > C0 + - S0
(1 + r )
T

rf
 Put-Call Parity

Given the following information is there an arbitrage opportunity and if so how can you
earn arbitrage profits? The risk-free interest rate (EAR) for the year is 10%.

Stock Time to Exercise Stock Put Price Call Price

Exercise Price Price
(months)
Stock A 6 £100 £90 £10 £15

K
C0 + = S0 + P0
(1 + r )
T
rf
£100
£15 + 1
= £110.35 £90 + £10 = £100
(1.1) 2

Is there mispricing? Yes

How can we take advantage of the mispricing?

 Put-Call Parity

K
C0 + = S0 + P0
(1 + rrf )T

£100
£15 + 1
= £110.35 £90 + £10 = £100
(1.1) 2

Go short (positive cash flow at t = 0) Go long (negative cash flow at t = 0)

Remember that the put call parity is based on the left-hand side of the equation giving the exact
same payoffs as the right-hand side of the equation at the exercise date t = T.

Since we have differential pricing in this example we can make an arbitrage profit.
 Put-Call Parity

t=0 Exercise date T

Cash flow at t = 0 Cash flow at t = T

ST ≤ K ST > K

Short call 15 0 100 - ST

Borrow PV(K) 95.35 -100 -100
Long stock -90 ST ST
Long put -10 100 – ST 0

Net cash flow 10.35 0 0

We have made an instant arbitrage profit at t = 0 of £10.35 due to the mispricing.

The End
Binomial Option Pricing
 Binomial Option Pricing

To price a call using the put call-parity you still need the price of the put, or to price a put using
the put call-parity you still need the price of the call.

Therefore we need another method in relation to the put-call parity to price options initially.

We will start with the replicating portfolio method then move onto the risk-neutral method. Both
methods will give the same solution although in practice the risk-neutral method is generally
easier/quicker to use. You need to be able to use both methods.

To derive formulae that will allow us to determine a no-arbitrage value for an option’s premium
on an underlying stock (where the premium is the price paid when an option is purchased) we
have to model the underlying stock price process.
 Binomial Option Pricing

For the Binomial model in a single period (single time period in this example is 3 months), the
underlying price can move from its current level S0 to one of only two new levels. Either the
price moves up by a factor u, thus reaching the level u(S0), or it moves down by a factor d to the
level d(S0) (where u > d).
Example t=0 t = 3 months
u = 1.2 Su = (u)S0 = (1.2)£20 = £24

S0 = £20

d = 0.9 Sd = (d)S0 = (0.9)£20 = £18

This seems pretty restrictive, prices can only move to one of two different levels in the next
period, but it’s easy to generalise to many periods and to think of the period length from t = 0 to
t = 3 months shrinking to cover a matter of seconds so that the process above starts to
resemble something more reasonable.
 Replicating Portfolio Method

Consider a European call option with K = £20 and three months to maturity. Suppose that S0 =
£20, u = 1.2, d = 0.9, and the risk-free rate for three months is 1.25%.

t=0 t = 3 months

Stock price
u = 1.2 £24
Stock price Call price
£20 Cu = max[(u)S0-K,0] = £4
Call price
? d = 0.9 Stock price
£18
Call price
Cd = max[(d)S0-K,0] = £0
 Replicating Portfolio Method

We can create a replicating portfolio today for the option by:

✓ Buying Δ (delta) shares of the underlying stock.

✓ Buy B units of the risk-free bond (par value assumed to be £1).

Δ and B are unknowns.

The cash flows at the exercise date are:

 Replicating Portfolio Method

Solving the simultaneous equations:

2
= B = −12
3
Therefore, to replicate the payoffs of the call we need to buy 2/3 shares of the stock and sell 12
units of the bond.

Since the payoffs to the call and the replicating portfolio are the same, through no arbitrage the
price of the call should be the same as the price of the replicating portfolio.

The price of the replicating portfolio is

B  2  −£12
S0  + = £20   + = 1.48.
1 + rrf  3  1.0125
 Replicating Portfolio Method
General case

We can generalise the replicating portfolio method we have used to price the call to price any
option eg, we can use the replicating portfolio method to price a put option. The notation in the
table uses a call but the same method works for a put if we replace the call payoffs with the put
payoffs.

Where the solutions to the general simultaneous equations give:

Cu − Cd uCd − dCu
= B=
S0 ( u − d ) u−d
 Risk-Neutral Method

We know from the replicating portfolio method that the price of the call is

B
C0 = S0  + .
1 + rrf

If we plug in for Δ and B we obtain

Cu − Cd uCd − dCu
C0 = +
( )
.
u−d ( u − d ) 1 + rrf
 Risk-Neutral Method

With some algebra we can show that

qCu + (1 − q ) Cd
C0 = ,
1 + rrf

q=
(1+ r ) − d
rf
.
where
u−d

The method above is called risk-neutral pricing.

To see where this name comes from, note that as we required d < (1 + r ) < u (no arbitrage), it
must be the case that q is between zero and one. Thus we can interpret q as if it were a
probability.
 Risk-Neutral Method

✓ Indeed, q is referred to as the risk-neutral probability of an up-move (and (1-q) is the risk-
neutral probability of a down-move). This is because, in a world where all investors were
risk-neutral, q would have to be the probability of an up-move and (1-q) the probability of a
down-move.

✓ Risk-neutral pricing can be used to price any derivative by calculating its expected payoff
under the risk-neutral probability structure and discounting this expected payoff back to the
present at the risk-free rate.

✓ Note again that the true probabilities of up and down-moves are entirely irrelevant. The only
probabilities that enter are the risk-neutral probabilities and these are not ‘real’ probabilities.
 Risk-Neutral Method

Consider again a European call option with K = £20 and three months to maturity. Suppose that
S0 = £20, u = 1.2, d = 0.9, and the risk-free rate for three months is 1.25%.

The risk-neutral probability q of an up move is

1 + rrf − d
q=
u−d

1.0125 − 0.9
q= = 0.375.
1.2 − 0.9

The risk-neutral probability (1-q) of a down move is

1 − q = 0.625.
 Risk-Neutral Method

t=0 t = 3 months

Stock price
u = 1.2 £24
Stock price Call price
£20 £4
Call price
? d = 0.9 Stock price
£18
Call price
£0

C ( q ) + Cd (1 − q ) £4 ( 0.375 ) + £0 ( 0.625 )
C0 = u C0 = = £1.48
1 + rrf 1.0125
 Binomial Option Pricing

Two methods for computing the price of an option:

Replicating portfolio method

✓ Determine the replicating portfolio (Δ and B).

✓ Price of the option is the cost of the replicating portfolio.

Risk-neutral method

✓ Determine the risk-neutral probability of an up-move, q.

✓ Price of the option by calculating its expected payoff under the risk-neutral probability
structure and discounting this expected payoff back to the present at the risk-free rate.

The two methods are equivalent. The replication method is longer, but also produces the
replicating portfolio.
The End
Speculation, Hedging and Arbitrage
 Speculation

Speculation is when an investor uses securities to place a bet (take a risky position) on the
direction in which they believe the underlying is likely to move.

Speculation using stocks

✓ If you think the price of the stock will go up, you can buy the stock.

✓ If you think the price of the stock will go down, you can sell the stock.

Speculation using options

✓ To speculate that the price of the underlying stock will go up, you can buy a call.

✓ To speculate that the price of the underlying will go down, you can buy a put.
 Speculation Example

An option position allows you to leverage your bet (think back to the replicating portfolio). Thus,
options in isolation are much riskier than stocks. That is, with the same amount of money
invested in a portfolio of options instead of the underlying stock, one can achieve a much higher
risk exposure.

Consider an underlying stock which had a price of 37 5/16 on October 15, 2007. Also, consider
the following options on the underlying stock on the same date.

We will consider the returns to investors who speculate and go long the stock, the call or the
put.
 Speculation Example

The table below provides price and return data on the underlying stock, call and put on October
15, 23, 27 and 28.
 Speculation Example

For example the returns between October 15 and October 27 are calculated as follows:

5 1 7 3 1
28 − 37 −3 6 −1
rstock = 16 = −25% rcall =2 8 = −87.1% rput = 8 2 = 325%
5 7 1
37 3 1
16 8 2

Since the underlying stock went down in price between October 15 and October 27 the stock
and call both have a negative return. However, the negative return on the call option is far
greater than the return on the underlying itself.

The return on the put is positive and large since the underlying stock price went down over the
period.
 Hedging

Hedging is defined as reducing risk by holding securities or contracts whose payoffs are
negatively correlated with some risk exposure.

Hedging strategies are used to hedge a position in the underlying asset. The derivatives market
can be used to hedge risk including derivatives such as:

✓ Forwards/futures

✓ Options
 Forward Hedging Example

A wheat farmer might arrange the following forward contract with a buyer (prior to harvest).

To supply 5000 bushels of wheat, six months from today (ie, on harvest), at a price of £4.50 per
bushel (ie, for a total consideration of 5000 X £4.50 = £22,500).

On the delivery date, if the market price of wheat turns out to be:

✓ £3.50. The farmer makes a gain, relative to the market price, of £1.00 per bushel, or 5000 X
£1 = £5000 in total.

✓ £4.75. The farmer makes a loss relative to the market price of £0.25 per bushel, or 5000 X
£0.25 = £1250 in total.

But regardless of what happens in the market, the farmer’s revenue is given. He will receive
£22,500. He has eliminated any uncertainty about this.
 Forward Hedging Example

In many cases forwards are cash-settled and physical settlement does not take place. The
buyer and seller settle their gains and losses through cash.

Payoff Payoff Payoff

F0,T
F0,T

ST
+ F0,T ST
= ST

Underlying asset Short forward Net payoff

ST ( F0,T − ST ) F0,T
 Arbitrage

Arbitrageurs exploit any mispricing in the market by simultaneously buying and selling equivalent
assets that exploits short-lived variations in their prices to generate arbitrage profits.

We have already seen an example of an arbitrage strategy to exploit mispricing in UK

government bonds.

Arbitrageurs can also make arbitrage profits in the derivatives market using replicating portfolios
if there is mispricing in:

✓ Forwards/futures

✓ Options
The End