1 C H A P T E R Introduction

Derivatives markets have become increasingly important in the world of finance and
investments. It is now essential for all finance professionals to understand how these
markets work, how they can be used, and what determines prices in them. This book
addresses these issues.
Derivatives are traded on exchanges and in what are termed “over-the-counter”
(OTC) markets. The two main products trading on exchanges are futures and options.
In the over-the counter markets forwards, swaps, options, and a wide range of other
derivatives transactions are agreed to. Prior to the crisis which started in 2007, the OTC
derivatives market was relatively free from regulation. This has now changed. As we
will explain, OTC market participants are now subject to rules requiring that trades be
reported, that collateral be provided, and that trading platforms be used.
This opening chapter starts by providing an introduction to futures markets and
futures exchanges. It then compares exchange-traded derivatives markets with OTC
derivatives markets and discusses forward contracts, which are the OTC counterpart of
futures contracts. After that, it introduces options and outlines the activities of hedgers,
speculators, and arbitrageurs in derivatives markets.

1.1 FUTURES CONTRACTS

A futures contract is an agreement to buy or sell an asset at a certain time in the future
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for a certain price. There are many exchanges throughout the world trading futures
contracts. These include the CME Group (www.cmegroup.com), the Intercontinental
Exchange (ICE; www.intercontinentalexchange.com), Euronext (www.euronext. com),
Eurex (www.eurexchange.com), BM&FBOVESPA (www.bmfbovespa.com.br), the
National Stock Exchange of India (www.nse-india.com), the Tokyo Financial Exchange
(www.tfx.co.jp), and the China Financial Futures Exchange (www.cffex.com.cn).
A table at the end of this book gives a more complete list.
Futures exchanges allow people who want to buy or sell assets in the future to trade
with each other. In June, a trader in New York might contact a broker with instructions
to buy 5,000 bushels of corn for September delivery. The broker would immediately
communicate the client’s instructions to the CME Group. At about the same time,

19

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 20 CHAPTER 1

June: Trader takes a long position in a September

futures contract on corn at 400 cents per bushel

September: Trader must buy 5,000 bushels of corn

for $20,000

Figure 1.1 A futures contract (assuming it is held to maturity)

another trader in Kansas might instruct a broker to sell 5,000 bushels of corn for Sep-
tember delivery. These instructions would also be passed on to the CME Group. A price
would be determined and the deal would be done.
The trader in New York who agreed to buy has what is termed a long futures position;
the trader in Kansas who agreed to sell has what is termed a short futures position. The
price is known as the futures price. We will suppose the price is 400 cents per bushel.
This price, like any other price, is determined by the laws of supply and demand. If at a
particular time more people wish to sell September corn than to buy September corn,
the price goes down. New buyers will then enter the market so that a balance between
buyers and sellers is maintained. If more people wish to buy September corn than to
sell September corn, the price goes up—for similar reasons.
Issues such as margin requirements, daily settlement procedures, trading practices,
commissions, bid–offer spreads, and the role of the exchange clearing house will be
discussed in Chapter 2. For the time being, we can assume that the end result of the
events just described is that the trader in New York has agreed to buy 5,000 bushels of
corn for 400 cents per bushel in September and the trader in Kansas has agreed to sell
5,000 bushels of corn for 400 cents per bushel in September. Both sides have entered
into a binding contract. The contract is illustrated in Figure 1.1.
A futures price can be contrasted with the spot price. The spot price is for immediate,
or almost immediate, delivery. The futures price is the price for delivery at some time
in the future. The two are not usually equal. As we will see in later chapters, the futures
price may be greater than or less than the spot price.

1.2 HISTORY OF FUTURES MARKETS

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Futures markets can be traced back to the Middle Ages. They were originally developed
to meet the needs of farmers and merchants. Consider the position of a farmer in June
of a certain year who will harvest a known amount of corn in September. There is uncer-
tainty about the price the farmer will receive for the corn. In years of scarcity it might be
possible to obtain relatively high prices, particularly if the farmer is not in a hurry to sell.
On the other hand, in years of oversupply the corn might have to be disposed of at fire-
sale prices. The farmer and the farmer’s family are clearly exposed to a great deal of risk.
Consider next a company that has an ongoing requirement for corn. The company is
also exposed to price risk. In some years an oversupply situation may create favorable
prices; in other years scarcity may cause the prices to be exorbitant. It can make sense
for the farmer and the company to get together in June (or even earlier) and agree on a

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 Introduction 21

price for the farmer’s estimated production of corn in September. This involves them
negotiating a type of futures contract. The contract provides a way for each side to
eliminate the risk it faces because of the uncertain future price of corn.
We might ask what happens to the company’s requirements for corn during the rest
of the year. Once the harvest season is over, the corn must be stored until the next
season. If the farmer stores the corn, the company and the farmer both face risks asso-
ciated with the future corn price, and again there is a clear role for futures contracts.

The Chicago Board of Trade

The Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and
merchants together. Initially, its main task was to standardize the quantities and quali-
ties of the grains that were traded. Within a few years, the first futures-type contract was
developed. It was known as a to-arrive contract. Speculators soon became interested in
the contract and found trading the contract to be an attractive alternative to trading the
grain itself. The CBOT developed futures contracts on many different underlying assets,
including corn, oats, soybeans, soybean meal, soybean oil, wheat, Treasury bonds, and
Treasury notes. It became part of the CME Group in 2007.

The Chicago Mercantile Exchange

In 1874 the Chicago Produce Exchange was established, providing a market for butter,
eggs, poultry, and other perishable agricultural products. In 1898 the butter and egg
dealers withdrew from the exchange to form the Chicago Butter and Egg Board. In
1919, this was renamed the Chicago Mercantile Exchange (CME) and was reorganized
for futures trading. Since then, the exchange has provided a futures market for many
commodities, including pork bellies (1961), live cattle (1964), live hogs (1966), and
feeder cattle (1971). In 1982 it introduced a futures contract on the Standard & Poor’s
(S&P) 500 Stock Index.
The Chicago Mercantile Exchange started futures trading in foreign currencies in
1972. The currency futures traded now include the euro, British pound, Canadian dollar,
Japanese yen, Swiss franc, Australian dollar, Mexican peso, Brazilian real, South African
rand, New Zealand dollar, Russian rouble, Chinese renminbi, Swedish krona, Czech
koruna, Hungarian forint, Israeli shekel, Korean won, Polish złoty, and Turkish lira. The
Chicago Mercantile Exchange developed the very popular Eurodollar futures contract.
(As later chapters will explain, this is a contract on the future value of a short-term
interest rate.) It has also introduced futures contracts on weather and real estate.
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The CME Group now includes the Chicago Board of Trade, the New York Mercan-
tile Exchange, and the Kansas City Board of Trade.

Electronic Trading
Traditionally futures have been traded using what is known as the open-outcry system.
This involves traders physically meeting on the floor of the exchange, known as the
“trading pit,” and using a complicated set of hand signals to indicate the trades they
would like to carry out. In the example we considered earlier, one floor trader would
represent the person in New York who wanted to buy September corn and another floor
trader would represent the person in Kansas who wanted to sell September corn.

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 22 CHAPTER 1

Business Snapshot 1.1 The Lehman Bankruptcy

On September 15, 2008, Lehman Brothers filed for bankruptcy. This was the largest
bankruptcy in US history and its ramifications were felt throughout derivatives mar-
kets. Almost until the end, it seemed as though there was a good chance that Lehman
would survive. A number of companies (e.g., the Korean Development Bank,
Barclays Bank in the UK, and Bank of America) expressed interest in buying it, but
none of these was able to close a deal. Many people thought that Lehman was “too
big to fail” and that the US government would have to bail it out if no purchaser
could be found. This proved not to be the case.
How did this happen? It was a combination of high leverage, risky investments,
and liquidity problems. Commercial banks that take deposits are subject to regula-
tions on the amount of capital they must keep. Lehman was an investment bank and
not subject to these regulations. By 2007, its leverage ratio had increased to 31:1,
which means that a 3–4% decline in the value of its assets would wipe out its capital.
Dick Fuld, Lehman’s Chairman and Chief Executive, encouraged an aggressive
deal-making, risk-taking culture. He is reported to have told his executives: “Every
day is a battle. You have to kill the enemy.” The Chief Risk Officer at Lehman was
competent, but did not have much influence and was even removed from the execu-
tive committee in 2007. The risks taken by Lehman included large positions in the
instruments created from subprime mortgages, which will be described in Chapter 8.
Lehman funded much of its operations with short-term debt. When there was a loss
of confidence in the company, lenders refused to roll over this funding, forcing it into
bankruptcy.
Lehman was very active in the over-the-counter derivatives markets. It had over a
million transactions outstanding with about 8,000 different counterparties. Lehman’s
counterparties were often required to post collateral and this collateral had in many
cases been used by Lehman for various purposes. Litigation attempting to determine
who owes what to whom has continued for many years after the bankruptcy filing.

Futures exchanges throughout the world have largely replaced the open outcry system
by electronic trading, where traders enter their required trades at a keyboard and a
computer is used to match buyers and sellers. Electronic trading has led to a growth in
high-frequency and algorithmic trading, which involve the use of computer programs
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to initiate trades, often without human intervention.

1.3 THE OVER-THE-COUNTER MARKET

Futures contracts are very popular exchange-traded contracts. Options, which are intro-
duced later in this chapter, also trade very actively on exchanges. But not all trading of
derivatives is on exchanges. Many trades take place in the over-the-counter (OTC) mar-
ket. Banks, other large financial institutions, fund managers, and corporations are the
main participants in OTC derivatives markets. The number of derivatives transactions
per year in OTC markets is smaller than in exchange-traded markets, but the average
size of the transactions is much greater.

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 Introduction 23

Business Snapshot 1.2 Systemic risk

Systemic risk is the risk that a default by one financial institution will create a
“ripple effect” that leads to defaults by other financial institutions and threatens the
stability of the financial system. There are huge numbers of over-the-counter
transactions between banks. If Bank A fails, Bank B may take a huge loss on the
transactions it has with Bank A. This in turn could lead to Bank B failing. Bank C that
has many outstanding transactions with both Bank A and Bank B might then take a
large loss and experience severe financial difficulties; and so on.
The financial system has survived defaults such as Drexel in 1990 and Lehman
Brothers in 2008, but regulators continue to be concerned. During the market tur-
moil of 2007 and 2008, many large financial institutions were bailed out, rather than
being allowed to fail, because governments were concerned about systemic risk.

When a nonfinancial company wants to trade a derivative in the OTC market, it

usually contacts a derivatives dealer (typically a large bank). If an agreement is reached,
the derivatives dealer may absorb the risks as part of its portfolio. Alternatively, it may
choose to enter into an offsetting transaction with another derivatives dealer.
Prior to the credit crisis, which started in 2007 and is discussed in some detail in
Chapter 8, OTC derivatives markets were largely unregulated. Following the credit
crisis and the failure of Lehman Brothers (see Business Snapshot 1.1), we have seen the
development of many new regulations affecting the operation of OTC markets. The
main purpose of the regulations is to improve the transparency of OTC markets and
reduce systemic risk (see Business Snapshot 1.2 for a discussion of systemic risk). The
over-the-counter market in some respects is being forced to become more like the
exchange-traded market. Three important changes are:
1. Standardized OTC derivatives between two financial institutions in the United
States must whenever possible be traded on what are referred to as swap execution
facilities (SEFs). These are platforms similar to exchanges where market partici-
pants can contact each other to agree on trades.
2. There is a requirement in most parts of the world that a central counterparty
(CCP) be used for most standardized derivatives transactions between two
financial institutions. The CCP’s role is to stand between the two sides in an over-
the-counter derivatives transaction in much the same way that an exchange
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does in the exchange-traded derivatives market. CCPs are discussed in more

detail in Chapter 2.
3. All trades must be reported to a central repository.

Market Size
Both the over-the-counter and the exchange-traded market for derivatives are huge.
Although the statistics that are collected for the two markets are not exactly compara-
ble, it is clear that the over-the-counter market is much larger than the exchange-traded
market. The Bank for International Settlements (www.bis.org) started collecting statis-
tics on the markets in 1998. Figure 1.2 compares (a) the estimated total principal
amounts underlying transactions that were outstanding in the over-the-counter markets

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 24 CHAPTER 1

800 Size of
market
700 ($ trillion)

600

500

400

300
OTC
200 Exchange

100

0
Jun-98 Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Jun-14

Figure 1.2 Size of over-the-counter and exchange-traded derivatives markets

between 1998 and 2014 and (b) the estimated total value of the assets underlying exchange-
traded contracts during the same period. Using these measures, the size of the over-the-
counter market was $630 trillion in December 2014 and that of the exchange-traded
market was $65 trillion at this time. Figure 1.2 shows that the OTC market grew rapidly
before the 2008 credit crisis and that there has been very little net growth since then.
In interpreting Figure 1.2, we should bear in mind that the principal underlying an
over-the-counter transaction is not the same as its value. An example of an over-the-
counter transaction is an agreement to buy 100 million U.S. dollars with British pounds
at a predetermined exchange rate in one year. The total principal amount underlying
this transaction is $100 million. However, the value of the transaction at a particular
point in time might be only $1 million. The Bank for International Settlements esti-
mates the gross market value of all OTC contracts outstanding in December 2014 to be
about $21 trillion.1

1.4 FORWARD CONTRACTS

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A forward contract is similar to a futures contracts in that it is an agreement to buy or

sell an asset at a certain time in the future for a certain price. But, whereas futures con-
tracts are traded on exchanges, forward contracts trade in the over-the-counter market.
Forward contracts on foreign exchange are very popular. Most large banks employ
both spot and forward foreign exchange traders. Spot traders are trading a foreign
currency for almost immediate delivery. Forward traders are trading for delivery at a
future time. Table 1.1 provides quotes for the exchange rate between the British pound
(GBP) and the U.S. dollar (USD) that might be made by a large international bank on

1
A contract that is worth $1 million to one side and —$1 million to the other side would be counted as
having a gross market value of $1 million.

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 Introduction 25
Table 1.1 Spot and forward quotes for the USD/GBP
exchange rate, May 13, 2015 (GBP = British pound;
USD = U.S. dollar; quote is number of USD per GBP)

Bid Offer
Spot 1.5746 1.5750
1-month forward 1.5742 1.5747
3-month forward 1.5736 1.5742
6-month forward 1.5730 1.5736

May 13, 2015. The quote is for the number of USD per GBP. The first row indicates
that the bank is prepared to buy GBP (also known as sterling) in the spot market (i.e.,
for virtually immediate delivery) at the rate of $1.5746 per GBP and sell sterling in the
spot market at $1.5750 per GBP. The second row indicates that the bank is prepared to
buy sterling in one month at $1.5742 per GBP and sell sterling in one month at $1.5747
per GBP; the third row indicates that it is prepared to buy sterling in three months at
$1.5736 per GBP and sell sterling in three months at $1.5742 per GBP; and so on.
The quotes are for very large transactions. (As anyone who has traveled abroad
knows, retail customers face much larger spreads between bid and offer quotes than
those in Table 1.1.) After examining the quotes in Table 1.1, a large corporation might
agree to sell £100 million in six months for $157.30 million to the bank as part of its
hedging program.
There is a relationship between the forward price of a foreign currency, the spot
price of the foreign currency, domestic interest rates, and foreign interest rates. This is
explained in Chapter 5.

1.5 OPTIONS
Options are traded both on exchanges and in the over-the-counter markets. There are
two types of option: calls and puts. A call option gives the holder the right to buy an
asset by a certain date for a certain price. A put option gives the holder the right to sell
an asset by a certain date for a certain price. The price in the contract is known as the
exercise price or the strike price; the date in the contract is known as the expiration date
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or the maturity date. A European option can be exercised only on the maturity date; an
American option can be exercised at any time during its life.
It should be emphasized that an option gives the holder the right to do something.
The holder does not have to exercise this right. This fact distinguishes options from
futures (or forward) contracts. The holder of a long futures contract is committed to
buying an asset at a certain price at a certain time in the future. By contrast, the holder
of a call option has a choice as to whether to buy the asset at a certain price at a certain
time in the future. It costs nothing (except for margin requirements, which will be dis-
cussed in Chapter 2) to enter into a futures contract. By contrast, a trader must pay an
up-front price, known as the option premium, for an option contract.

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 26 CHAPTER 1

Table 1.2 Prices of call options on Google, May 13, 2015; stock price: bid
$532.20; offer $532.34

Strike price June 2015 Sept. 2015 Dec. 2015

($) Bid Offer Bid Offer Bid Offer
475 57.90 61.80 66.00 68.90 73.50 76.50
500 34.80 37.10 45.90 47.90 54.90 56.60
525 16.70 17.30 30.40 31.30 40.20 41.10
550 5.60 6.20 18.60 19.40 28.10 29.00
575 1.55 1.80 10.50 11.30 18.80 20.20

The largest exchange in the world for trading stock options is the Chicago Board
Options Exchange (CBOE). Table 1.2 gives the bid and offer quotes for some of the
call options trading on Google (ticker symbol: GOOG) on May 13, 2015. Table 1.3 does
the same for put options trading on Google on that date. The tables have been con-
structed from data on the CBOE web site. The Google stock price at the time of the
quotes was bid 532.20, offer 532.34. The bid–offer spread for an option, as a percentage
of its price, is greater than that for the underlying stock and depends on the volume of
trading. The option strike prices in the tables are $475, $500, $525, $550, and $575.
The maturities are June 2015, September 2015, and December 2015. The June options
have a maturity date of June 19, 2015; the September options have a maturity date of
September 18, 2015; the December options have a maturity date of December 18, 2015.
(The maturity date is the third Friday of the delivery month.)
The tables illustrate a number of properties of options. The price of a call option
decreases as the strike price increases; the price of a put option increases as the strike
price increases. Both types of options tend to become more valuable as their time to
maturity increases. These properties of options will be discussed further in Chapter 10.
Suppose that a trader instructs a broker to buy one December call option contract
on Google with a strike price of $550. The broker will relay these instructions to a
trader at the CBOE and the deal will be done. The (offer) price is $29.00, as indicated
in Table 1.2. This is the price for an option to buy one share. In the United States, an

Table 1.3 Prices of put options on Google, May 13, 2015; stock price:
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$532.20; offer $532.34

Strike price June 2015 Sept. 2015 Dec. 2015

($) Bid Offer Bid Offer Bid Offer
475 0.95 1.05 5.50 9.20 12.50 15.20
500 2.95 3.30 13.00 13.80 21.30 22.10
525 9.40 9.90 22.40 23.20 31.30 32.00
550 22.90 24.40 35.20 36.40 44.10 45.00
575 42.70 45.80 51.90 53.50 59.70 61.00

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 Introduction 27
50 Profit (‘000s) 10 Profit (‘000s)

40 0
0 200 400 600 800 1,000
–10 Stock price ($)
30
–20
20
–30
10
–40
Stock price ($)
0 –50
0 200 400 600 800 1,000
–10 –60
(a) (b)

Figure 1.3 Net profit from (a) purchasing a contract consisting of 100 Google December
call options with a strike price of $550 and (b) selling a contract consisting of 100 Google
September put options with a strike price of $525

option contract is an agreement to buy or sell 100 shares. Therefore, the trader must
arrange for $2,900 to be remitted to the exchange through the broker. The exchange
will then arrange for this amount to be passed on to the party on the other side of the
transaction.
In our example, the trader has obtained at a cost of $2,900 the right to buy 100
Google shares for $550 each. If the price of Google does not not rise above $550.00
by December 18, 2015, the option is not exercised and the trader loses $2,900.2 But
if Google does well and the option is exercised when the bid price for the stock is
$650, the trader is able to buy 100 shares at $550 and immediately sell them for $650
for a profit of $10,000—or $7,100 when the initial cost of the options is taken into
account.3
An alternative trade would be to sell one September put option contract with a strike
price of $525 at the bid price of $22.40. This would lead to an immediate cash inflow of
100 × 22.40 = $2, 240. If the Google stock price stays above $525, this option is not exer-
cised and the trader makes a profit of this amount. However, if stock price falls and the
option is exercised when the stock price is, say, $480 there is a loss. The trader must buy
100 shares at $525 when they are worth only $480. This leads to a loss of $4,500, or $2,260
when the initial amount received for the option contract is taken into account.
The stock options trading on the CBOE are American (i.e., they can be exercised at
any time). If we assume for simplicity that they are European, so that they can be exer-
cised only at maturity, the trader’s profit as a function of the final stock price for the two
trades we have considered is shown in Figure 1.3.
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Further details about the operation of options markets and how prices such as those
in Tables 1.2 and 1.3 are determined by traders are given in later chapters. At this stage
we note that there are four types of participants in options markets:
1. Buyers of calls
2. Sellers of calls

2
The calculations here ignore commissions paid by the trader.
3
The calculations here ignore the effect of discounting. Theoretically, the $10,000 should be discounted from
the time of exercise to the purchase date when calculating the payoff.

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 28 CHAPTER 1

3. Buyers of puts
4. Sellers of puts
Buyers are referred to as having long positions; sellers are referred to as having short
positions. Selling an option is also known as writing the option.

1.6 HISTORY OF OPTIONS MARKETS

The first trading in put and call options began in Europe and in the United States as
early as the eighteenth century. In the early years the market got a bad name because
of certain corrupt practices. One of these involved brokers being given options on a
certain stock as an inducement for them to recommend the stock to their clients.

Put and Call Brokers and Dealers Association

In the early 1900s a group of firms set up the Put and Call Brokers and Dealers Associ-
ation. The aim of this association was to provide a mechanism for bringing buyers and
sellers together. Traders who wanted to buy an option would contact one of the member
firms. This firm would attempt to find a seller or writer of the option from either its own
clients or those of other member firms. If no seller could be found, the firm would under-
take to write the option itself in return for what was deemed to be an appropriate price.
The options market of the Put and Call Brokers and Dealers Association suffered
from two deficiencies. First, there was no secondary market. The buyer of an option did
not have the right to sell it to another party prior to expiration. Second, there was no
mechanism to guarantee that the writer of the option would honor the contract. If the
writer did not live up to the agreement when the option was exercised, the buyer had
to resort to costly lawsuits.

The Formation of Options Exchanges

In April 1973 the Chicago Board of Trade set up a new exchange, the Chicago Board
Options Exchange, specifically for the purpose of trading stock options. Since then
options markets have become increasingly popular. By the early 1980s the volume of
trading had grown so rapidly that the number of shares underlying the stock option
contracts traded each day in United States exceeded the daily volume of shares traded
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on the New York Stock Exchange.

The exchanges trading options in the United States now include the Chicago Board
Options Exchange (www.cboe.com), NASDAQ OMX (www.nasdaqtrader.com),
NYSE Euronext (www.euronext.com), the International Securities Exchange
(www.iseoptions.com), and the Boston Options Exchange (www.bostonoptions.com).
Options trade on several thousand different stocks as well as stock indices, foreign
currencies, and other assets.
Most exchanges offering futures contracts also offer options on these contracts. Thus,
the CME Group offers options on corn futures, live cattle futures, and so on. Options
exchanges exist all over the world (see the table at the end of this book).

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 Introduction 29

The Over-the-Counter Market for Options

The over-the-counter market for options has grown very rapidly since the early 1980s
and is now bigger than the exchange-traded market. One advantage of options traded
in the over-the-counter market is that they can be tailored to meet the particular needs
of a corporate treasurer or fund manager. For example, a corporate treasurer who wants
a European call option to buy 1.6 million British pounds at an exchange rate of 1.5580
may not find exactly the right product trading on an exchange. However, it is likely that
many derivatives dealers would be pleased to provide a quote for an over-the-counter
contract that meets the treasurer’s precise needs.

1.7 TYPES OF TRADER

Futures, forward, and options markets have been outstandingly successful. The main
reason is that they have attracted many different types of trader and have a great deal
of liquidity. When a trader wants to take one side of a contract, there is usually no prob-
lem in finding someone who is prepared to take the other side.
Three broad categories of trader can be identified: hedgers, speculators, and arbitra-
geurs. Hedgers use futures, forwards, and options to reduce the risk that they face from
potential future movements in a market variable. Speculators use them to bet on the
future direction of a market variable. Arbitrageurs take offsetting positions in two or
more instruments to lock in a profit. As described in Business Snapshot 1.3, hedge funds
have become big users of derivatives for all three purposes.
In the next few sections, we consider the activities of each type of trader in more detail.

1.8 HEDGERS
In this section we illustrate how hedgers can reduce their risks with forward contracts
and options.

Hedging Using Forward Contracts

Suppose that it is May 13, 2015, and ImportCo, a company based in the United States,
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knows that it will have to pay £10 million on August 13, 2015, for goods it has purchased
from a British supplier. The USD/GBP exchange rate quotes made by a financial insti-
tution are shown in Table 1.1. ImportCo could hedge its foreign exchange risk by buying
pounds (GBP) from the financial institution in the three-month forward market at
1.5742. This would have the effect of fixing the price to be paid to the British exporter
at $15,742,000.
Consider next another U.S. company, which we will refer to as ExportCo, that is
exporting goods to the United Kingdom and on May 13, 2015, knows that it will receive
£30 million three months later. ExportCo can hedge its foreign exchange risk by selling
£30 million in the three-month forward market at an exchange rate of 1.5736. This
would have the effect of locking in the U.S. dollars to be realized for the pounds at
$47,208,000.

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 30 CHAPTER 1

Business Snapshot 1.3 Hedge funds

Hedge funds have become major users of derivatives for hedging, speculation, and
arbitrage. They are similar to mutual funds in that they invest funds on behalf of
clients. However, they accept funds only from professional fund managers or finan-
cially sophisticated individuals and do not publicly offer their securities. Mutual
funds are subject to regulations requiring that the shares be redeemable at any time,
that investment policies be disclosed, that the use of leverage be limited, and so on.
Hedge funds are relatively free of these regulations. This gives them a great deal of
freedom to develop sophisticated, unconventional, and proprietary investment
strategies. The fees charged by hedge fund managers are dependent on the fund’s
performance and are relatively high—typically 2 plus 20%, i.e., 2% of the amount
invested plus 20% of the profits. Hedge funds have grown in popularity, with about
$2 trillion being invested in them throughout the world. “Funds of funds” have been
set up to invest in a portfolio of hedge funds.
The investment strategy followed by a hedge fund manager often involves using
derivatives to set up a speculative or arbitrage position. Once the strategy has been
defined, the hedge fund manager must:
1. Evaluate the risks to which the fund is exposed
2. Decide which risks are acceptable and which will be hedged
3. Devise strategies (usually involving derivatives) to hedge the unacceptable risks.
Here are some examples of the labels used for hedge funds together with the trading
strategies followed:
Long/Short Equities: Purchase securities considered to be undervalued and short
those considered to be overvalued in such a way that the exposure to the overall
direction of the market is small.
Convertible Arbitrage: Take a long position in a thought-to-be-undervalued convert-
ible bond combined with an actively managed short position in the underlying equity.
Distressed Securities: Buy securities issued by companies in, or close to, bankruptcy.
Emerging Markets: Invest in debt and equity of companies in developing or emerg-
ing countries and in the debt of the countries themselves.
Global Macro: Carry out trades that reflect anticipated global macroeconomic trends.
Merger Arbitrage: Trade after a possible merger or acquisition is announced so that
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a profit is made if the announced deal takes place.

Example 1.1 summarizes the hedging strategies open to ImportCo and ExportCo.
Note that a company might do better if it chooses not to hedge than if it chooses to
hedge. Alternatively, it might do worse. Consider ImportCo. If the exchange rate is
1.5000 on August 13 and the company has not hedged, the £10 million that it has to pay
will cost $15,000,000, which is less than $15,742,000. On the other hand, if the exchange
rate is 1.6000, the £10 million will cost $16,000,000—and the company will wish it had
hedged! The position of ExportCo if it does not hedge is the reverse. If the exchange
rate in August proves to be less than 1.5736, the company will wish it had hedged; if the
rate is greater than 1.5736, it will be pleased it has not done so.

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 Introduction 31

Example 1.1 Hedging with forward contracts

It is May 13, 2015. ImportCo must pay £10 million on August 13, 2015, for goods
purchased from Britain. Using the quotes in Table 1.1, it buys £10 million in the
three-month forward market to lock in an exchange rate of 1.5742 for the pounds
it will pay.
ExportCo will receive £30 million on August 13, 2015, from a customer in Brit-
ain. Using quotes in Table 1.1, it sells £30 million in the three-month forward mar-
ket to lock in an exchange rate of 1.5736 for the pounds it will receive.

This example illustrates a key aspect of hedging. Hedging reduces the risk, but it is
not necessarily the case that the outcome with hedging will be better than the outcome
without hedging.

Hedging Using Options

Options can also be used for hedging. Example 1.2 considers an investor who in May of
a particular year owns 1,000 shares of a company. The share price is $28 per share. The
investor is concerned about a possible share price decline in the next two months and
wants protection. The investor could buy 10 July put option contracts on the company’s
stock with a strike price of $27.50. Each contract is on 100 shares. The position would
therefore give the investor the right to sell a total of 1,000 shares for a price of $27.50.
If the quoted option price is $1, each option contract would cost 100 × $1 = $100 and
the total cost of the hedging strategy would be 10 × $100 = $1,000.
The strategy costs $1,000 but guarantees that the shares can be sold for at least $27.50
per share during the life of the option. If the market price of the stock falls below $27.50,
the options will be exercised so that $27,500 is realized for the entire holding. When the
cost of the options is taken into account, the amount realized is $26,500. If the market
price stays above $27.50, the options are not exercised and expire worthless. However,
in this case the value of the holding is always above $27,500 (or above $26,500 when the
cost of the options is taken into account). Figure 1.4 shows the net value of the portfolio
(after taking the cost of the options into account) as a function of the stock price in two
months. The dotted line shows the value of the portfolio assuming no hedging.
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Example 1.2 Hedging with options

It is May. An investor who owns 1,000 shares of a company and wants protection
against a possible decline in the share price over the next two months. Market
quotes are as follows:
Current share price: $28
July 27.50 put price: $1
The investor buys 10 put option contracts for a total cost of $1,000. This gives the
investor the right to sell 1,000 shares for $27.50 per share during the next two
months.

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 32 CHAPTER 1

40,000 Value of
holding ($)

35,000

30,000
Hedging
No hedging

25,000

Stock price ($)

20,000
20 25 30 35 40

Figure 1.4 Value in Example 1.2 of the investor’s holding in two months

A Comparison
There is a fundamental difference between the use of forward contracts and options for
hedging. Forward contracts are designed to neutralize risk by fixing the price that the
hedger will pay or receive for the underlying asset. Option contracts, by contrast, pro-
vide insurance. They offer a way for investors to protect themselves against adverse
price movements in the future while still allowing them to benefit from favorable price
movements. Unlike forwards, options involve the payment of an up-front fee.

1.9 SPECULATORS
We now move on to consider how futures and options markets can be used by specula-
tors. Whereas hedgers want to avoid an exposure to adverse movements in the price of
an asset, speculators wish to take a position in the market. Either they are betting that
the price of the asset will go up or they are betting that it will go down.
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Speculation Using Futures

Consider a U.S. speculator who in February thinks that the British pound will
strengthen relative to the U.S. dollar over the next two months and is prepared to
back that hunch to the tune of £250,000. One thing the speculator can do is purchase
£250,000 in the spot market in the hope that the sterling can be sold later at higher
price. (The sterling once purchased would be kept in an interest-bearing account.)
Another possibility is to take a long position in four CME April futures contracts on
sterling. (Each futures contract is for the purchase of £62,500.) Table 1.4 summarizes
the two alternatives on the assumption that the current exchange rate is 1.5470 dollars

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 Introduction 33

Table 1.4 Speculation using spot and futures contracts. One futures contract is on £62,500.
Initial margin for four futures contracts = $20,000

Possible trades
Buy £250,000 Buy 4 futures contracts
Spot price = 1.5470 Futures price = 1.5410
Investment $386,750 $20,000
Profit if April spot = 1.6000 $13,250 $14,750
Profit if April spot = 1.5000 −$11,750 −$10,250

per pound and the April futures price is 1.5410 dollars per pound. If the exchange rate
turns out to be 1.6000 dollars per pound in April, the futures contract alternative enables
the speculator to realize a profit of (1.6000 − 1.5410) × 250,000 = $14,750. The spot mar-
ket alternative leads to 250,000 units of an asset being purchased for $1.5470 in February
and sold for $1.6000 in April, so that a profit of (1.6000 − 1.5470) × 250,000 = $13,250 is
made. If the exchange rate falls to 1.5000 dollars per pound, the futures contract gives
rise to a (1.5410 − 1.5000) × 250,000 = $10,250 loss, whereas the spot market alternative
gives rise to a loss of (1.5470 − 1.5000) × 250,000 = $11,750. The alternatives appear to
give rise to slightly different profits and losses, but these calculations do not reflect the
interest that is earned or paid.
What then is the difference between the two alternatives? The first alternative of
buying sterling requires an up-front investment of $386,750 (= 250,000 × 1.5470). By
contrast, the second alternative requires only a small amount of cash—perhaps
$20,000—to be deposited by the speculator in what is termed a margin account (this is
explained in Chapter 2). The futures market allows the speculator to obtain leverage.
With a relatively small initial outlay, a large speculative position can be taken.

Speculation Using Options

Options can also be used for speculation. Suppose that it is October and a speculator
considers that a stock is likely to increase in value over the next two months. The stock
price is currently $20, and a two-month call option with a $22.50 strike price is cur-
rently selling for $1. Table 1.5 illustrates two possible alternatives assuming that the
speculator is willing to invest $2,000. One alternative is to purchase 100 shares.
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Table 1.5 Comparison of profits from two alternative

strategies for using $2,000 to speculate on a stock worth
$20 in October

Speculator’s strategy December stock price

$15 $27
Buy 100 shares −$500 $700
Buy 2,000 call options  −$2,000 $7,000

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 34 CHAPTER 1

Another involves the purchase of 2,000 call options (i.e., 20 call option contracts). Sup-
pose that the speculator’s hunch is correct and the price of the stock rises to $27 by
December. The first alternative of buying the stock yields a profit of

100 × ( $27 − $20 ) =

$700

However, the second alternative is far more profitable. A call option on the stock with
a strike price of $22.50 gives a payoff of $4.50, because it enables something worth $27
to be bought for $22.50. The total payoff from the 2,000 options that are purchased
under the second alternative is

2,000 × $4.50 =
9,000
Subtracting the original cost of the options yields a net profit of

$9,000 − $2,000 =
$7,000
The options strategy is, therefore, ten times more profitable than the strategy of buying
the stock.
Options also give rise to a greater potential loss. Suppose the stock price falls to $15
by December. The first alternative of buying stock yields a loss of

100 × ( $20 − $15) =

$500

Because the call options expire without being exercised, the options strategy would lead
to a loss of $2,000—the original amount paid for the options. Figure 1.5 shows the profit
or loss from the two strategies as a function of the price of the stock in two months.
Options like futures provide a form of leverage. For a given investment, the use of
options magnifies the financial consequences. Good outcomes become very good, while
bad outcomes result in the whole initial investment being lost.

10000 Profit ($)

8000

6000

4000 Buy shares

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Buy options
2000

0
15 20 25 30
–2000 Stock price ($)

–4000

Figure 1.5 Profit or loss from two alternative strategies for speculating on a stock currently
worth $20

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 Introduction 35

A Comparison
Futures and options are similar instruments for speculators in that they both provide a
way in which a type of leverage can be obtained. However, there is an important differ-
ence between the two. When a speculator uses futures the potential loss as well as the
potential gain is very large. When options are used, no matter how bad things get, the
speculator’s loss is limited to the amount paid for the options.

1.10 ARBITRAGEURS
Arbitrageurs are a third important group of participants in futures, forward, and options
markets. Arbitrage involves locking in a riskless profit by simultaneously entering into
transactions in two or more markets. In later chapters we will see how arbitrage is
sometimes possible when the futures price of an asset gets out of line with its spot price.
We will also examine how arbitrage can be used in options markets. This section illus-
trates the concept of arbitrage with a very simple example.
Example 1.3 considers a stock that is traded in both New York and London. Suppose
that the stock price is $152 in New York and £100 in London at a time when the exchange
rate is $1.5500 per pound. An arbitrageur could simultaneously buy 100 shares of the
stock in New York and sell them in London to obtain a risk-free profit of

100 × ( $1.55 × 100 ) − $152 

or $300 in the absence of transactions costs. Transactions costs would probably eliminate
the profit for a small trader. However, a large investment bank faces very low transactions
costs in both the stock market and the foreign exchange market. It would find the arbitrage
opportunity very attractive and would try to take as much advantage of it as possible.
Arbitrage opportunities such as the one in Example 1.3 cannot last for long. As arbi-
trageurs buy the stock in New York, the forces of supply and demand will cause the

Example 1.3 An arbitrage opportunity

A stock is traded in both New York and London. The following quotes have been
obtained:
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New York: $152 per share

London: £100 per share
Value of £1: $1.5500
A trader does the following:
1. Buys 100 shares in New York
2. Sells the shares in London
3. Converts the sale proceeds from pounds to dollars.
This leads to a profit of
100 × ( $1.55 × 100 ) − $152  = 300

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 36 CHAPTER 1

dollar price to rise. Similarly, as they sell the stock in London, the sterling price will be
driven down. Very quickly the two prices will become equivalent at the current exchange
rate. Indeed, the existence of profit-hungry arbitrageurs makes it unlikely that a major
disparity between the sterling price and the dollar price could ever exist in the first
place. Generalizing from this example, we can say that the very existence of arbitrageurs
means that in practice only very small arbitrage opportunities are observed in the prices
that are quoted in most financial markets. In this book most of the arguments concern-
ing futures prices, forward prices, and the values of option contracts will be based on
the assumption that there are no arbitrage opportunities.

1.11 DANGERS
Derivatives are very versatile instruments. As we have seen they can be used for hedg-
ing, for speculation, and for arbitrage. It is this very versatility that can cause problems.
Sometimes traders who have a mandate to hedge risks or follow an arbitrage strategy
become (consciously or unconsciously) speculators. The results can be disastrous. One
example of this is provided by the activities of Jérôme Kerviel at Société Général (see
Business Snapshot 1.4).
To avoid the type of problems Société Général encountered it is very important for
both financial and nonfinancial corporations to set up controls to ensure that deriva-
tives are being used for their intended purpose. Risk limits should be set and the activ-
ities of traders should be monitored daily to ensure that the risk limits are adhered to.
Unfortunately, even when traders follow the risk limits that have been specified, big
mistakes can happen. Some of the activities of traders in the derivatives market during
the period leading up to the start of the credit crisis in July 2007 proved to be much
riskier than they were thought to be by the financial institutions they worked for. As
will be discussed in Chapter 8, house prices in the United States had been rising fast.
Most people thought that the increases would continue—or, at worst, that house prices
would simply level off. Very few were prepared for the steep decline that actually hap-
pened. Furthermore, very few were prepared for the high correlation between mortgage
default rates in different parts of the country. Some risk managers did express reserva-
tions about the exposures of the companies for which they worked to the U.S. real estate
market. But, when times are good (or appear to be good), there is an unfortunate ten-
dency to ignore risk managers and this is what happened at many financial institutions
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during the 2006–2007 period. The key lesson from the credit crisis is that financial insti-
tutions should always be dispassionately asking “What can go wrong?”, and they should
follow that up with the question “If it does go wrong, how much will we lose?”

SUMMARY
In this chapter we have taken a first look at futures, forward, and options markets.
Futures and forward contracts are agreements to buy or sell an asset at a certain time
in the future for a certain price. Futures contracts are traded on an exchange, whereas
forward contracts are traded in the over-the-counter market. There are two types of

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 Introduction 37

Business Snapshot 1.4 SocGen’s big loss in 2008

Derivatives are very versatile instruments. They can be used for hedging, specula-
tion, and arbitrage. One of the risks faced by a company that trades derivatives is
that an employee who has a mandate to hedge or to look for arbitrage opportunities
may become a speculator.
Jérôme Kerviel joined Société Général (SocGen) in 2000 to work in the compli-
ance area. In 2005, he was promoted and became a junior trader in the bank’s Delta
One products team. He traded equity indices such as the German DAX index, the
French CAC 40, and the Euro Stoxx 50. His job was to look for arbitrage opportuni-
ties. These might arise if a futures contract on an equity index was trading for a dif-
ferent price on two different exchanges. They might also arise if equity index futures
prices were not consistent with the prices of the shares constituting the index. (This
type of arbitrage is discussed in Chapter 5.)
Kerviel used his knowledge of the bank’s procedures to speculate while giving the
appearance of arbitraging. He took big positions in equity indices and created ficti-
tious trades to make it appear that he was hedged. In reality, he had large bets on the
direction in which the indices would move. The size of his unhedged position grew
over time to tens of billions of euros.
In January 2008, his unauthorized trading was uncovered by SocGen. Over a three-
day period, the bank unwound his position for a loss of 4.9 billion euros. This was at
the time the biggest loss created by fraudulent activity in the history of finance. (Later
in the year, a much bigger loss from Bernard Madoff’s Ponzi scheme came to light.)
Rogue trader losses were not unknown at banks prior to 2008. For example, in the
1990s, Nick Leeson, who worked at Barings Bank, had a mandate similar to that of Jérôme
Kerviel. His job was to arbitrage between Nikkei 225 futures quotes in Singapore and
Osaka. Instead he found a way to make big bets on the direction of the Nikkei 225 using
futures and options, losing $1 billion and destroying the 200-year old bank in the
process. In 2002, it was found that John Rusnak at Allied Irish Bank had lost $700 million
from unauthorized foreign exchange trading. The lessons from these losses are that it is
important to define unambiguous risk limits for traders and then to monitor what they
do very carefully to make sure that the limits are adhered to.

options: calls and puts. A call option gives the holder the right to buy an asset by a
certain date for a certain price. A put option gives the holder the right to sell an asset
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by a certain date for a certain price. Options trade both on exchanges and in the over-
the-counter market.
Futures, forwards, and options have been very successful innovations. Three main
types of participants in the markets can be identified: hedgers, speculators, and arbitra-
geurs. Hedgers are in the position of facing risk associated with the price of an asset.
They use futures, forward, or option contracts to reduce or eliminate this risk. Specula-
tors wish to bet on future movements in the price of an asset. Futures, forward, and
option contracts can give them extra leverage; that is, the contracts can increase both
the potential gains and potential losses in a speculative investment. Arbitrageurs are in
business to take advantage of a discrepancy between prices in two different markets. If,
for example, they see the futures price of an asset getting out of line with the spot price,
they will take offsetting positions in the two markets to lock in a profit.

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 38 CHAPTER 1

FURTHER READING
Chancellor, E. Devil Take the Hindmost—A History of Financial Speculation. New York: Farra
Straus Giroux, 2000.
Merton, R. C. “Finance Theory and Future Trends: The Shift to Integration,” Risk, 12, 7 (July 1999):
48–51.
Miller, M. H. “Financial Innovation: Achievements and Prospects,” Journal of Applied Corporate
Finance, 4 (Winter 1992): 4–11.
Zingales, L. “Causes and Effects of the Lehman Bankruptcy,” Testimony before Committee on
Oversight and Government Reform, United States House of Representatives, October 6,
2008.

Quiz (Answers at End of Book)

1.1. What is the difference between a long futures position and a short futures position?
1.2. Explain carefully the difference between (a) hedging, (b) speculation, and (c) arbitrage.
1.3. What is the difference between (a) entering into a long futures contract when the futures
price is $50 and (b) taking a long position in a call option with a strike price of $50?
1.4. An investor enters into a short forward contract to sell 100,000 British pounds for U.S.
dollars at an exchange rate of 1.5000 U.S. dollars per pound. How much does the investor
gain or lose if the exchange rate at the end of the contract is (a) 1.4900 and (b) 1.5200?
1.5. Suppose that you write a put contract with a strike price of $40 and an expiration date in
three months. The current stock price is $41 and one put option contract is on 100 shares.
What have you committed yourself to? How much could you gain or lose?
1.6. You would like to speculate on a rise in the price of a certain stock. The current stock price
is $29 and a three-month call with a strike price of $30 costs $2.90. You have $5,800 to
invest. Identify two alternative strategies. Briefly outline the advantages and disadvan-
tages of each.
1.7. What is the difference between the over-the-counter and the exchange-traded market?
What are the bid and offer quotes of a market maker in the over-the-counter market?

Practice Questions (Answers in Solutions Manual/Study Guide)

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1.8. Suppose you own 5,000 shares that are worth $25 each. How can put options be used to
provide you with insurance against a decline in the value of your holding over the next
four months?
1.9. A stock when it is first issued provides funds for a company. Is the same true of an exchange-
traded stock option? Discuss.
1.10. Explain why a futures contract can be used for either speculation or hedging.
1.11. A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months. The
live-cattle futures contract on the Chicago Mercantile Exchange is for the delivery of
40,000 pounds of cattle. How can the farmer use the contract for hedging? From the
farmer’s viewpoint, what are the pros and cons of hedging?

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 Introduction 39

1.12. It is July 2016. A mining company has just discovered a small deposit of gold. It will take
six months to construct the mine. The gold will then be extracted on a more or less con-
tinuous basis for one year. Futures contracts on gold are available on the New York Mer-
cantile Exchange. There are delivery months every two months from August 2016 to
December 2017. Each contract is for the delivery of 100 ounces. Discuss how the mining
company might use futures markets for hedging.
1.13. Suppose that a March call option on a stock with a strike price of $50 costs $2.50 and is
held until March. Under what circumstances will the holder of the option make a gain?
Under what circumstances will the option be exercised? Draw a diagram showing how the
profit on a long position in the option depends on the stock price at the maturity of the
option.
1.14. Suppose that a June put option on a stock with a strike price of $60 costs $4 and is held
until June. Under what circumstances will the holder of the option make a gain? Under
what circumstances will the option be exercised? Draw a diagram showing how the profit
on a short position in the option depends on the stock price at the maturity of the option.
1.15. It is May and a trader writes a September call option with a strike price of $20. The stock
price is $18 and the option price is $2. Describe the trader’s cash flows if the option is held
until September and the stock price is $25 at this time.
1.16. An investor writes a December put option with a strike price of $30. The price of the
option is $4. Under what circumstances does the investor make a gain?
1.17. The CME Group offers a futures contract on long-term Treasury bonds. Characterize the
traders likely to use this contract.
1.18. An airline executive has argued: “There is no point in our using oil futures. There is just
as much chance that the price of oil in the future will be less than the futures price as there
is that it will be greater than this price.” Discuss the executive’s viewpoint.
1.19. “Options and futures are zero-sum games.” What do you think is meant by this statement?
1.20. A trader enters into a short forward contract on 100 million yen. The forward exchange
rate is $0.0080 per yen. How much does the trader gain or lose if the exchange rate at the
end of the contract is (a) $0.0074 per yen; (b) $0.0091 per yen?
1.21. A trader enters into a short cotton futures contract when the futures price is 50 cents per
pound. The contract is for the delivery of 50,000 pounds. How much does the trader gain
or lose if the cotton price at the end of the contract is (a) 48.20 cents per pound; (b) 51.30
cents per pound?
1.22. A company knows that it is due to receive a certain amount of a foreign currency in four
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months. What type of option contract is appropriate for hedging?

1.23. A company in the United States expects to have to pay 1 million Canadian dollars in six
months. Explain how the exchange rate risk can be hedged using (a) a forward contract;
(b) an option.
1.24. A trader buys a call option with a strike price of $30 for $3. Does the trader ever exercise
the option and lose money on the trade. Explain.
1.25. A trader sells a put option with a strike price of $40 for $5. What is the trader’s maximum
gain and maximum loss? How does your answer change if it is a call option?
1.26. “Buying a put option on a stock when the stock is owned is a form of insurance.” Explain
this statement.

Hull, John. Fundamentals of Futures and Options Markets, Global Edition, Pearson Education, Limited, 2022. ProQuest Ebook Central,
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 40 CHAPTER 1

Further Questions
1.27. Trader A enters into a forward contract to buy an asset for $1,000 in one year. Trader B
buys a call option to buy the asset for $1,000 in one year. The cost of the option is $100.
What is the difference between the positions of the traders? Show the profit as a function
of the price of the asset in one year for the two traders.
1.28. On May 13, 2015, as indicated in Table 1.2, the spot offer price of Google stock is $532.34
and the offer price of a call option with a strike price of $525 and a maturity date of Sep-
tember is $30.40. A trader is considering two alternatives: buy 100 shares of the stock and
buy 100 September call options. For each alternative, what is (a) the upfront cost, (b) the
total gain if the stock price in September is $600, and (c) the total loss if the stock price in
September is $500. Assume that the option is not exercised before September and if stock
is purchased it is sold in September.
1.29. What is arbitrage? Explain the arbitrage opportunity when the price of a dually listed
mining company stock is $50 (USD) on the New York Stock Exchange and $60 (CAD) on
the Toronto Stock Exchange. Assume that the exchange rate is such that 1 USD equals
1.18 CAD. Explain what is likely to happen to prices as traders take advantage of this
opportunity.
1.30. In March, a U.S. investor instructs a broker to sell one July put option contract on a stock.
The stock price is $42 and the strike price is $40. The option price is $3. Explain what the
investor has agreed to. Under what circumstances will the trade prove to be profitable?
What are the risks?
1.31. A U.S. company knows it will have to pay 3 million euros in three months. The current
exchange rate is 1.1500 dollars per euro. Discuss how forward and options contracts can
be used by the company to hedge its exposure.
1.32. A stock price is $29. An investor buys one call option contract on the stock with a strike
price of $30 and sells a call option contract on the stock with a strike price of $32.50. The
market prices of the options are $2.75 and $1.50, respectively. The options have the same
maturity date. Describe the investor’s position.
1.33. The price of gold is currently $1,200 per ounce. Forward contracts are available to buy or
sell gold at $1,400 per ounce for delivery in one year. An arbitrageur can borrow money
at 5% per annum. What should the arbitrageur do? Assume that the cost of storing gold
is zero and that gold provides no income.
1.34. Discuss how foreign currency options can be used for hedging in the situation described
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in Example 1.1 so that (a) ImportCo is guaranteed that its exchange rate will be less than
1.5900, and (b) ExportCo is guaranteed that its exchange rate will be at least 1.5500.
1.35. The current price of a stock is $94, and three-month European call options with a strike
price of $95 currently sell for $4.70. An investor who feels that the price of the stock will
increase is trying to decide between buying 100 shares and buying 2,000 call options (20
contracts). Both strategies involve an investment of $9,400. What advice would you give?
How high does the stock price have to rise for the option strategy to be more profitable?
1.36. On May 13, 2015, an investor owns 100 Google shares. As indicated in Table 1.3, the bid
share price is $532.20 and a December put option with a strike price of $500 costs $22.10.
The investor is comparing two alternatives to limit downside risk. The first involves

Hull, John. Fundamentals of Futures and Options Markets, Global Edition, Pearson Education, Limited, 2022. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/uwsau/detail.action?docID=6977575.
Created from uwsau on 2024-05-13 03:35:59.
 Introduction 41

buying one December put option contract with a strike price of $500. The second involves
instructing a broker to sell the 100 shares as soon as Google’s price reaches $500. Discuss
the advantages and disadvantages of the two strategies.
1.37. A trader buys a European call option and sells a European put option. The options have
the same underlying asset, strike price, and maturity. Describe the trader’s position. Under
what circumstances does the price of the call equal the price of the put?
Copyright © 2022. Pearson Education, Limited. All rights reserved.

Hull, John. Fundamentals of Futures and Options Markets, Global Edition, Pearson Education, Limited, 2022. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/uwsau/detail.action?docID=6977575.
Created from uwsau on 2024-05-13 03:35:59.