Chapter 1

Introduction

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What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options,
exotics…

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Why Derivatives Are Important
Derivatives play a key role in transferring risks in the
economy
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity prices, insurance payouts, the weather, etc
Many financial transactions have embedded
derivatives
The real options approach to assessing capital
investment decisions has become widely accepted

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How 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

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Forward Price
The forward price for a contract is the
delivery price that would be applicable to
the contract if 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)

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Terminology
The party that has agreed to buy
has what is termed a long position
The party that has agreed to sell
has what is termed a short position

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Example
On May 21, 2020, the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months at an
exchange rate of 1.2230
This obligates the corporation to pay
$1,223,000 for £1 million on November 21,
2020
What are the possible outcomes?

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If the spot rate on November 21, 2020 is
higher than 1.2230 (e.g., 1.2500):

The corporation would have benefited from entering

into the forward contract.
At the new spot rate of 1.2500 USD/GBP, the
corporation would need to pay $1,250,000 to buy £1
million if it were to transact in the spot market.
However, due to the forward contract, the corporation
only pays $1,223,000 (as per the forward rate of
1.2230).
Gain: The corporation saves $1,250,000 -
$1,223,000 = $27,000.
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If the spot rate on November 21, 2020 is
lower than 1.2230 (e.g., 1.2000):
The corporation would face a loss from the forward
contract.
At the new spot rate of 1.2000 USD/GBP, the
corporation would need to pay $1,200,000 to buy £1
million in the spot market.
Due to the forward contract, the corporation is locked
into paying $1,223,000.
Loss: The corporation pays $1,223,000 - $1,200,000
= $23,000 more than if it had used the spot market.

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Profit from a Long Forward Position (K=
delivery price=forward price at time contract is entered into)

Profit

Price of Underlying
K at Maturity, ST

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Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into)

Profit

Price of
K Underlying
at Maturity,
ST

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Futures Contracts
Agreement to buy or sell an asset for a
certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC,
a futures contract is traded on an exchange

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Examples of Futures Contracts
Agreement to:
Buy 100 oz. of gold @ US$1800/oz. in
December
Sell £62,500 @ 1.2500 US$/£ in March
Sell 1,000 bbl. of oil @ US$40/bbl. in April

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1. An Arbitrage Opportunity?

Suppose that:
The price of a non-dividend-paying stock is
$60
The 1-year forward price of the stock is $65
The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?

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The Forward Price of a Non-
Dividend Paying Stock

If the spot price is S and the forward price 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 = 60, T = 1, and r =0.05 so that
F = 60(1+0.05) = 63

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Arbitrage Strategy:
Borrow $60 at the 5% risk-free rate and buy the stock today.
Sell a forward contract at the 1-year forward price of $65.
After one year, repay the loan with interest: 60×(1+0.05)=63.
Deliver the stock under the forward contract and receive $65.
Profit:
You would pay $63 to settle the loan and receive $65 from the
forward contract, giving you a risk-free profit of 65−63=2 dollars
per share.

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2. Another Arbitrage Opportunity?
Suppose that:
The price of a non-dividend-paying stock is
$60
The 1-year forward price of the stock is $60
The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?

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Arbitrage Strategy:
Sell the stock today for $60.
Invest $60 at the risk-free rate (5%) for one year.
Enter a forward contract to buy the stock back in one year for
$60.
After one year:
Your investment will grow to 60×(1+0.05)=636360×(1+0.05)=63
dollars.
You will buy the stock through the forward contract for $60.
Profit:
You gain $63 from the investment and pay $60 for the stock,
resulting in a risk-free profit of 63−60=3 dollars per share.

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1. Oil: An Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$50
- The quoted 1-year futures price of oil is
US$60
- The 1-year US$ interest rate is 5% per
annum
- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

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Arbitrage Strategy:
Buy oil today at the spot price of $50 and incur 2% storage
costs for one year.
Sell a futures contract at the quoted price of $60.
After one year, deliver the oil through the futures contract,
paying the storage cost and earning the higher futures price.
Costs and Profits:
You pay storage costs: 50×(1+0.02)=51.
The oil is sold for $60 at the futures price, giving a profit of
60−51=9 dollars per barrel.

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2. Oil: Another Arbitrage Opportunity?

Suppose that:
- The spot price of oil is US$50
- The quoted 1-year futures price of oil is
US$40
- The 1-year US$ interest rate is 5% per
annum
- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?

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Arbitrage strategy
To exploit this opportunity, you can follow this strategy:
Buy oil in the spot market at $50.
Store the oil for one year (incurring a 2% storage cost).
Enter into a short futures contract to sell oil in one year at the
quoted futures price of $40.
In one year, the oil can be delivered at the futures price of $40,
but the cost to hold the oil (including interest and storage) is
$53.5. Since the market futures price is much lower than this
theoretical price, you would profit from the difference by selling
oil in the spot market at a higher value than it costs to hold and
store

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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)

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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

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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

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Types of Traders
Hedgers
Speculators
Arbitrageurs

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Hedging Examples
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

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Value of Shares with and without
Hedging (Figure 1.4)
40,000 Value of Holding ($)

35,000

No Hedging
30,000 Hedging

25,000

Stock Price ($)

20,000
20 22 24 26 28 30 32 34 36 38

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Speculation Example
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?

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An investor with $2,000 and a bullish outlook on a
stock that is currently priced at $20 has two primary
strategies to capitalize on the expected price
increase over the next two months:
1. Buy Shares Directly (Buying the Stock)
Cost: $20 per share
With $2,000, the investor can buy:
2,000/20=100 shares

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Outcome: If the stock price increases to, say, $25
per share, the total value of the investment will be:
100×25=2,500
The profit will be: 2,500 - 2,000 = 500 (25% gain)
If the stock price falls, the investor incurs losses on
the initial capital.

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Buy Call Options
Call Option: Strike price of $22.50, priced at
$1 per option contract.
Cost per option: $1 (premium), giving the
right (but not the obligation) to buy the stock
at $22.50.
With $2,000, the investor can buy:
2,000/1=2,000 call \
Each option controls 1 share, so 2,000 call
options provide exposure to 2,000 shares.
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Outcome:
If the stock price rises to $25:The option is exercised, and the
investor pays $22.50 per share to acquire the stock. The profit
per share would be:
25−22.50=2.50 (after exercising the option)}
The total profit for 2,000 options would be:
2.50×2,000=5,0002.50
The total profit after deducting the initial $2,000 investment:
5,000 - 2,000 = 3,000
If the stock price remains below $22.50 at expiration, the
options expire worthless, and the investor loses the entire
$2,000.

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Arbitrage Example
A stock price is quoted as £100 in London
and $120 in New York
The current exchange rate is 1.2300
What is the arbitrage opportunity?

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Dangers
Traders can switch from being hedgers to
speculators or from being arbitrageurs to
speculators
It is important to set up controls to ensure that
trades are using derivatives in for their
intended purpose
Soc Gen (see Business Snapshot 1.4) is an
example of what can go wrong

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Hedge Funds (see Business Snapshot 1.3)
Hedge funds are not subject to the same rules as
mutual funds and cannot offer their securities
publicly.
Mutual funds must
disclose investment policies,
make shares redeemable at any time,
limit use of leverage
Hedge funds are not subject to these constraints.
Hedge funds use complex trading strategies are big
users of derivatives for hedging, speculation and
arbitrage

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Examples of Hedge Fund
Strategies
Long/Short Equities
Convertible Arbitrage
Distressed Securities
Emerging Markets
Global Macro
Merger Arbitrage

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