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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown. Chapter 21. Chapter 21 - An Introduction to Derivative Markets and Securities. Questions to be answered:

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Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby Frank K. Reilly & Keith C. Brown

Chapter 21

chapter 21 an introduction to derivative markets and securities
Chapter 21 - An Introduction to Derivative Markets and Securities

Questions to be answered:

  • What distinguishes a derivative security such as a forward, futures, or option contract, from more fundamental securities, such as stocks and bonds?
  • What are the important characteristics of forward, futures, and option contracts, and in what sense can the be interpreted as insurance policies?
chapter 21 an introduction to derivative markets and securities1
Chapter 21 - An Introduction to Derivative Markets and Securities
  • How are the markets for derivative securities organized and how do they differ from other security markets?
  • What terminology is used to describe transactions that involve forward, futures, and option contracts?
  • How are prices for derivative securities quoted and how should this information be interpreted?
chapter 21 an introduction to derivative markets and securities2
Chapter 21 - An Introduction to Derivative Markets and Securities
  • What are similarities and differences between forward and futures contracts?
  • What do the payoff diagrams look like for investments in forward and futures contracts?
  • What do the payoff diagrams look like for investments in put and call option contracts?
  • How are forward contracts, put options, and call options related to one another?
chapter 21 an introduction to derivative markets and securities3
Chapter 21 - An Introduction to Derivative Markets and Securities
  • How can derivatives be used in conjunction with stock and Treasury bills to replicate the payoffs to other securities and create arbitrage opportunities for an investor?
  • How can derivative contracts be used to restructure cash flow patterns and modify the risk in existing investment portfolios?
derivative instruments
Derivative Instruments
  • Value is depends directly on, or is derived from, the value of another security or commodity, called the underlying asset
  • Forward and Futures contracts are agreements between two parties - the buyer agrees to purchase an asset from the seller at a specific date at a price agreed to now
  • Options offer the buyer the right without obligation to buy or sell at a fixed price up to or on a specific date
why do derivatives exist
Why Do Derivatives Exist?
  • Assets are traded in the cash or spot market
  • It is sometimes advantageous enter into a transaction now with the exchange of asset and payment at a future time
  • Risk shifting
  • Price formation
  • Investment cost reduction
derivative instruments1
Derivative Instruments
  • Forward contracts are the right and full obligation to conduct a transaction involving another security or commodity - the underlying asset - at a predetermined date (maturity date) and at a predetermined price (contract price)
    • This is a trade agreement
  • Futures contracts are similar, but subject to a daily settling-up process
forward contracts
Forward Contracts
  • Buyer is long, seller is short
  • Contracts are OTC, have negotiable terms, and are not liquid
  • Subject to credit risk or default risk
  • No payments until expiration
  • Agreement may be illiquid
futures contracts
Futures Contracts
  • Standardized terms
  • Central market (futures exchange)
  • More liquidity
  • Less liquidity risk - initial margin
  • Settlement price - daily “marking to market”
options
Options
  • The Language and Structure of Options Markets
    • An option contract gives the holder the right-but not the obligation-to conduct a transaction involving an underlying security or commodity at a predetermined future date and at a predetermined price
options1
Options
  • Buyer has the long position in the contract
  • Seller (writer) has the short position in the contract
  • Buyer and seller are counterpartiesin the transaction
options2
Options
  • Option Contract Terms
    • The exercise price is the price the call buyer will pay to-or the put buyer will receive from-the option seller if the option is exercised
  • Option Valuation Basics
    • Intrinsic value represents the value that the buyer could extract from the option if he or she she exercised it immediately
    • The time premium component is simply the difference between the whole option premium and the intrinsic component
  • Option Trading Markets-options trade both in over-the-counter markets and on exchanges
options3
Options
  • Option to buy is a call option
  • Option to sell is a put option
  • Option premium - paid for the option
  • Exercise price or strike price - price agreed for purchase or sale
  • Expiration date
    • European options
    • American options
options4
Options
  • At the money:
    • stock price equals exercise price
  • In-the-money
    • option has intrinsic value
  • Out-of-the-money
    • option has no intrinsic value
investing with derivative securities
Investing With Derivative Securities
  • Call option
    • requires up front payment
    • allows but does not require future settlement payment
  • Forward contract
    • does not require front-end payment
    • requires future settlement payment
options pricing relationships
Options Pricing Relationships

Factor Call Option Put Option

Stock price + -

Exercise price - +

Time to expiration + +

Interest rate + -

Volatility of underlying stock price + +

profits to buyer of call option
Profits to Buyer of Call Option

Profit from Strategy

3,000

Exercise Price = $70

Option Price = $6.125

2,500

2,000

1,500

1,000

500

0

(500)

Stock Price at Expiration

(1,000)

40

50

60

70

80

90

100

profits to seller of call option
Profits to Seller of Call Option

Profit from Strategy

1,000

Exercise Price = $70

Option Price = $6.125

500

0

(500)

(1,000)

(1,500)

(2,000)

(2,500)

Stock Price at Expiration

(3,000)

40

50

60

70

80

90

100

profits to buyer of put option
Profits to Buyer of Put Option

Profit from Strategy

3,000

2,500

2,000

Exercise Price = $70

Option Price = $2.25

1,500

1,000

500

0

Stock Price at Expiration

(500)

(1,000)

40

50

60

70

80

90

100

profits to seller of put option
Profits to Seller of Put Option

Profit from Strategy

1,000

500

0

Exercise Price = $70

Option Price = $2.25

(500)

(1,000)

(1,500)

(2,000)

(2,500)

Stock Price at Expiration

(3,000)

40

50

60

70

80

90

100

the relationship between forward and option contracts
The Relationship Between Forward and Option Contracts

Put-call parity

    • Long in WYZ common at price of S0
    • Long in put option to deliver WYZ at X on T
      • Purchase for P0
    • Short in call option to purchase WYZ at X on T
      • Sell for C0
  • Net position is guaranteed contract (risk-free)
  • Since the risk-free rate equals the T-bill rate:

(long stock)+(long put)+(short call)=(long T-bill)

creating synthetic securities using put call parity
Creating Synthetic Securities Using Put-Call Parity
  • Risk-free portfolio could be created using three risky securities:
    • stock,
    • a put option,
    • and a call option
  • With Treasury-bill as the fourth security, any one of the four may be replaced with combinations of the other three
adjusting put call spot parity for dividends
Adjusting Put-Call Spot Parity For Dividends
  • The owners of derivative instruments do not participate directly in payment of dividends to holders of the underlying stock
  • If the dividend amounts and payment dates are known when puts and calls are written those are adjusted into the option prices

(long stock) + (long put) + (short call) = (long T-bill) + (long present value of dividends)

put call forward parity
Put-Call-Forward Parity
  • Instead of buying stock, take a long position in a forward contract to buy stock
  • Supplement this transaction by purchasing a put option and selling a call option, each with the same exercise price and expiration date
  • This reduces the net initial investment compared to purchasing the stock in the spot market
put call forward parity1
Put-Call-Forward Parity

The difference between put and call prices must equal the discounted difference between the common exercise price and the contract price of the forward agreement, otherwise arbitrage opportunities would exist

an introduction to the use of derivatives in portfolio management
An Introduction To The Use Of Derivatives In Portfolio Management
  • Restructuring asset portfolios with forward contracts
    • shorting forward contracts
    • tactical asset allocation to time general market movements instead of company-specific trends
    • hedge position with payoffs that are negatively correlated with existing exposure
    • converts beta of stock to zero, making a synthetic T-bill, affecting portfolio beta
an introduction to the use of derivatives in portfolio management1
An Introduction To The Use Of Derivatives In Portfolio Management
  • Protecting portfolio value with put options
    • purchasing protective puts
    • keep from committing to sell if price rises
    • asymmetric hedge
    • portfolio insurance
  • Either
    • hold the shares and purchase a put option, or
    • sell the shares and buy a T-bill and a call option
the internet investments online
www.cboe.com

www.cbot.com

www.cme.com

www.cme.com/educational/hand1.htm

www.liffe.com

www.options-iri.com

The InternetInvestments Online
slide30
End of Chapter 21
  • An Introduction to Derivative Markets and Securities
future topics chapter 22
Future topicsChapter 22
  • Forward and Futures Contracts