Introduction to Options and Futures

 Alberto Manconi
email: alberto.manconi@unibocconi.it
Finance Department
2-E2-03, via Roentgen

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 Thursday, 13:00 – 14:00, over Zoom

 Email your question(s) to me 48 hours beforehand

▪ It helps me prepare to answer your questions

▪ It helps you think carefully about the material

 Office hours ≠ Tutoring

☺ Specific question(s) about specific point(s)

 “I wasn’t paying attention in class, could you explain the whole

topic all over again?”
 Thursday, 13:00 – 14:00, over Zoom

 Email your question(s) to me 48 hours beforehand

 Office hours ≠ Tutoring

 Want to discuss your MSc applications and career plans?

▪ I’m very happy to talk about this with you and give you tips

▪ It’s important to get feedback on your applications/career plans,

and your professors are a good source of information
 Felix Gerding
email: felix.gerding@phd.unibocconi.it
Finance Department
via Roentgen
Main task: Grading
 Risk management
Banks, asset mgmt, insurance, and large companies use
derivatives to hedge risk

 Asset management
Asset management companies and the prop trading desk of some
banks use derivatives, e.g., to obtain leverage
 Financial engineering
The largest, most dynamic financial institutions develop new
derivatives (or combine well-known ones in innovative ways)
 Acquire knowledge of the functioning of the
markets for the main derivative instruments
 Understand and apply the mathematical and
econometric tools used to formalize financial
problems and data analysis
 Understand role of derivative instruments in the
market and as a corporate risk management tool
 Develop and train critical thinking about financial
problems
 J. Hull, “Options, Futures, and Other
Derivatives”, Prentice Hall, 10th edition
(other editions – within reason – also work!)

 There’s a solutions manual – not mandatory,

but handy
Dear professor,
I am currently doing my internship at Goldman Sachs in
London in the Securities division and wanted to thank
you for the course in Options and Futures.
It has been very helpful and I am going back to the slides
you have provided us with.
The book by Hull is everywhere in the floor and it is
considered the “bible”!
 Yes
▪ I will assume a solid knowledge of basic financial
mathematics, prob & stats, and calculus
 Why?
▪ Valuing derivatives relies on mathematical techniques –
hard to say anything otherwise
▪ Many tasks you will face on the job require you to know
that math: using and/or writing computer code for pricing,
estimating VaR, designing new products, etc.
▪ Anyone can commit a formula to memory. Understanding
where it comes from is more challenging and rewarding!
 Lectures

 Case studies

 Problems

 “Take-home” mid-terms

 Final exam
 Wed & Thu
 Check Blackboard regularly
 Largely follow the textbook, but:
▪ There will be textbook material we don’t go over
in class – still exam material, unless otherwise
stated

▪ There will be enhancements

 Hybrid mode
 Participation: Making a comment…
< 1 time in 3 classes – don’t be too shy!

> 3 times in 1 class – let others speak too!

 This course is hands-on
▪ Develop critical thinking

▪ Practice theory encountered in class

▪ Application to challenging real-world problems

 Key component of business education world-

wide
 Great for practice
 We will see some examples in class, but you
should practice on your own
 Solving problems is how we learn
 The spirit: Apply the tools we learn in class, to
find a solution to problems we have not seen
before
 Two (2) “take-home” mid-terms

▪ Distributed via BlackBoard

▪ Per test: Two shots, over a one-week period

 Can account for 30% of your grade, for the
first time you take the exam

 Expiration: Any retake means you forfeit the

take-home mid-terms grades, and your grade
is 100% based on the exam
 Partly about solving problems
▪ Similar to end-of-chapter textbook problems
▪ We will see some in class

 Partly about applying the theory and

discussing its applications
▪ Similar to the kind of discussions we have in class
▪ Plenty of examples to develop intuition
 Unreasonably difficult, impossible to pass
Difficulty

Ridicolously easy, guaranteed pass

Dec Jan I Jan II Jul Sep

 First take of the exam:
max { 70% × Final exam score +
15% × Take-home mid-term #1 +
15% × Take-home mid-term #2 ;
100% × Final exam score }

 Any retake:
100% × Final exam grade
 I can only write one for you if I know you –
participate in the class discussion!
 I need time to write one!
▪ Ask me at least two months before your deadline

 My letter will mention your performance on

my course (would not be credible otherwise)
1973 1997
The Black-Scholes formula:

𝐶 = 𝑆0 𝑁 𝑑 − 𝐾𝑒 −𝑟𝑇 𝑁 𝑑 − 𝜎 𝑇

where:

𝑆 𝜎2
ln 𝐾 + 𝑟 + 2 𝑇
𝑑=
𝜎 𝑇
1998 2003

. LTCM: hedge fund founded by John Meriwether, Myron Scholes “Derivatives are financial
and Robert C. Merton weapons of mass
. First years: returns of over 40% destruction” – W. Buffett
. In 1998: lost $4.6 billion following the Russian financial crisis
“…a love for money can blind us to averting
preventable disasters.”
Source: http://www.forbes.com/sites/stevedenning/2013/01/08/five-years-after-the-financial-meltdown-the-water-is-still-full-of-big-
sharks/#3dd17ec65474
 You want to buy a car. The dealer offers you a
price of $20,000
 Place order today, take delivery in 3 months
 Forward contract: you have the right and
obligation to buy in 3m
 Let’s see your gains/losses in 3m
 You don’t have the loan arranged, and offer
the dealer non-refundable $500 to hold the
price for 3 months
 Option contract: you have the right, but not
the obligation, to buy in 3m
 Let’s see your gains/losses
Derivative: A financial contract, between two or
more parties, whose value is derived from the
future value of an underlying asset

…in our case, underlying asset = the car

 Forward
Buyer and seller agree today on the delivery
of a specified quantity and quality of an asset
at a future date, for a given price
 Futures
Similar to forward, except it has a
standardized specification and is traded on
organized exchange. Profits and losses are
realized on a daily basis
 FX quotes for GBP (24 May 2010)

Bid Offer
Spot 1.4407 1.4411
1-month forward 1.4408 1.4413
3-month forward 1.4410 1.4415
6-month forward 1.4416 1.4422
Source: CBOE, reprinted in Hull, Table 1.2
 1.60

1.55
US$ per £

1.50

1.45

1.40
15-May 4-Jun 24-Jun 14-Jul 3-Aug 23-Aug 12-Sep 2-Oct
Source: Datastream
 Forwards
and Futures
 Option
Confers the right, but not the obligation, to
buy (call) or sell (put) a specified asset at a
specified price up until or at a specific date
  Google option prices (15 Jun 2010)
Strike Jul 2010 Sep 2010 Dec 2010 Jul 2010 Sep 2010 Dec 2010
Price Bid Bid Bid Offer Offer Offer

460 43.30 51.90 63.40 44.00 53.90 64.80

480 28.60 39.70 50.80 29.00 40.40 52.30
500 17.00 28.30 40.60 17.40 29.30 41.30
520 9.00 19.10 31.40 9.30 19.90 32.00
540 4.20 12.70 23.10 4.40 13.00 24.00
560 1.75 7.40 16.80 2.10 8.40 17.70
Source: CBOE, reprinted in Hull, Table 1.3

Check more recent quotes: http://www.cboe.com/delayedquote/quotetable.aspx

 Options
(& others)

Forwards
and Futures
 Option
Confers the right, but not the obligation, to
buy (call) or sell (put) a specified asset at a
specified price up until or at a specific date
 Swap
Simultaneous buying and selling of similar
asset or obligation of equivalent capital
between two parties
 Options
(& others)

Swaps

Forwards
and Futures
 Risk
Derivatives are
used to shift
elements of risk
and act as a form
of insurance
“Impossible to see, the future is”
–Yoda, Jedi Master
Ancient Egypt: 1600s: 1800s:
. Wheat forwards . Options on . Puts & calls on
tulips in Holland stocks at LSE
. Rice futures in . CBOT futures
Japan on grain

→ What’s the first source of risk traded?

 1970s: since 1980s:
. CME financial futures . Explosive growth on OTC
(FX, interest rate), transactions starting with
CBOE options on swaps
stocks
. Credit derivatives
. Black & Scholes
option pricing formula

→ Second source of risk? → Third source of risk?

 Hedger
Someone who is exposed to an unwanted risk, and
wants to pass it to another party willing to accept it

Ex. 1: Farmer who wants to protect future value of harvest (corn, grain…)
against price fluctuations
Ex. 2: Manufacturer who will need to buy a commodity (oil, coffee…) and
may buy option to stabilize production costs
Ex. 3: Portfolio manager who wants to guarantee a minimum rate of
return
 Options
(& others)
Hedging
with…
Swaps

Forwards
and Futures
 Speculator
Buys/sells derivatives in hope of profiting from price
changes to his/her advantage

 Arbitrageur
Trades with a view to exploit any price changes
within derivatives markets or relative to cash or
prices in the underlying markets
 Options
(& others)
Hedging
with…
Swaps

Pricing…
Forwards
and Futures
Slightly more formalism. Introduce more
specialized concepts, to work with stochastic
Options
processes in the Black-Scholes framework. (& others)
Some basic (as well as, time permitting, less
basic) numerical solutions.

Minimal mathematical formalism. Swaps

Focus on the building blocks:
• Pricing: Replicating and hedging portfolio
approaches
• Hedging: How to limit the exposure of your
investments to risk, using financial derivatives Forwards
and Futures
Source: The Economist, 16 Nov 2009: http://www.economist.com/node/14843667
 Regulated exchange floors
▪ CME, LIFFE, etc. have approved members and
rules for safe environment for trading

 Over-the-counter (OTC)
▪ Trading takes place directly between dealers and
principals via phone or computer

 Electronic system
 Exchange traded OTC
Futures, options Forwards, options, swaps,…
anything!
Standardized contracts Customizable
Prices determined Market players must contact
competitively on the each other
exchange floor
Positions traded out Positions need to be
transferred
 800
OTC
Notional Outstanding Amt, $Tr

640 Exchange-traded

480

320

160

0
Jun-00 Jun-03 Jun-06 Jun-09 Jun-12 Jun-15
 Exchanges trading futures Exchanges trading options
Chicago Board of Trade CBOE
Chicago Mercantile Exchange American Stock Exchange
LIFFE (London) Philadelphia Stock Exchange
Eurex (Europe) Pacific Exchange
BM&F (Sao Paulo) LIFFE (London)
TIFFE (Tokyo) Eurex (Europe)
 Are derivatives “evil”? “Financial weapons of
mass destruction”?

 Very versatile financial instruments

 Sometimes traders who should hedge or

arbitrage turn into speculators
 Using futures: You’re a US trader convinced
that BPD will appreciate in 2 months

▪ Buy £250,000 spot at $1.4470/£

▪ Buy 4 futures (1 contract = £62,500) at $1.4410/£;

margin account = $20,000
  Using futures $1.4470/£ × £250,000

Buy £250,000 spot Buy 4 futures contracts

Spot price = $1.4470/£ Futures price = $1.4410
Upfront investment $361,750 $20,000
Profit if future exchange
rate = $1.5/£ $13,250 $14,750
Profit if future exchange
rate = $1.4/£ –$11,750 –$10,250

Derivatives allow you to obtain leverage: Can take a large

speculative position (“exposure”) with a small initial investment
 Using options: You have a hunch that IBM,
currently trading at $20, will go up

▪ Buy 100 shares (cost: $2,000)

▪ Buy 20 call option contracts with strike price

$22.5, premium $1, each giving right to buy 100
shares (cost: $2,000)
 Using options: If IBM goes up to $27 ☺
▪ Profit from buying 100 shares:
100 × $27 − $20 = $700

▪ Profit from buying 20 option contracts:

20 × 100 × $4.50 − $2,000 = $7,000
  Using options: If IBM goes down to $15 
▪ Loss from buying 100 shares:
100 × $15 − $20 = −$500

▪ Loss from buying 20 option contracts:

−$2,000
Leverage can generate large losses, despite a relatively small initial
investment
 Jérôme Kerviel
▪ Futures trader at
Société Générale
▪ Makes it appear as if
he’s arbitraging – but
in fact speculates
▪ 2008: losses
uncovered of $4.9bn
 1995: rogue trader Nick
Leeson bankrupts
Barings Bank
 2002: John Rusnak
causes $700m loss at
Allied Irish Bank (AIB)
from unauthorized FX
trades
 …
 Some accounts of the
2007-09 crisis

 Complex derivatives
(CDO, CDO2, …) looked
safe, hiding large risk

 Investors loaded up on
them, causing the crash
 Are derivatives useful, or
a financial weapon of
mass destruction?
 Options
(& others)
Hedging
Financial with…
markets and
Swaps
corporate
applications
Pricing…
Forwards
and Futures
 Are derivatives useful, or
a financial weapon of
mass destruction?

 More likely: A powerful

financial instrument

 See how you feel at the

end of our classes