Financial Derivatives: An Introduction Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012
Financial Derivatives:
An Introduction
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012
What is a Financial Derivative?
• A derivative is an instrument whose value depends on,
or is derived from, the value of other assets.
• The underlying assets may be stocks, currencies,
interest rates, commodities, debt instruments,
insurance payouts, etc.
• Derivatives’ types: forwards, futures, options, swaps,
exotics, etc.
• Example: a stock option is a derivative whose value is
dependent on the price of a stock.
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Why Derivatives Are Important?
• Derivatives are actively traded on many exchanges
throughout the world.
• Many different types of forward contracts, swaps,
options, and others have been entered into the Over-
The-Counter (OTC) markets by financial institutions,
fund managers, and corporate treasurers.
• Derivatives are added to bond issues, used in executive
compensation plans, embedded in capital investment
opportunities, used to transfer risks in mortgages from
the original lenders to investors, and so on.
• Numerous financial transactions have embedded
derivatives.
Why Derivatives Are Important?
• Derivatives play a key role in transferring risks in the
economy from one entity to another.
• The derivatives market is huge; it is much bigger than
the stock market when measured in terms of
underlying assets.
• The value of the assets underlying outstanding
derivatives transactions is several times the world’s
GDP.
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How Derivatives are Used?
• Hedging: traders face a risk exposure to the price of
an asset and take a position in a derivative to offset
this exposure.
• Speculation: traders use derivatives to bet on the
future direction of the price of an asset (they have
no risk to offset).
• Arbitrage: involves taking offsetting positions in two
or more different markets to lock in a profit.
Hedge funds have become big users of derivatives for
all three purposes.
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Hedge Funds
• 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,
• take no short positions.
• Hedge funds are not subject to these constraints.
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Where Derivatives Are Traded?
In derivatives exchange markets
Traditionally, derivatives exchanges have used what is
known as the ‘open outcry system.’ This involves traders
physically meeting on the floor of the exchange,
shouting, and using a complicated set of hand signals to
indicate the trades they would like to carryout.
Exchanges are increasingly replacing this system by
electronic trading. This involves traders entering their
desired trades at a keyboard and a computer being used
to match buyers and sellers.
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Where Derivatives Are Traded?
In the OTC markets
It is a telephone and computer-linked network of dealers.
Trades are usually between two financial institutions or
between a financial institution and one of its clients
(typically a corporate treasurer or a fund manager).
Financial institutions often act as market makers: they
are always prepared to quote both a bid price (a price at
which they are prepared to buy) and an offer price (a
price at which they are prepared to sell).
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Where Derivatives Are Traded?
OTC markets
• Advantage: the terms of a contract do not have to be
those specified by an exchange. Market participants
are free to negotiate any mutually attractive deals.
• Disadvantage: due to differentiation in OTC
derivatives’ contracts, the risk that a contract will not
be honoured is higher.
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Size of OTC and Exchange-Traded Markets
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Source: BIS. Chart shows total principal amounts for OTC market and value of
underlying assets for exchange market
Derivatives and the 2007-8 Financial Crisis
• Derivatives markets have come under a great deal of
criticism because of their role in the late 2000s crisis.
• Derivative products were created from portfolios of
risky mortgages in the U.S. using a procedure known
as securitisation. Many of the products that were
created became worthless when house prices
declined.
• Financial institutions, and investors throughout the
world lost a huge amount of money and the world was
plunged into the worst recession it had experienced for
many generations.
The Lehman Brothers Bankruptcy
• Lehman’s filed for bankruptcy in 2008. This was the
biggest bankruptcy in the 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.
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Forward contracts
A forward contract is an agreement to buy or sell an
asset at a certain future time for a certain price. It
can be contrasted with a spot contract, which is an
agreement to buy or sell an asset today.
Forward traders are trading for delivery at some
future time; spot traders are trading for immediate
delivery.
The party that agrees to buy the underlying contract
assumes a long position to a forward contract. The
other party agrees a short position.
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Forward contracts
• The forward price for a contract is the delivery price
that would be applicable to the contract if were
negotiated today.
• The forward price may be different for contracts of
different maturities.
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Foreign Exchange Quotes for US$/GBP
May 24, 2010 (Bank X)
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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
Foreign exchange forward contracts: Example
• On May 24, 2010 the treasurer of a corporation enters
into a long forward contract to buy £1m in six months
at an exchange rate of 1.4422
• This obligates the corporation to pay $1,442,200 for £1
million on November 24, 2010
• Both sides have made a binding commitment.
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Foreign exchange forward contracts: Exercise
Investor B enters into a short forward contract to sell
£100,000 for US $ at an exchange rate of 1.4000 US $
per £.
How much does B gain or lose if the exchange rate at
the end of the contract is:
(a) 1.3900
(b) 1.4200
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Futures Contracts
• Like a forward contract, a futures contract is an
agreement between two parties to buy or sell an
asset at a certain time in the future for a certain
price.
• A wide range of commodities and financial assets
form the underlying assets in futures contracts. The
commodities include pork bellies, live cattle, sugar,
wool, lumber, copper, aluminum, gold, and tin. The
financial assets include stock indices, currencies,
and Treasury bonds. Futures prices are regularly
reported in the financial press.
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Futures Contracts
• Unlike forward contracts, futures contracts are
normally traded on an exchange. Hence, their price
is determined by the laws of demand and supply.
• As the two parties usually do not know each other,
the exchange provides a mechanism that gives the
two parties a guarantee that the contract will be
honoured.
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Futures Contracts: Example
A trader enters into a short cotton futures contract
when the futures price is £0.5000 per unit of cotton.
The contract is for the delivery of 50,000 units. How
much does the trader gain or lose if the cotton price at
the end of the contract is
a) £0.4820 per unit?
b) £0.5130 per unit?
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Options
• Options are traded both on exchanges and in the
OTC market.
• Two main types of options:
• A call option gives the holder the right to buy the
underlying asset by a certain date for a certain price.
A put option gives the holder the right to sell the
underlying asset by a certain date for a certain price.
• The price in an option contract is known as the
exercise price or the strike price.
• The date in the contract is known as the expiration
date or maturity.
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Options
• American options can be exercised at any time up to
the expiration date.
• European options can be exercised only on the
expiration date itself.
• An option gives the holder the right to do something.
The holder does not have to exercise this right. This
is what distinguishes options from forwards and
futures, where the holder is obligated to buy or sell
the underlying asset.
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Options
• There are four types of participants in options
markets:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
• Buyers are referred to as having long positions;
sellers are referred to as having short positions.
• Selling an option is also known as writing the option.
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Options vs forward contracts: Example
• What is the difference between entering into a long
forward contract when the forward price is £50 and
taking a long position in a call option with a strike
price of £50?
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Options vs forward contracts: Example
• In the forward contract, the trader is obligated to buy
the asset for £50. (The trader does not have a
choice.)
• In the call option, the trader has an option to buy the
asset for £50. (The trader does not have to exercise
the option.)
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Hedging using forward contracts: Example
• Suppose that on May 24, 2010 Company L which is
based in U.S., has to pay £10m on August 24, 2010 for
goods it has purchased from a British supplier.
• Company L expects that the $/£ exchange rate will be
more than 1.4500 on August 2010.
• Company L is a customer of Bank X.
• Company L wants to hedge against foreign exchange
rate risk.
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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
Hedging using forward contracts: Example
To hedge its foreign exchange risk:
Company L can write a forward contract with Bank X
and buy £10m in the 3-month forward exchange
market for 1.4415.
This would have the effect of fixing the price to be paid
to the British exporter at $14,415,000 instead of
$14,500,000 on August 24, 2010.
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Hedging using options: Example
• Consider an investor who owns 1,000 Microsoft
shares in May 2013. The share price is $28/share.
• The investor is concerned about a possible share
price decline in the next 2 months and wants
protection (he expects to decrease to $20/share).
• The investor could buy ten July 2013 put option
contracts on Microsoft with a strike price of $27.50.
This would give the investor the right to sell a total of
1,000 shares for a price of $27.50.
• If the quoted option price is $1, this strategy costs
$1,000 but guarantees that the shares can be sold for
at least $27.50 per share during the life of the option.
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Hedging using options: Example
• If the market price of Microsoft falls below $27.50, the
options will be exercised, so that $27,500 is realised
for the entire holding. When the cost of the options is
taken into account, the amount realised is $26,500.
• 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
$27,500 (or above $26,500 when the cost of the
options is taken into account).
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Value of Microsoft Shares with and
without Hedging
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20,000
25,000
30,000
35,000
40,000
20 25 30 35 40
Value of Holding ($)
Stock Price ($)
No Hedging
Hedging
Hedging: futures vs. options
Two fundamental differences in the use of forward
contracts and options for hedging:
Forward contracts are designed to neutralise risk
by fixing the price that the hedger will pay or
receive for the underlying asset.
Option contracts offer a way for investors to protect
themselves against adverse price movements in
the future while still allowing them to benefit from
favourable price movements.
Unlike forwards, options involve the payment of an
up-front fee.
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