Introduction

Chapter 1

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 1
 The Nature of Derivatives

A derivative is an instrument whose

value depends on the values of other
more basic underlying variables

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 2
 Examples of Derivatives

• Futures Contracts
• Forward Contracts
• Swaps
• Options

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 3
 Ways Derivatives are Used

 To hedge risks
 To speculate (take a view on the
future direction of the market)
 To lock in an arbitrage profit
 To change the nature of a liability
 To change the nature of an investment
without incurring the costs of selling
one portfolio and buying another

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 4
 Why Derivatives Are Important
 Derivatives play a key role in transferring risks in the
economy
 There are many underlying assets: stocks, currencies,
interest rates, commodities, debt instruments, electricity,
insurance payouts, the weather, etc.
 Many financial transactions have embedded derivatives
 The real options approach to assessing capital
investment decisions, which values the options
embedded in investments using derivatives theory, has
become widely accepted

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 5
 Futures Contracts

 A futures contract is an agreement to

buy or sell an asset at a certain time in
the future for a certain price
 By contrast, in a spot contract there is
an agreement to buy or sell the asset
immediately (or within a very short
period of time)

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 6
 Exchanges Trading Futures
 CME Group
 Intercontinental Exchange
 NYSE Euronext
 Eurex
 BM&FBovespa (Sao Paulo, Brazil)
 National Stock Exchange of India
 China Financial futures Exchange
 and many more (see list at end of book)

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 7
 Futures Price

 The futures price for a particular contract

is the price at which you agree to buy or
sell at a future time
 It is determined by supply and demand in
the same way as a spot price

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 8
 Futures Trading
 Traditionally futures contracts have been traded
using the open outcry system where traders
physically meet on the floor of the exchange
 CME largely closed this in 2015 for futures

Image sources:
https://www.businessinsider.com/what-did-people-do-at-the-cme-2015-3#the-trading-pit-is-where-all-of-the-
screaming-and-yelling-takes-place-1
https://www.cnbc.com/2015/02/06/its-hard-to-mourn-the-loss-of-open-outcry-trading-commentary.html

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 9
 Electronic Trading
 This has now been largely replaced by
electronic trading and high frequency
algorithmic trading is becoming an
increasingly important part of the market

 CME Globex

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 10
 Examples of Futures Contracts

Agreement to:
 buy 100 oz. of gold @ US$1,750/oz.
in December
 sell £62,500 @ 1.5500 US$/£ in
March
 sell 1,000 bbl. of oil @ US$85/bbl. in
April

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 11
 Terminology

 The party that has agreed to buy

has a long position
 The party that has agreed to sell
has a short position

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 12
 Example

 January: an investor enters into a long

futures contract to buy 100 oz of gold @
$1,750 per oz in April
 April: the price of gold is $1,825 per oz
What is the investor’s profit or loss?

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 13
 Over-the Counter (OTC) Markets

 The over-the counter market is an

important alternative to exchanges
 Trades are usually between financial
institutions, corporate treasurers, and fund
managers
 Transactions are much larger than in the
exchange-traded market

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 14
Size of OTC and Exchange-Traded Markets
(Figure 1.2, Page 6)

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © 15
John C. Hull 2013
 The Lehman Bankruptcy (Business
Snapshot 1.1, page 4)

 Lehman’s filed for bankruptcy on September 15,

2008. This was the biggest bankruptcy in US history
 Lehman was an active participant in the OTC derivatives
markets and got into financial difficulties because it took
high risks and found it was unable to roll over its short
term funding
 It had hundreds of thousands of transactions
outstanding with about 8,000 counterparties
 Unwinding these transactions has been challenging for
both the Lehman liquidators and their counterparties

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 16
 New Regulations for OTC Market
 The OTC market is becoming more like the
exchange-traded market.
 New regulations introduced since the crisis
mean that:
 Standard OTC products must be traded on swap
execution facilities (market participant platforms)
 A central clearing party (CCP) must be used as an
intermediary for standard products
 Trades must be reported to a central registry

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 17
 Systemic Risk
 New regulations were introduced because
of concerns about systemic risk
 OTC transactions between financial
institutions lead to systemic risk because a
default by one large financial institution
can lead to losses by other financial
institutions…

Fundamentals of Futures and Options Markets, 9th Ed, Ch 1, Copyright © John C. Hull 2016 18
 Forward Contracts
 Forward contracts are similar to futures
except that they trade in the over-the-
counter (OTC) market
 Forward contracts are popular on
currencies and interest rates

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 19
 Forward Price
 The forward price for a contract is the
delivery price that would be applicable to
the contract if it were negotiated today
(i.e., it is the delivery price that would
make the contract worth exactly zero)
 The forward price may be different for
contracts of different maturities (as
shown by the table)

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 20
 Foreign Exchange Quotes for
USD/GBP exchange rate on June
22, 2012 (See Table 1.1, page 7)
Bank Bid Bank Offer
Spot 1.5585 1.5589

1-month forward 1.5582 1.5587

3-month forward 1.5579 1.5585

6-month forward 1.5573 1.5580

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 21
 Example (page 5)
 On June 22, 2012 the treasurer of a
corporation might enter into a long forward
contract to sell £100 million in six months
at an exchange rate of 1.5573
 This obligates the corporation to pay £100
million and receive $155.73 million on
December 22, 2012
 What are the possible outcomes?
Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 22
 Options

 A call option is an option to buy a

certain asset by a certain date for a
certain price (the strike price)
 A put option is an option to sell a
certain asset by a certain date for a
certain price (the strike price)

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 23
 American vs European Options
 An American option can be exercised at
any time during its life
 A European option can be exercised only
at maturity

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 24
Google Call Option Prices (June 25, 2012
Stock Price: bid 561.32, offer 561.51; See page 8)

Strike July July Sept Sept Dec Dec

Price ($) Bid Offer Bid Offer Bid Offer
520 46.50 47.20 55.40 56.80 67.70 70.00
540 31.70 32.30 41.60 42.50 55.30 56.20
560 20.00 20.40 30.20 30.70 44.20 45.00
580 11.30 11.60 20.70 21.20 34.50 35.30
600 5.60 5.90 13.50 13.90 26.30 27.10

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 25
Google Put Option Prices (June 25, 2012
Stock Price: bid 561.32, offer 561.51; See page 8)

Strike July July Sept Sept Dec Dec

Price ($) Bid Offer Bid Offer Bid Offer

520 5.00 5.30 13.60 14.00 25.30 26.10

540 10.20 10.50 19.80 20.30 32.80 33.50
560 18.30 18.70 28.10 28.60 41.50 42.30
580 29.60 30.00 38.40 39.10 51.80 52.60
600 43.80 44.40 51.10 52.10 63.50 64.90

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 26
 Exchanges Trading Options

 Chicago Board Options Exchange

 International Securities Exchange
 NYSE Euronext
 Eurex (Europe)
 and many more (see list at end of book)

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 27
 Options vs Futures/Forwards
 A futures/forward contract gives the
holder the obligation to buy or sell at a
certain price
 An option gives the holder the right to buy
or sell at a certain price

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 28
 Hedge Funds (see Business Snapshot 1.3, page 12)
 Hedge funds are not subject to the same rules as
mutual funds and cannot offer their securities publicly.
 Mutual funds must
 disclose investment policies,
 makes shares redeemable at any time,
 limit use of leverage
 Hedge funds are not subject to these constraints.

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 29
 Three Reasons for Trading
Derivatives:
Hedging, Speculation, and Arbitrage
 Hedge funds trade derivatives for all three
reasons
 When a trader has a mandate to use
derivatives for hedging or arbitrage, but
then switches to speculation, large losses
can result. (See SocGen, Business Snapshot 1.4,
page 19)

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 30
 Hedging Examples (Example 1.1 and 1.2,
page 13)

 A US company will pay £10 million for imports

from Britain in 3 months and decides to
hedge using a long position in a forward
contract
 An investor owns 1,000 shares currently
worth $28 per share. A two-month put with a
strike price of $27.50 costs $1. The investor
decides to hedge by buying 10 contracts

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 31
 Value of Shares with and without
Hedging (Fig 1.4, page 14)

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 32
 Speculation Example (pages 15)

 An investor with $2,000 to invest feels

that a stock price will increase over the
next 2 months. The current stock price
is $20 and the price of a 2-month call
option with a strike of $22.50 is $1
 What are the alternative strategies?

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 33
 Speculation Example (pages 15)

1. Buy the shares outright

 $2,000 / $20 per share = 100 shares

2. Buy options contract

 Call option contract
 $2,000 / $1 option premium = 2,000 options
 2,000 options / 100 per contract = 20 contracts

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 34
 Which is better?
 If stock price falls by $5
 Value of shares
= 100 shares @ $15 = $1,500
 Profit = proceeds – cost

= $1,500 - $2,000 = -$500

 Return = -$500/$2,000 = -25% return

Value of option
= market price – strike price
 Value of options = $15 - $22.50
= 2,000 options x -$7.50 = no value = -$7.50
 Profit = proceeds – premium cost

= $0 - $2,000 = -$2,000
 Return = -$2,000/$2,000 = -100% return

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 35
 Which is better?
 If stock price increases by $7
 Value of shares
= 100 shares @ $27 = $2,700
 Profit = proceeds – cost

=$2,700 - $2,000
 Return = $700/$2,000 = 35% return Value of option
= market price – strike price
= $27 - $22.50
 Value of options = $4.50
= 2,000 options x $4.50 = $9,000
 Profit = proceeds – premium cost

= $9,000 - $2,000 = $7,000

 Return = $7,000/$2,000 = 350%

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 36
 Arbitrage Example (page 17)

 A stock price is quoted as £100 in

London and $152 in New York
 The current exchange rate is 1.5500
 What is the arbitrage opportunity?

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 37
 1. Gold: An Arbitrage
Opportunity?
 Suppose that:
 The spot price of gold is US$1,700 per ounce

 The quoted 1-year futures price of gold is

US$1,800
 The 1-year US$ interest rate is 5% per
annum
 No income or storage costs for gold

 Is there an arbitrage opportunity?

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 38
 2. Gold: Another Arbitrage
Opportunity?
 Suppose that:
 The spot price of gold is US$1,700

 The quoted 1-year futures price of gold is

US$1,680
 The 1-year US$ interest rate is 5% per
annum
 No income or storage costs for gold

 Is there an arbitrage opportunity?

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 39
 The Futures Price of Gold

If the spot price of gold is S & the futures price is

for a contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
In our examples, S=1700, T=1, and r=0.05 so
that
F = 1700(1+0.05) = 1,785

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 40
 1. Oil: An Arbitrage Opportunity?

Suppose that:
 The spot price of oil is US$80
 The quoted 1-year futures price of
oil is US$90
 The 1-year US$ interest rate is 5%
per annum
 The storage costs of oil are 2% per
annum
 Is there an arbitrage opportunity ?

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 41
 2. Oil: Another Arbitrage
Opportunity?
 Suppose that:
 The spot price of oil is US$80
 The quoted 1-year futures price of
oil is US$75
 The 1-year US$ interest rate is 5%
per annum
 The storage costs of oil are 2% per
annum
 Is there an arbitrage opportunity?

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright © John C. Hull 2013 42