Hull, Options, Futures & Other Derivatives
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1 P1.T3. Financial Markets & Products Hull, Options, Futures & Other Derivatives Bionic Turtle FRM Study Notes Sample By David Harper, CFA FRM CIPM and Deepa Raju
2 Hull, Chapter 1: Introduction DESCRIBE THE OVER-THE-COUNTER MARKET, DISTINGUISH IT FROM TRADING ON AN EXCHANGE, AND EVALUATE ITS ADVANTAGES AND DISADVANTAGES DIFFERENTIATE BETWEEN OPTIONS, FORWARDS, AND FUTURES CONTRACTS... 4 IDENTIFY AND CALCULATE OPTION AND FORWARD CONTRACT PAYOFFS CALCULATE AND COMPARE THE PAYOFFS FROM HEDGING STRATEGIES INVOLVING FORWARD CONTRACTS AND OPTIONS
3 Hull, Chapter 1: Introduction Describe the over-the-counter market, distinguish it from trading on an exchange, and evaluate its advantages and disadvantages. Differentiate between options, forwards, and futures contracts. Identify and calculate option and forward contract payoffs. Calculate and compare the payoffs from hedging strategies involving forward contracts and options. Calculate and compare the payoffs from speculative strategies involving futures and options. Calculate an arbitrage payoff and describe how arbitrage opportunities are temporary. Describe some of the risks that can arise from the use of derivatives. Describe the over-the-counter market, distinguish it from trading on an exchange, and evaluate its advantages and disadvantages. A derivatives exchange is a central marketplace where participants can trade standardized contracts. The over-the-counter (OTC) market is an alternative to exchanges where trades take place between two counterparties directly or through a network of dealers linked by recorded phone conversations and computers. The key differences include the following: Exchange Traded Markets Trading takes place in an exchange or electronically through a centralized marketplace Contracts are standardized and defined by the exchange Exchange clearing house assumes credit risk Subject to regulations Though number of derivatives contracts traded per year are larger, the average size of transactions is smaller than OTC markets Other than large financial institutions, the participants include retail investors A trader can easily close out his position prior to maturity by acquiring exactly offsetting positions with any market participant. Over-The-Counter Markets Trading takes place over-the-counter via interdealer brokers or directly through phone or Contracts may be customized and there is more negotiating flexibility with respect to features Trades may be cleared bilaterally or through a CCP which assumes the credit risk Largely unregulated prior to crisis but now new regulations are affecting their operations Trades are typically larger and total value the market is much larger than trades in the exchange Banks, other large financial institutions, fund managers, and corporations are the main participants Traders can attempt to negotiate an early termination of a particular contract, but it is may be more difficult to find a counterparty with exactly offsetting positions. 3
4 Advantage of OTC Customization (a.k.a., tailored exposure): The terms of a contract do not have to be those specified by an exchange. Market participants are free to negotiate any mutually attractive deal for any type of security. The OTP markets for derivatives are huge and thus may provide ample liquidity for trading in certain instruments. Disadvantage of OTC Counterparty risk may be high when trades do not take place through a central counterparty (CCP). Since trades can be highly customized, for certain securities, active trading may not take place due to liquidity issues. Differentiate between options, forwards, and futures contracts A forward contract is an obligation (agreement) to buy or sell an asset at a certain future time for a certain price and is traded over-the-counter. For example, an oil producer promises to sell 10 million barrels of oil next December at a pre-agreed price of $ per barrel. A futures contract is similar to a forward, but trades on an exchange. The exchange (clearinghouse) is effectively the counterparty. An option gives holder the right (but not the obligation) to buy/sell at a certain price. Options are traded both on exchanges and in the over-the-counter markets. Whereas it costs nothing to enter into a forward or futures contract, there is a cost (option premium) to acquiring an option. For example, an executive has the right (but not the obligation) to buy 10,000 shares of her company s stock next December, at the pre-agreed (strike or exercise) price of $35 per share. Unlike a long forward position, she is not obligated to purchase. Instead she has the option to either exercise or not exercise this right. 4
5 Identify and calculate option and forward contract payoffs. Forward Payoff: If is the delivery price and is the spot price of the asset at maturity of the contract: Payoff for a long position in forward contract is Payoff for a short position in forward contract is Since the forward has no initial cost, its profit plot is identical to its payoff plot. Option Payoff: Payoff for a call option buyer (long) is (, 0). The payoff to the call seller(short) is the negative of this value. Payoff for a put option buyer (long) is (, 0). The payoff to the put seller(short) is the negative of this value. Since an option has an initial cost (the option premium), option charts plot the option profit as payoff minus the premium cost of the option. =. Note the difference between an option payoff and an option profit: Premium: Initial cost (or initial investment or up-front cost) Payoff: Gain or loss on exercise (i.e., intrinsic value at exercise) Profit: Payoff of the option less its initial cost. o To the long who buys the option: ( ) =. o To the short who sells (writes) the option: ( ) =. Below is the payoff plot for the forwards. As mentioned, the profit plot and payoff plot for the forwards are the same. 5
6 Below is the payoff and profit plot for the options. Long call, K = $20.00 $6 Profit Payoff $6 $4 $4 $2 $0 $2 ($2) $0 ($4) ($2) $15 $17 $19 $21 $23 $25 Long put, K = $20.00 Profit Payoff $15 $17 $19 $21 $23 $25 1. Question: If the price (premium) is $4.00 for a call option with a strike (exercise) of $30.00, what are the payoff and profit on a long position (option buyer), if the option expires when the stock is $38.50? 2. Answer: Payoff on a long call = MAX[0, S(t) K] = MAX[0, ] = $8.50 Profit on the long call = payoff premium = $ = $ Question: If the price (premium) is $3.80 for a put option with a strike (exercise) of $20.00, what are the payoff and profit on a short position (option writer), if the option expires when the stock is $13.00? 4. Answer: Payoff on a short put = -MAX[0, K S(t)] = -MAX[0, 20-13] = -$7.00 Profit on the short put = premium payoff = $7.00 = -$3.20. Calculate and compare the payoffs from hedging strategies involving forward contracts and options. Both forwards and options can be used to hedge but there are key differences. The forward does not require an upfront investment or a premium while an option requires a premium. Forward contracts are designed to neutralize risk by fixing the price that the hedger will pay or receive for the underlying asset. However, the contract can produce a loss as well as a profit. Options, in contrast provide 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. While the forward contract is an obligation, an option does not have to be exercised, and can be left to expire worthless if conditions are unfavorable. Thus, unlike the forward contract, the payoff structure for the option is asymmetric. 6
7 Example: Hedging strategies using options Consider an investor who owns 1,000 shares of a particular at a share price of $28.00 per share. The investor is concerned about a possible share price decline in the next 2 months and wants protection. The investor could buy put option contracts expiring in 2 months on the company s stock with a strike price of $ The quoted option price is $1.00 per option contract. Each option contract would cost 100 * $1.00 = $ and the total cost of the hedging strategy would be 10 *$ = $1, The strategy costs $1, 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, is realized for the entire holding. When the cost of the options is taken into account, the amount realized is $26, 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, (or above $26, when the cost of the options is taken into account). The figure below (Hull Fig 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 2 months. 7
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