Week 1: Futures, Forwards and Options derivative three Hedge: Speculation: Futures Contract: buy or sell

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1 Week 1: Futures, Forwards and Options - A derivative is a financial instrument which has a value which is determined by the price of something else (or an underlying instrument) E.g. energy like coal/electricity - There are three main classes of derivatives: Futures/Forward Contracts Options Swaps - Hedge: A tool for companies and investors to reduce risks - Speculation: Derivatives are investment vehicles which can make bets which are highly leveraged So the potential profit or loss can be relatively large compared to the initial cost of making the bet - Derivatives can also be used to take advantage of a price differential between markets - Futures Contract: A contract to buy or sell an asset at a time in the future for a certain price. This is a standardised contract. These contracts are traded on organised exchanges They also require a safety deposit known as "margin" - Forwards Contract: Identical to a futures contract except the contract is not standardised. These contracts are traded in an "over-the-counter" market (OTC) Also tailored to the needs of the parties - It is worth noting that a futures contract fixes the price at a steady level (usually the price when the contract was written): However there is an obligation to buy or sell the underlying commodity in the future (no choice) - In contrast, an option allows the holder the right (but not the obligation, so that's why it's called an OPTION) to buy or sell the underlying instrument from/to the option writer at a specified price and date: A long investor has the option to choose if the option is exercised or not - There are two basic option types: Call Option: Right to buy the underlying asset (you "call" the asset to you) Put Option: Right to sell the underlying asset *you "put" the asset out to sell) - Depending on the exercise style of the options, they can be classified into two types: European Options: Can only be exercised on their date of expiry American Options: Can be exercised at any time including the date of expiry

2 Basic Option Terminology The following definitions assume a call option from the buyer's point of view - Strike/Exercise Price: What the buyer will pay for the asset. - Exercise: The act of paying the strike price to receive the asset - Expiration Date: This is the date where the option must be exercised or it becomes worthless It is worth noting that only the buyer (or holder) can decide whether to exercise the option or not For a call option, the condition to exercise is S T > K where S T is the stock price (i.e. the price of the underlying commodity on the stock market) and K is the strike price. This implies that someone who bought a call option will only exercise their right to buy the underlying commodity if the strike price is cheaper than the stock price. For a put option the condition to exercise will be S T < K. This implies that someone who bought a put option will only exercise their right to sell the commodity if the stock price is lower than the strike price. - The option premium is the amount that the buyer must pay to buy the options contract

3 Option Positions - There are four option positions: Long Call: Right to buy Long Put: Right to sell Short Call: Obligation to sell Short Put: Obligation to buy - The long positions are from a buyer's (holder's) perspective, and the short positions are from the seller's perspective If you buy a contract you are "long" a call and if you sell a contract you are "short" a contract - Only the long party makes the decision whether to exercise the option or not - Call Value = S T - K - Put Value = K - S T Call Options - Payoff = max (0, S T - K) for holders since you will not exercise if you will make a loss - But the payoff does not take into account the premium paid to exercise the right: Payoff - Premium (long position profit) Payoff + Premium (short position profit) Note that the time value of money is usually ignored in those calculations - Graph of a long call option (flip the graph around the y-axis for a short call) - Break-Even point: S T = K + P (where P is the premium) - Always exercise if S T > K as you will either reduce your loss or make a profit - However due to unlimited downside risk writing a call option is very risky

4 Put Options - Payoff = max (0, K - S T ) - Break-Even point: S T = K - P - Graph of a long put option (flip it around the y-axis for a short put) - Only limited downside risk this time "Moneyness" of an Option - In-the-money: Positive payoff if the option is exercised immediately - Out-of-the-money: Negative payoff if the option is exercised immediately - At-the-money: When the strike price is approximately equal to the stock price - Profit is irrelevant when determining the moneyness of an option Value of an Option - Intrinsic Value: Maximum of zero and the value of the option if it was exercised immediately Call Option: max (0, S T - K) Put Option: max (0, K - S T ) - Time Value: Probability that the option will increase in intrinsic value before it expires - The value of an option is hence: Intrinsic Value + Time Value = Option Value Complex Payoffs - We combine an European Option with the underlying asset or another option to create a different payoff structure - There are 4 types of complex payoffs: Covered Call Protective Put

5 Bull Spread Bear Spread - Covered Call: The writer of an option has a long position in the underlying asset and a short position in the call option This eliminates the unlimited downside risk should the price of the underlying asset increase Profit is similar to the profit in a short put position - Protective Put: The buyer of the option has a long position in the underlying asset and a long position in the put option So if the stock price falls, there is a limited downside risk if the stock price falls Profit is similar to that of a long call position

6 - Bull Spread: An investor buys a call option and sells an otherwise identical call option with a higher strike price (K) Can also be constructed with put options Advantage: Loss potential is capped Disadvantage: Profit potential is capped Investor here believes the stock price will increase - Bear Spread: An investor buys a put option and sells an otherwise identical put option with a lower strike price (K) Can also be constructed with call options Same advantage and disadvantage of a bull spread Here the investor believes the stock price will decrease

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