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An Introduction To Forwards and Options

Financial markets

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61 views

An Introduction To Forwards and Options

Financial markets

Uploaded by

erg534
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 22

Chapter 2

An Introduction
to Forwards
and Options

Introduction
Basic derivatives contracts

Forward contracts
Call options
Put Options

Types of positions

Long position
Short position

Graphical representation

Payoff diagrams
Profit diagrams

Copyright 2006 Pearson Addison-Wesley.

2-2

Forward Contracts
Definition: a binding agreement (obligation) to buy/sell an
underlying asset in the future, at a price set today
Futures contracts are the same as forwards in principle except for
some institutional and pricing differences.
A forward contract specifies

The features and quantity of the asset to be delivered

The delivery logistics, such as time, date, and place

The price the buyer will pay at the time of delivery


Today

Expiration
date

Copyright 2006 Pearson Addison-Wesley.

2-3

Reading Price Quotes


Settlement price
Low of the day
High of the day

Lifetime high
Daily change

The open price

Lifetime low
Open interest

Expiration month

Copyright 2006 Pearson Addison-Wesley.

2-4

Payoff on a Forward Contract


Payoff for a contract is its value at expiration
Payoff for

Long forward = Spot price at expiration Forward price

Short forward = Forward price Spot price at expiration

Example 2.1: S&R (special and rich) index:

Today: Spot price = $1,000, 6-month forward price = $1,020

In six months at contract expiration: Spot price = $1,050


Long position payoff = $1,050 $1,020 = $30
Short position payoff = $1,020 $1,050 = ($30)

Copyright 2006 Pearson Addison-Wesley.

2-5

Payoff Diagram for Forwards


Long and short forward positions on the
S&R 500 index

Copyright 2006 Pearson Addison-Wesley.

2-6

Forward Versus Outright Purchase

Forward payoff

Bond payoff

Forward + bond = Spot price at expiration $1,020 + $1,020


= Spot price at expiration

Copyright 2006 Pearson Addison-Wesley.

2-7

Additional Considerations
Type of settlement

Cash settlement: less costly and more practical


Physical delivery: often avoided due to
significant costs

Credit risk of the counter party

Major issue for over-the-counter contracts


Credit check, collateral, bank letter of credit

Less severe for exchange-traded contracts


Exchange guarantees transactions, requires collateral

Copyright 2006 Pearson Addison-Wesley.

2-8

Call Options
A non-binding agreement (right but not an obligation)
to buy an asset in the future, at a price set today
Preserves the upside potential, while at the same time
eliminating the unpleasant downside (for the buyer)
The seller of a call option is obligated to deliver
if asked
Today

Expiration date

or
at buyers choosing

Copyright 2006 Pearson Addison-Wesley.

2-9

Examples
Example 2.3: S&R index

Today: call buyer acquires the right to pay $1,020 in six months for
the index, but is not obligated to do so
In six months at contract expiration: if spot price is
$1,100, call buyers payoff = $1,100 $1,020 = $80
$900, call buyer walks away, buyers payoff = $0

Example 2.4: S&R index

Today: call seller is obligated to sell the index for $1,020


in six months, if asked to do so
In six months at contract expiration: if spot price is
$1,100, call sellers payoff = $1,020 $1,100 = ($80)
$900, call buyer walks away, sellers payoff = $0

Why would anyone agree to be on the seller side?

Copyright 2006 Pearson Addison-Wesley.

2-10

Definition and Terminology


A call option gives the owner the right but not the obligation to
buy the underlying asset at a predetermined price during a
predetermined time period
Strike (or exercise) price: the amount paid by the option buyer for
the asset if he/she decides to exercise
Exercise: the act of paying the strike price to buy the asset
Expiration: the date by which the option must be exercised or
become worthless
Exercise style: specifies when the option can be exercised

European-style: can be exercised only at expiration date


American-style: can be exercised at any time before expiration
Bermudan-style: Can be exercised during specified periods

Copyright 2006 Pearson Addison-Wesley.

2-11

Reading Price Quotes


S&P 500
Index Options

Strike price

Copyright 2006 Pearson Addison-Wesley.

2-12

Payoff/Profit of a Purchased Call


Payoff = Max [0, spot price at expiration strike price]
Profit = Payoff future value of option premium
Examples 2.5 & 2.6:

S&R Index 6-month Call Option


Strike price = $1,000, Premium = $93.81, 6-month
risk-free rate = 2%

If index value in six months = $1100


Payoff = max [0, $1,100 $1,000] = $100
Profit = $100 ($93.81 x 1.02) = $4.32

If index value in six months = $900


Payoff = max [0, $900 $1,000] = $0
Profit = $0 ($93.81 x 1.02) = $95.68

Copyright 2006 Pearson Addison-Wesley.

2-13

Diagrams for Purchased Call


Payoff at expiration

Profit at expiration

Copyright 2006 Pearson Addison-Wesley.

2-14

Payoff/Profit of a Written Call


Payoff = max [0, spot price at expiration
strike price]
Profit = Payoff + future value of option premium
Example 2.7

S&R Index 6-month Call Option


Strike price = $1,000, Premium = $93.81, 6-month
risk-free rate = 2%

If index value in six months = $1100


Payoff = max [0, $1,100 $1,000] = $100
Profit = $100 + ($93.81 x 1.02) = $4.32

If index value in six months = $900


Payoff = max [0, $900 $1,000] = $0
Profit = $0 + ($93.81 x 1.02) = $95.68

Copyright 2006 Pearson Addison-Wesley.

2-15

Put Options
A put option gives the owner the right but not
the obligation to sell the underlying asset at a
predetermined price during a predetermined
time period
The seller of a put option is obligated to buy if asked
Payoff/profit of a purchased (i.e., long) put

Payoff = max [0, strike price spot price at expiration]


Profit = Payoff future value of option premium

Payoff/profit of a written (i.e., short) put

Payoff = max [0, strike price spot price at expiration]


Profit = Payoff + future value of option premium

Copyright 2006 Pearson Addison-Wesley.

2-16

Put Option Examples


Examples 2.9 & 2.10

S&R Index 6-month Put Option


Strike price = $1,000, Premium = $74.20, 6-month
risk-free rate = 2%

If index value in six months = $1100


Payoff = max [0, $1,000 $1,100] = $0
Profit = $0 ($74.20 x 1.02) = $75.68

If index value in six months = $900


Payoff = max [0, $1,000 $900] = $100
Profit = $100 ($74.20 x 1.02) = $24.32

Copyright 2006 Pearson Addison-Wesley.

2-17

Profit for a Long Put Position


Profit table

Profit diagram

Copyright 2006 Pearson Addison-Wesley.

2-18

A Few Items to Note


A call option becomes more profitable when the
underlying asset appreciates in value
A put option becomes more profitable when the
underlying asset depreciates in value
Moneyness

In-the-money option: positive payoff


if exercised immediately
At-the-money option: zero payoff
if exercised immediately
Out-of-the money option: negative payoff
if exercised immediately

Copyright 2006 Pearson Addison-Wesley.

2-19

Options and Insurance


Homeowners insurance as a put option

Copyright 2006 Pearson Addison-Wesley.

2-20

Equity Linked CDs


The 5.5-year CD promises to repay initial invested
amount and 70% of the gain in S&P 500 index

Assume $10,000 invested when S&P 500 = 1300

Final payoff =

$10,000 1 0.7 max 0, final 1


1300

Where Sfinal= value of the


S&P 500 after 5.5 years

Copyright 2006 Pearson Addison-Wesley.

2-21

Option and Forward Positions: A Summary

Copyright 2006 Pearson Addison-Wesley.

2-22

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