Chap 02 Aem 421

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering
Chapter 2, Page 1
AEM 421, Fall
Chapter 2 Basic Derivatives and an Introduction to Financial

Engineering
2.1
2.2
2.3
2.4
2.5
2.6
2.7
Introduction
Forwards (and Futures), Options, and Swaps
Traders choices: Now or later? Obligation or Choice?
Forwards and Futures
Options
Call Options
Put Options
Swaps
The Long and Short in Different Markets
Financial Engineering and Risk ManagementBreak & Build Approach in Practice
Financial Engineering
Sign Assignment to a Commodity or a Securitys Cash Flows
at Different Dates
Buying a HouseDerivatives, Modern Finance and the American Dream
Summary
Further Information, References, Questions and Problems
Information
References
Questions and Problems
2.1
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Introduction
Painters first learn to sketch. As we will be painting derivatives in this book, why dont we
begin by sketching its three major kinds? Painting can come later.
The first chapter gave a birds eye view of financial markets and derivative securities, the
mechanics of trading, the types of traders, and the risks that come from derivatives. In this
chapter, we build on that foundation and define the three basic kinds of derivatives
forwards (and futures), options, and swaps. We describe them through examples and keep the
discussion intuitiveformal developments will come later. We hope that this approach will
enable you to learn the material faster. A schematic diagram will help you to see how the
different markets can be classified and linked.
Derivatives can be combined like the plastic Lego blocks that children play with. Just as
you can snap together simple Lego blocks to build beautiful toys, you can combine simple
derivatives and other securities to create new derivatives tailored to different market
conditions and investment needs. You can also break down a complex derivative into simpler
parts. We will practice this break & build approach many times in this book.
If we are serious in our studies, then why indulge in childlike games of breaking down
and building up with derivatives? Several reasons come to mind.
The first concerns solving the fundamental problem of pricing derivativeswe break a
derivative into simpler parts, price those simple parts, and add them up to get the original
derivatives price. Later you will see that arbitrage, like glue, binds these prices together and
makes sure that this technique works. For example, you can price a convertible bond as the
sum of a regular bond and an option to convert that bond into a fixed number of stocks of the
issuing company. An extendible bond may be valued as the price of a straight bond plus an
option to extend the bonds life. So, when a rocket scientist tries to sell you a complex
looking derivative at an exorbitant priceyou can find its exact worth by this method and
prevent yourself from being gouged.
After pricing, what comes next? For example, can we assemble derivatives from scratch
and use them to modify a portfolios return to meet various investment objectives? The
answer is yes, you can design derivatives by this method and use them to modify or to create
portfolios. This is the second reason. The break & build approach will help you to control a
portfolios return by adding or removing features, tailoring it to a clients whims or your
desires. You have just seen how simple bonds can be made more enticing by attaching extra
featuresconvertible and extendible bonds raise more cash for the issuer upfront. Callable
bonds on the other hand protect issuers from adverse interest rate movementsusing this
break & build approach we can price them as a straight bond and an option held by the issuer
to retire them. Such seductive features make derivatives appealing in strange new ways to
buyers and sellers.
Our third reason was best said by a former student sharing his derivative trading
experience with MBAs: After a while, everything starts looking like forwards and options.
Like the trader, you too will start seeing derivatives in day-to-day life. If you are truly
blessed, you will find derivatives in life and car insurance, lines of credit, an agreement to
sell your car a month after graduation, the lowest price guaranteed by a vendor, a raincheck
offered by a department store, the option to prepay a car loan or a house mortgage, lease or
purchase options on furniture, locking in a tuition rate for four years of undergraduate
Chapter 2, Page 3
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studies, tenure granted to a professor, and in a host of other affairs. The break & build
approach will train you to spot them faster and discern them quicker. Wouldnt this come
handy when negotiating complex business transactions?
To build with blocks, we must know what each piece can do. The widely used jargons
long and short loosely mean buying and selling, but the exact process varies from market
to market, which we need to understand to fit them in our framework. A short position in
stock is somewhat different from a short position in a forward (or futures) contract, which is
quite different from a short position in a call option, and which in turn is very different from
a short position in a put. You will understand this before we finish the chapter.
Once you are familiar with what one can do with these building blocks, we will introduce
financial engineering, which applies engineering methods to financial economics. This
raises our second reason for studying the break & build approach to an elevated level
financial engineering studies how firms can design derivative securities to solve practical
problems and exploit economic opportunities by altering the risk-return tradeoff. This vast
subject is taught at varying depths in a wide variety of colleges and universities.
Every American dreams of owning a house. You select a house, take out a mortgage,
make monthly payments for a fixed number of years, and the house belongs to you. What can
be simpler than that? But halcyon days are overmodern finance and derivatives have
surreptitiously crept into your life. We cannot resist the temptation of showing you some of
the derivatives as well as the complex financial decisions that come into play in such
mundane a transaction. As before, we wrap up with sources of further information, and a
collection of questions and problems.
2.2
Forwards (and Futures), Options, and Swaps
Traders Choices: Now or Later? Obligation or Choice?

Suppose you are planning to buy gold. Financial markets offer you several choices allowing
you to buy now or later (see Figure 2-1 for a simple representation of some of these
transactions and derivatives).
a) You can buy gold now. This means buying gold in the spot (or cash) market.
b) You can buy gold in the future but at a price that you now negotiate. This means buying
gold in the forward or in the futures market.
c) You would like to buy gold in the future only if the price is favorableif the spot price is
more than a fixed amount that is now specified. This means buying an option on gold or
on gold futures.
Buying spot by paying cash is straightforwardpeople have done that for milleniums.
Forwards and options have also existed for aeons, but only in recent times have they started
trading on organized exchanges. Forwards and futures are obligations to trade in the future
the buyer has to buy and the seller has to sell at the determined delivery price.
The asset thats traded in the cash market or the spot market is often referred as the spot.
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FIGURE 2-1
A SIMPLE REPRESENTATION OF SOME TRANSACTIONS AND DERIVATIVES
TRANSACTION/DERIVATIVE
(STARTING DATE)
a) Spot market transaction
Buyer and seller negotiate terms;
trade immediately at ongoing price
b) Forward contract
Buyer and seller negotiate terms
INTERMEDIATE DATES
---
---
MATURITY DATE
---
Trade according to terms

fixed at starting date
c) Futures contract
Similar to forward but has some key
differences (see Chapter 4)
Cash flows
Cash flow
d) Call option
Call holder can buy underlying
asset at a fixed price until maturity;
pays call writer a premium
Holder may buy

(depends on terms)
Holder buys when

asset price > fixed price
d) Put option
Put holder can sell underlying
asset at a fixed price until maturity;
pays put writer a premium
Holder may sell

(depends on terms)
Holder sells when

asset price < fixed price
e) Swaps
Two parties agree to exchange
a series of cash flows
Cash flows
Cash flow
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Options however arent a binding obligation to buy or sell. Rather, it is at the discretion
or option of the buyer. For these rights the buyer pays a fee or a premium. By paying a
premium upfront, a call option buyer gets the right to buy an asset at a fixed price until a
future date, while a put option holder gets the right to sell. If its sweet, you are rewarded, if
its nasty then you are protectedsuch rights dont come for free.
What about the swaps? The parties in a swap simply exchange (swap) particular cash
flows in the future. Reminiscent of summer days in the sun and ice cream, the simplest swaps
go by the fancy name of plain vanilla. Parties in a plain vanilla interest rate swap trade
fixed for floating interest payments, while those in a plain vanilla currency swap exchange
one currency for another. Swaps have been wildly successful. Since the first negotiation of a
swap in London in 1981, the demand for plain vanilla as well as more complex varieties of
flavored swaps has exploded in the global markets.
The break & build approach can be used to understand swaps. Swaps can be analyzed as
a series of forward contracts. This takes the wind out of valuing swaps and allows us to focus
on the two basic pricing problems: How do you price a forward and futures? How do you
price an option? We study these questions in later chapters.
How does a cash market trade differ from a later day transaction? Surprisingly, by
agreeing to trade later, you are unknowingly creating derivatives! Our gold example easily
shows this. Suppose gold is worth $300 per ounce at this moment in the spot market. If one
buys gold now and stores it, future price changes will cause trading gains or losses, and thats
quite acceptable. Things however are different when the buying at $300 is delayed by even
five minutes. A spate of buy orders may come in during those five minutes and jack the price
up to $302. If this happens, you will pay $300 for gold that you can resell for $302,
pocketing the two dollars. If gold prices fall, you lose instead. The byproduct of this decision
to trade later at the now-fixed price is a forward contract: a derivative whose ultimate value is
derived from the spot price of gold at the contract end. By agreeing to transact later you have
unknowingly entered into a forward contract. In a forward contract, the absolute price of gold
isnt as important as how the spot differs from the agreed-upon price.
Consider another type of contract that lets you buy gold in the future if the ultimate spot
price is more than $300, but exempts you from buying if its less. This is our call option. A
put allows you to sell gold at $300 if the spot ends lower, else you walk away. A put option is
like insuranceit protects you when the assets price falls.
Even this simple discussion elicits an observation. If postponing transactions
automatically creates derivatives and insurance contracts are options, then no matter how
strong a critics credentials, the idea of banning derivatives would not fly. Derivatives are too
fundamental to everyday business transactions.
Lets move on to the next set of more detailed questions: How do you find the delivery
price for a forward (or futures)? What is a fair premium for an option? How can you design a
schedule of swap payments? Pricing questions will come in later in the book. For now, we
introduce the basic derivatives through some simple examples.
2
Although Warren Buffett has been known to dislike derivatives, Buffetts company Berkshire Hathaway has
substantial investments in several insurance companies.
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Forwards and Futures

Forward contracts abound in every day life. Suppose you agree to buy my Cadillac a month
from now for $10,000. This is a forward contractyou will have a long position, I will hold
a short position, the delivery price is $10,000, and the delivery date is one month hence.
A forward contract is the simplest of derivatives. The counterparties in a forward (as well
as in a futures contract) lock in a price for a future transaction: in other wordscontract
now, transact later. A forward contract or a forward is an agreement between a buyer and
a seller to trade some commodity at a fixed price at a later date. This fixed price is called the
forward price (or delivery price) and the later date is the delivery date or the maturity
date. A futures contract is similar to a forward, except for some intermediate cash flows and
various contractual features attached to make them safer (listed in detail in Chapter 4). Both
forwards and futures are derivatives as their values are derived from the spot price of some
underlying commodity.
By market convention, no money changes hands when these contracts are created. As
such, the delivery price yields a fair price for future trading of the asset. How do we find
this delivery price? Its actually quite straightforwardin Chapter 5 we will show you how
to compute the forward price of a whole range of contracts by following some simple
principles. Once you know how to compute the delivery price of a forward contract, you can
do the same for a futures contract.
Example 2-1 Forward contract
Example 1-2 of the first chapter showed the creation of a forward contract. We continue
with that example. Today is the 1st of January. You agreed to buy 50 ounces of gold from
me at $300 per ounce on May 15th.
Forwards trade in the OTC (inter-bank) market. Since you agreed to buy at a later date,
you hold a long position in a forward contract. I hold a short position because I
agreed to sell gold at a future date.
What does the long or the short pay for a forward contract? Nothing but the brokerage
costs. When the contract begins, its delivery price is adjusted so that the contract is
agreed to without exchanging cash. This implies that the market value of the contract is
zero at its start. No cash is exchanged between the long and short until the delivery date.
Not quite convinced? Lets perform a thought experiment. Suppose that the delivery price
is set low enough so that the forward contract is worth an awful lot to the long. To enter
the forward contract he pays this amount to buy it from the short. What happens if we
start raising this delivery price? The contract will then start losing its luster to the long.
Being a zero-sum game, the contract will start gaining value to the short. As soon as we
reach the fair price for delivery, magically the contract will be worth zero to both sides.
What happens at delivery? It all depends on where the spot settles on that fateful day. If
the spot is higher than the delivery price of $300, then long wins. If its less, she loses.
The forward contract terminates after delivery.
We can now summarize a forward transaction as:
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FIGURE 2-2
TIMELINE FOR A FORWARD CONTRACT
Starting date (time t)

|
Delivery / maturity date (time T)

|
Negotiate delivery price, F(t,T)

or F, and other contract terms.
Long agrees to buy at F.
Short agrees to sell at F.
(We will usually start at time 0)
Physical delivery or cash settlement.

Longs payoff is S(T) F.
Shorts payoff is [S(T) F].
Forward Transaction (see Figure 2-2)

Initially
The long and the short traders agree on the underlying commodity, its delivery price, the
transaction size, date and place of the transaction. Forwards exist as entries in brokerage
firms computer accounts, so there is no physical exchange of deeds or ownership
certificates.
On delivery date
If the traders decide on a physical delivery, the short gives the asset to the long and gets the
delivery price.
If they decide on a cash settlement, and if the spot price is higher than the delivery price,
then the short pays the price difference to the long. If the opposite happens and the spot
settles lower than the delivery price, the long pays the price difference to the short.
Futures Transaction
Futures and forward contracts are fraternal twins in nature, for the two transactions are
very similar but not identical. Although contractual provisions make futures more complex
than forwards, in reality, hard though it may be to believe, they make futures safer to hold
and easier to trade. The major characteristic of a futures contract is daily settlement: the
delivery price of a futures contract (the futures price) gets adjusted daily, and the long and the
shorts brokerage accounts get debited or credited by this adjustment. Forward contracts have
no daily settlement. This can be clarified as follows. Forward contracts fix a price for a future
transaction that remains locked over the life of the contract. Futures contract resettle each day
effectively changing the agreed upon price for the future transaction. The resettlement
generates a cash flow called marking-to-market.
Before we move ahead, lets adopt some conventions:
From now on, all prices will be for one unit of an asset or commodity. Multiply
them by contract size and you will get the total value of the transaction.
Unless noted otherwise, we will start at time 0 (or date 0).
When the context is easy to understand, we will suppress arguments like t
and T to reduce clutter. For example, when simplicity doesnt sacrifice
clarity, we will denote F(t,T) by F(t) or F.
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We will now summon the power of algebra to precisely understand these concepts, and
analyze many different forward contracts at once.
Figure 2-2 gives the key dates in a forward contract. As there are no intermediate cash
inflows or outflows, we can focus only on the beginning and the end. Suppose the forward
starts today. Let F(t,T) be the forward price (or delivery price) that we decide now (time t) for
a transaction on the delivery date (T). These dates enter as the two arguments in this price.
The first argument, t, shows the date the forward price is quoted, and the second argument, T,
gives the delivery date. To keep things simple, we will usually start at time t = 0; the forward
price would then be F(0,T). And to reduce clutter, we will often write F(t,T) or F(0,T) as F.
How is the delivery price linked to the forward price? When the contract starts, by
definition the forward price equals the delivery price, denoted by F. We said before that the
delivery price is so determined that theres no cash exchange at this time. The delivery price
remains fixed over the life of the contract.
The forward price, which is the delivery price of newly written contracts, can of course
change. If we wait a day and enter into the forward contract tomorrow (date t+1) for buying
gold at the same delivery date T, the price will probably change. The new delivery price or
the forward price will be set at F(t+1,T) or F(1,T).
Let Spot() or S() be the spot price (or cash price) for an immediate transaction.
Generically, S(t) is spot price at any time t; it takes on values S(0) at starting date 0 and S(T)
on the delivery date T. We can call up a broker and easily get S(0), but who on the earth can
foretell what S(T) will be on the delivery date?
The value of the forward contract to the long position holder at the delivery date (T)
is [S(T) F]. Standing at time present, we dont know what this will be.
If theres a physical delivery, the long gets a commodity worth S(T), which she can
immediately cash in. This is shown with a positive sign. She pays the delivery price F. This
liability enters her payoff with a negative sign.
If theres cash settlement, the long gets S(T) F from the short when S(T) > F, and pays
F S(T) if S(T) < F.
The short position holders payoff at delivery time is [S(T) F] = F S(T).
In a physical delivery, the short gets paid the delivery price F, a cash inflow. He
surrenders to the long an asset thats worth S(T) in the marketthis liability is shown with a
negative sign.
If the contract is cash settled, then the short gets F S(T) if F > S(T), otherwise she pays
S(T) F to the long.
3
If you can predict stock prices correctlyyou will become a multimillionaire instantly. But keep your talents
secretonce people know that you are an informed trader, nobody will trade with you anymore!
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Notice that the long and shorts payoffs are exactly opposite of one anothers. As longs
gain exactly equals shorts loss and vice versa, forward contracts are zero-sum gamesif
you add up the two payoffs, the net result is zero. To reduce work, just compute one payoff.
You can effortlessly get the other by just changing the sign. This, of course, works only if
market imperfections like taxes and brokerage fees are ignored.
Example 2-1 (continued) Payoffs to the long and short forward contract at delivery
(Prices are for an ounce of gold.)
Example 2-1 visits us againthis time with notations!
Today is the 1st of January, which is date 0. The forward price we decide now for delivery
on May 15th (date T) is F(Jan1, May15) = F = $300. This is the delivery price.
Suppose the spot price on the delivery date turns out to be Spot(May 15) = S(T) = $305.
Long forwards payoff on delivery date is (305 300) = $5, or a gain of 5 dollars.
The long pays $300 only for an asset worth $305 in the spot market.
Short forwards payoff at time T is (305 300) = $5, or a loss of 5 dollars.
Due to contractual obligations, the short is forced to accept this below market price
for gold on the delivery date.
If instead, S(T) turns out to be $290 on the delivery date, then
Longs payoff at delivery time is (290 300) = $10, or a loss of 10 dollars.
She is forced to pay $300 for an asset worth only $290 in the market.
Shorts payoff at delivery time is (290 300) = $10, or a gain of 10 dollars.
Observe that for each S(T), the long and the shorts payoffs add to zero, confirming the
zero-sum nature of this trade.
Profit or loss from long and short forward positions on the delivery date (time T) is given
in Figure 2-3. The horizontal or the x-axis plots the spot price of gold [S(T)] on the
delivery date while the vertical or the y-axis plots the profit or loss (customarily denoted
by the Greek letter ) from the forward contract. The payoff to the long is a straight line
that makes a 45-degree angle with the horizontal axis, and cuts the vertical axis at
negative $300, which is longs maximum loss. This happens when the spot (gold) is
worthless, but the long still has to pay $300 for it. Beyond this each dollar increase in the
spot price cuts back longs loss by a dollar. If gold is worth $1, then longs loss is 300 1
= $299: if its worth $100, then the loss is $200. The long and short break even at $300. If
the gold price ends up being higher than $300 on the delivery date, then the long starts
seeing the profits. The broken lines show the rise and the run for the slope of this payoff
linetogether with the slanting straight line they form an isosceles triangle. An isosceles
triangle has two sides equal, which happens here because rise equals run. Thus a dollar
increase in spot raises profits by a dollar. An isosceles triangle to the southwest of $300
can easily demonstrate the result we stated earlier in this paragraph. Figure 2-3 also
shows that the profit potential for the long is infinite.
FIGURE 2-3
PROFIT / LOSS FROM FORWARD CONTRACT ON THE DELIVERY DATE
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Profit / Loss,
Long forward
$300
RISE
45
0
RUN
F = $300
$300
S(T), spot price on

delivery date
Short forward
The payoff to the short is the downward sloping dotted straight line, which makes a
negative 45-degree angle with the horizontal axis. If the horizontal axis was a mirror,
shorts payoff would be the mirror image of longs payoff. When gold is worth 0, the
short makes $300, as worthless gold will now be sold for $300. Thus the shorts payoff
line touches the vertical axis at $300. For each dollar increase in golds price, the shorts
profit goes down by a dollar. If gold is worth $1, then the shorts profit will be 300 1 =
$299, and so on. If gold goes up and beyond $300, then the short starts losing money.
Shorts maximum loss is unboundedif gold really soars, the short can lose his shirt!
Example 2-2 Futures contract

We are trading againyou go long and I go short. We will try to do the transaction in
Example 2-1. As we are now trading a futures contract, we must go through an exchange.
Gold futures trade in the New York Mercantile Exchange (NYM). Each contract is for
100 troy ounces of gold. Standardization makes the contracts liquid. No gold futures
matures in May. There are contracts for April and July instead. These months may not
suit your buying needs, or my selling desires. Thats a drawback of standardized contracts
we have to choose from whatevers available. Suppose we decide to trade July futures.
The futures price for July gold futures is $302 per ounce. You agree to buy 100 ounces of
gold in July for $302 by going long one July futures contract. In reality, profits and losses
are realized on a daily basis and debited/credited to traders accounts at the brokerage
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houses. This effectively resets the delivery price at maturity to the current futures price.
The brokers who match us will charge commissions. The order can be handled manually
by a trader on the exchange or automatically executed via a computerized system.
If I go short, I agree to sell 100 ounces of gold in July. My effective selling price will be
close to $302. Taxes, interest charges, and other market imperfections will make the July
price a bit different from $302. If they are ignored, futures like forward contracts are a
zero sum game.
The parties in forwards and futures are obliged to trade at a later date. Suppose that the
buyer (or the seller) wants to walk out of the transaction if the price turns against her. If she
desires such flexibility, she will have to turn to the options market, where she can purchase
the right to buy or the right to sell for a fee.
Options
You have graduated from school, got a great job, and bought a new car. The state law
mandates that you get adequate auto insurance coverage. You call up different agents and
buy auto insurance at the best rate in the town. Welcome to optionsthe government has
just forced you to buy a put option.
What then are option contracts and how do they differ from forward contracts and
futures? What are calls and puts? How do American and European options differ? These
questions are answered in this section.
Options come in two basic typescalls and puts, names you have heard before. A call
option gives the buyer the right, but not the obligation, to buy an asset from (to call from)
the seller on or before a fixed future date at a price that is agreed today. The buyer is also
called the holder, the taker or the owner. The seller is known as the grantor, the issuer, the
maker or the writer. The fixed future date is referred as the maturity date or the
expiration date, while the fixed price is variously known as the exercise price or the strike
price or the striking price.
Conversely, a put option gives the buyer the right to sell (to put to) the asset to the
writer at the strike price until the expiration date.
A call buyer is bullish because she expects that the underlying asset will go up in
value. A put buyer is bearish, for he expects the asset to fall in value. If call buyer is
bullish, it comes as no surprise that the call writer is bearish. The put writer is bullish. Fond
as we are of using (Wall!) Street language, we will say that the option buyer is long the
option, so the writer ends up with a short position.
The names call and put come from what the long can do with these options. A call
gives the buyer the option to buy, that is, to call the asset away from the writer. Conversely, a
put gives the owner the choice to sell, or put the asset to the writer. In each case, the writer
stands and waits and takes the other side of the buyers trade. The buyers have options. They
pay premiums to the writers for these services.
4
An international student inquired, Why is a down market shown by a bear, a powerful and majestic animal?
The answer lies in how the animals carry themselves: a bull walks with its head gazing up, while a bear stoops
with its head drooping down. But remember that a bear can also run very fast!
Chapter 2, Page 12
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Have you noticed that calls and puts have a lot in common with insurance policies? They
do. Its no surprise that these options can be seen as insurance contracts for hedging or risk
reduction. The put, for example, protects the holder from a meltdown in asset value. If
someone hits your car, the insurance company will pay you (subject to some deductibles) to
restore the car to its original value. A call insures someone who has sold an asset short, i.e.,
sold it in the past while agreeing to buy it back in the future. No wonder an option price is
called a premium. Indeed, it is what you pay for the insurance protection.
American and European are two option types. A European option can only be exercised
at the maturity date of the option, whereas an American option can be exercised at any time
up to and including its expiration date. What we defined earlier are calls and puts of the
American type. The adjectives European and American, tell us how options differ in exercise
choices and have nothing to do with where they tradein Europe, America, Africa, Asia, or
Australia. Many different European style options trade in the U.S. and across the Atlantic,
many different American style options transact in Europe.
How did the names European and American options came into being? One of us (Jarrow)
heard an interesting story from Robert Merton. In the sixties, Mertons mentor the great Paul
Samuelson, the first American to win the Nobel Prize in Economics, was working on warrant
and option pricing. In those days, options with and without early exercise feature traded as
OTC instruments. Samuelson was told by one of the Wall Street types that only the
sophisticated European mind can understand the early exercise feature of options. Samuelson
hit back and reversed things by naming options with early exercise features as American
options and those without as the European ones.
Both types of options have the same value on the expiration date. Before expiration
however, American options are at least as valuable as their European counterparts. They do
what European options can do, but they also offer the early exercise feature, which is
something more. You dont pay less when you are getting more. Finance is not a subject of
faith, and the next chapter will show how profit-seeking traders will arbitrage to make this
happen. Such simple insights are useful when studying option properties.
Let us summon the power of algebra again.
Call Options
Take a European call option that has just been written on an asset whose spot price is S(0)
where 0 is todays date. This option is currently worth c(0) or c, has an exercise price of K,
and matures at some later date, T.
What is the payoff to a European call at its expiration? As we said, its the same as for an
American call, for the two are identical on expiration. At maturity, the call holder has the
right to buy the asset for the strike price K. If the asset price at maturity, S(T), is less than this
exercise price, then the call is worthless. Its cheaper for the owner to buy it in the open
market rather than acquiring it through option exercise. Thus when S(T) is $90 and the strike
is $95, the option is worthless. The holder does better by buying in the spot market. If on the
other hand the asset is worth more than the strike on the maturity date, the (long) call holder
will definitely exercise and get the asset for K, making S(T) K in the process. For example,
if S(T) is $101 and K is $95, the option is worth $6. The option ceases to exist after its
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expiration date. Figure 2-4 summarizes these insights in a timeline for an exchange traded
option.
FIGURE 2-4
TIMELINE FOR AN EXCHANGE TRADED CALL OPTION
Starting date (time 0)

|
Intermediate date
|
Broker matches buyer and seller.

Long can exercise an
Buyer (long) pays the call premium American option.
and gets the call from the
Traders can also close out
writer (short) .
their positions.
(If none of these happens,
traders meet at time T).
5
Expiration date (time T)

|___________________
If S(T) >K, long exercises
long gives up call,
pays strike price to and
gets the asset from
the writer. The long
nets S(T) K.
If S(T) K, call expires
worthless.
Thus the call buyers payoff at maturity or if immediately exercised at any time over
the life of the option is:
cSK
for Spot, S > Strike, K
0
otherwise.
This is called a calls intrinsic value or exercise value. This boundary condition helps
us to: (1) precisely understand a calls payoff at maturity or when exercised immediately, (2)
draw the payoff diagram as well as the profit/loss diagram, and (3) simplify the math in some
later formulas in the book.
But intrinsic value is only a part of an options value. The rest may be viewed as time
value, which is the extra value of an option due to the fact that good things can happen in the
time left until maturity. We will explore these issues in later chapters. Meanwhile, we use the
boundary condition to draw Figure 2-5 as well as other diagrams.
FIGURE 2-5
5
Like futures and forwards before, the options exist as brokerage firms computer entries. A transfer of
ownership rights, rather than a physical exchange of deeds or certificates is what occurs.
Chapter 2, Page 14
AEM 421, Fall
PAYOFF AND PROFIT / LOSS DIAGRAMS FOR APRIL 95 CALL OPTION

ON THE EXPIRATION DATE
Payoff
Payoff
long call
45
95
0
S(T), spot price
at expiration
45
S(T)
short call
Profit / Loss
Profit / Loss
long call
0
-4
95
45
c(0)+K
S(T)
c
0
99
45
S(T)
short call
Example 2-3 European call option

Creation and trading of a call option
Today is the 1st of January, which is our date 0. Suppose you buy from me one contract of
April 95 call option on Your Beloved Machines, Inc. for $4. You get the right to buy 100
YBM stocks from me by paying the strike price K = $95 per share on the 3rd Friday of
April. Options trade on a round lot of stocks. 2 contracts would have given you option on
200 stocks, and so on.
You, the buyer, have an option and I, the seller, have the obligation. You must pay me a
premium (fee / options price) for taking this risk.
You are long the callthe buyer, the holder, or the owner. You pay c(0) = c = $4 (per
share) upfront for this right. The call option is an asset, and depending on the luck of the
draw, it may be valuable in the future.
Chapter 2, Page 15
AEM 421, Fall
I am short the callthe seller, or the writer. I get $4 for giving away this right. My
short call position can be a liability in the future.
We have abstracted quite a bit from the real world by considering a perfect market
where market imperfections like transactions costs, taxes, etc. are assumed away. In
reality the brokers who match us will charge commissions for their services. A dealer will
quote a bid and an ask price for the option premium, and will step in if she can offer a
better price than the one at which we are trading. Once you know how these contracts
work, you can easily adjust it to reality.
As with stock orders on the NYSE, exchange traded options orders can be handled
manually by a trader on the exchange floor, or matched by a computerized system.
After purchase, you can sell the option and close out your positionyou may win or lose
in the process. Quite independently, I can buy the option and close out my position. As
exchange-traded options are more liquid than over-the-counter onesyou retain the
flexibility of walking away.
Had this been an American callyou, the buyer, would also have the right to exercise the
option at any time before expiration. If you decide to exercise, Id be forced to sell 100
YBM shares at $95 per share. Later on you will see that instead of exercising, in most
cases you are better off by selling a call. Options are often worth more alive
(unexercised) than dead (exercised).
Suppose you decide not to exercise, and we both decide not to close out our positions.
Then, we lie low for these months and meet again on the maturity date.
Payoffs to long and short call at expiration

Suppose the YBM stock is worth $101 at its maturity on the 3 rd Friday of April. Then the
option has ended in-the-money, for its worth more than the strike. As a long, you pay
$95 for stock worth $101, and make $6 before any transaction costs, which is the calls
intrinsic value. But you paid $4 for the call itself. So your net profit is $2. In reality,
transaction costs like trading at the bid-ask spread, brokerage commissions, interest on
the premium will cut into your profit.
To avoid the hassle of paying the broker a fee for exercising and yet another fee for
selling the YBM shares that you will get, you can close out your position just at the time
of expiration. Then you will pay just one transaction fee for selling the option, and the $6
price difference will net you $2.
I, the short, lose $6. But I made $4 upfront when writing the option. So my net loss is $2,
which is your net gain. The options being zero-sum games, the total gain across the
traders is zero. In reality, my losses will be higher than $2 per share as I also will have to
pay the transaction costs.
If YBM is worth $90 at maturity, your option would expire worthless, out-of-themoney in traders language. Its intrinsic value is zero. Why buy something for $95 when
its only worth $90 in the market? If you are keen on getting YBM, go and tap the spot
market. The $4 I made is mine to keep.
What happens if YBM stock on expiration date closes at $95 or nearly so? Traders say
that the call is at-the-money.
Payoff and profit/loss diagrams for call option (Figure 2-5)
Chapter 2, Page 16
AEM 421, Fall
Figure 2-5 shows the payoff diagrams and profit/loss diagrams for call options.
Transaction costs and any interests paid or earned on these investments are ignored. Once
you know how they work, you can always plow them back later.
The payoff diagrams show the payoff to the long or the short position on the expiration
date. These diagrams plot the stock price at expiration, S(T), along the horizontal axis and
the option payoff along the vertical axis. If S(T) is less than $95, then you, the long
position holder, get nothing. Money starts flowing when S(T) is greater than K, and the
option lands up in-the-money. Your payoff increases by a dollar for every dollar increase
in S(T) beyond $95. That is why your payoff first lies flat along the horizontal axis, and
then at $95 it leaps at a 45 degree angle (remember the isosceles triangle from a forward
contract). My short positions payoff is the mirror image of yours. I lose nothing at
expiration until S(T) reaches $95 beyond which my payoff slides down at a negative 45
degrees. Your gain comes at my expense.
The profit or loss diagrams take option prices into accountotherwise they are very
similar to the payoff diagrams. As before, these diagrams plot the stock price at
expiration, S(T), along the horizontal axis but they have profit or loss (denoted by )
from option positions along the vertical axis. If S(T) is less than $95, you (long) lose $4,
the premium you paid for the call. This also is your maximum loss. When S(T) is more
than $95, you will definitely exercise the call optiona dollar rise in S(T) will increase
the value of your position by a dollar. When S(T) is $99, we break evenyour $4 gain
exactly offsets your initial $4 investmentgiving us zero profit. When S(T) goes
beyond $99 its even sweetertechnically speaking, you have limitless profit potential.
My payoff is the mirror image of yoursfor S(T) less than $95, I retain the initial $4,
which also is my maximum profit; beyond $95, your exercise of the option cuts into this
amount. Note what the diagram revealscall-writing can cause far bigger losses than
call-buying. While a buyer, at worst, can lose the premium, the writers maximum loss is
potentially unbounded. The folks at options exchanges recognize thisthey require an
option writer to be far wealthier than an option buyer.
Put Options
Now consider a European put option that has just been written on the same asset with the
same maturity date (T) but with a different strike price, still denoted by K (didnt we say that
we will use the power of algebra!). This put is currently worth p(0) or p. What is this
options payoff at maturity?
If the assets spot price at maturity is greater than the strike price, the put is worthless. If
the spot price ends lower than the strike, then its worth the price difference, which is K
S(T).
We can write the puts payoff at maturity or if immediately exercised as
p K S, for spot, S < strike, K
0
otherwise
This is called a puts intrinsic value or exercise value or the boundary condition.
At expiration, a call is valuable if the spot price is higher than the strike. But, a put is
worthwhile when the opposite happens and the spot price ends below the strike. As with the
call, observe that: (1) the boundary condition will help us draw the much-needed profit / loss
diagrams, (2) the writers obligation is the exact opposite of the buyers payoff, and (3) like
Chapter 2, Page 17
AEM 421, Fall
futures and forwards, options also are zero-sum games. And similar to a call, intrinsic value
is only a part of an options value for the rest may be viewed as time value.
For convenience, we summarize the put option below. As with the call, we will walk
through a numerical example (Example 2-4) and draw the payoff as well as profit / loss
diagrams (Figure 2-6)
FIGURE 2-6
PAYOFF AND PROFIT / LOSS DIAGRAMS FOR A PUT OPTION
ON THE EXPIRATION DATE
Payoff
Payoff
100
long put
0
45
0
100
S(T), spot price

at expiration
K
45
S(T)
short put
100
Profit / Loss
Profit / Loss
94
long put
0
6
45
K
94
p
0
S(T)
K6
45
100
short put
Kp
S(T)
Chapter 2, Page 18
AEM 421, Fall
Options Transaction: European put option

Initially
Buyer pays the premium and gets the put from the writer.
At expiration
a) When S(T) < K, the buyer (long) exercises the put.
The long exercises the put, gives the asset to the writer, and gets the strike price. Longs net
payoff is K S(T).
b) When S(T) K, the put expires worthless.
Example 2-4 European put option
On the 1st of January (time 0), you buy from me two contracts of July 100 put options on
GE. They give you the right to sell 200 BUG stocks at the strike price K = $100 on the 3rd
Friday of July.
You are long the putthe buyer, the holder, or the owner and have paid $6 per share
upfront for this right to sell. You have a potential future asset.
I am short the putthe seller, or the writer. I get the premium p(0) = p = $6 for selling
this right. I can lose money at a later date.
As with calls, after the initial transaction, we can close out our positions. All you or I
have to do is trade on the opposite side of the same option. Had this been an American
put, you would also have the right to exercise early.
Suppose we decide to hold the put to its full term. If GE ends at $90 at expiration, this
option is in-the-money. Your stocks worth $90 sell for $100 and fetch you $10 per share,
which is the puts intrinsic value.
If on the other hand GE ends at $101 at the maturity date, your put is worthless, out-ofthe-money, and has an intrinsic value of zero. Your only loss is the $6 that you paid
earlier.
Had GE closed at $100, the option would have been at-the-money.
Options Transactions: American call and put options

American options begin the same way as the European options. Unlike European options,
the owner (buyer) has the right to exercise the option at any time until the expiration date.
The payoffs for an option buyer at expiration or when exercised immediately can be
compactly written as
c = max(0, S K) and
p = max(0, K S).
max means maximum of the two arguments shown. This is same as the intrinsic value or
the exercise value.
Chapter 2, Page 19
AEM 421, Fall
Suppose that K = 95 as in the call example, and the stock price at maturity date T, S(T) =
90, implying S(T) K = 5. As the maximum of 5 and 0 is clearly 0, the option value, c(T)
is 0 at expiration. When S(T) = 101, then S(T) K = 6 is the answer. Whenever S(T) > K, 0
is discarded and calls payoff equals S(T) K. For S(T) < K, the term S(T) K is negative.
The call is not exercised, and zero takes over by the property of max. You can similarly
understand a puts payoff.
The important question isHow do you find todays option prices, c and p? The
answer is the classic Black-Scholes-Merton (BSM) model that gives exact prices for
European options, which we will study in Chapter 11. But what about American options?
Unfortunately, they have no closed-form solution. However, most exchange-traded options
are of the American typeand we still have to price them. Moreover, academics as well as
the practitioners have to make a living. So they have developed numerical procedures
(computer programs) to value American options and still continue to do so. In later chapters,
you will learn some of these techniques.
6
Swaps
Unlike futures, forwards, and options, swaps are the new kids on the block in the derivatives
market. While other derivatives have traded for centuries, swaps got started in 1981.
Although they seem quite different from these other derivatives, one can view them as a
series of forward contracts and price them accordingly. We will give two examples of
swaps.
A swap is an agreement between two or more parties (counterparties) to exchange a
series of cash payments over a stated period. A swap contract specifies the currency, interest
rate, and timetable for cash payments, what to do when one side defaults, and other issues
that can affect their relationship. Because they are OTC instruments, swaps must be carefully
documented. They dont have the protection that standardized exchange traded derivatives
enjoy.
Since the first swap was traded in 1981, the market has grown rapidly, and is now
measured in trillions of dollars. Swaps trade in an OTC market thats primarily centered in
London. LIBOR (London Interbank Offer Rate), a rate at which major London banks are
willing to lend dollar denominated funds to other banks, is used to determine the cash
payments on most swap contracts. As in other financial markets, swap market has its own
brokers and dealers. These swap facilitators (also called banks) help bring the
counterparties together or take part in a swap deal.
Swaps are more like forwards than futures. As they are customized, they come in many
flavors and varieties. Plain vanilla interest rate and currency swaps being the two of its
simplest kinds.
Why have swaps flourished? Perhaps you can tell a story of absolute advantage where
one party raises cash cheaper than the other at a fixed rate, while the other does the same at
the floating rate, and then they swap and split the gains. Or you can tell a story of
6
A closed-form solution is an exact mathematical formula like x = (a + b)2. If you know a and b, you can
easily solve for x. BSM model solves an options price in terms of known variables and functions like the
cumulative normal distribution.
Chapter 2, Page 20
AEM 421, Fall
comparative advantage that one learns in International Trade courses. You can perhaps tell
similar stories for currency swaps. Parties enter a swap to transform one kind of cash flows
to another. The swaps markets provide a cost-efficient way of doing that with little
transactions costs.
In the following example (shown in Figure 2-7), suppose that I want to borrow at a fixed
rate but my current loan is at a floating rate. Your situation is just the opposite. A swap can
help both of us.
Example 2-5 Plain vanilla interest rate swap (fixed vs. floating; Figure 2-7)
Ive borrowed $10 million for 3 years at a floating rate and I want to switch to a fixed
interest rate loan. My current funding costs are floating and equals LIBOR + 2%.
Youve borrowed $10 million dollars for 3 years at a fixed rate of 7% and you want to
switch to a floating rate.
We can swap. We work out a deal where I agree to pay you 7% while you will pay me
LIBOR + 2%. This will go on for three years.
While most swaps have half-yearly payments, lets assume for simplicity that we will
trade cash flows once a year. As a result of this agreement, my cash flows are (LIBOR +
2%) + (LIBOR + 2%) 7% = 7%: while yours are 7% + 7% (LIBOR + 2%) =
(LIBOR + 2%). The swap switched our existing loans to the other type.
In reality, no principal changes hands. Thats why $10 million is called the notional
principal. It never moves and is only used for accounting purposes. Depending on the
value of the LIBOR, we pay each other the difference (net payment). Let us find out the
net payments if LIBOR takes 4%, 5%, and 7% during the 3 years.
FIGURE 2-7
EXAMPLE OF A PLAIN VANILLA INTEREST RATE SWAP: TRANSFORMING
A FIXED RATE LOAN INTO A FLOATING RATE LOAN (AND VICE-VERSA)
BEFORE SWAP
ME
YOU
Raised $10 million

My cost is
(LIBOR + 2%) / year
Raised $10 million

Your cost is
7% / year
Chapter 2, Page 21
AEM 421, Fall
AFTER SWAP
YOU
LIBOR + 2%
Your net cost is

(LIBOR + 2%)
per year
ME
My net cost is
7% / year
7%
7%
LIBOR + 2%
(1st year, LIBOR = 4%)

I owe you 7%.
You owe me (4 + 2) = 6%.
I will pay you 1% of $10 million, or $100,000 at the end of first year.
(2nd year, LIBOR = 5%)
I owe you 7%.
You owe me (5 + 2) = 7%.
Net payment is 0.
(3rd year, LIBOR = 7%)
I owe you 7%.
You owe me (7 + 2) = 9%.
You will pay me 2% of $10 million, or $200,000 at the end of third year.
And then the contract ends.
Who would use such swaps? Our neighborhood bank, for example, can use them to better
manage its asset and liability portfolio. Bank loans out funds for long periods at fixed rates
(house mortgage loans, auto loans, personal loans, etc.), and fund those assets by paying
depositors (savings accounts, checking accounts, etc.) a floating rate of interest. Suppose a
banks cost of funds is LIBOR + 2%, and its long term portfolio earns 10%. If the bank can
do this swap, its obligation would now be 7% per year. It can merrily earn 10% 7% = 3%
on its asset, and will be immune from any interest rate risk.
Many multinational companies these days are building manufacturing facilities away
from home. Often these new plants are opened in less developed countries like Thailand and
Mexico where labor is cheap. Or, sometimes, they are built where the companies sell their
wares. American companies have long recognized this, and General Motors Opel division
Chapter 2, Page 22
AEM 421, Fall
and Ford Europe are results of such insight. Recently, German and Japanese automakers have
been opening plants in the U.S. to avoid currency fluctuations and assuage American buyers
by creating local jobs. Although resurrection of old ideas, such plants go by the fancy name
of transplants.
To open a factory, you need lots of local currency. Often a manufacturer can more easily
raise cash at home because they have long standing relationships with banks. As with a plain
vanilla interest rate swap, the companies can raise cash domestically and then enter into a
currency swap. Example 2-6 explores and explains such a scenario. No wonder, currency
swaps are widely used.
Example 2-6 Plain vanilla currency swap (Dollars for Euro)
Suppose the dollar ($)/euro () exchange rate is such that each euro is worth $0.95. Lets
assume that General Motors wants to build an auto plant in Germany and BMW wants to
do the same in the U.S. As each company is better known in their home turfs, lets
assume that they can raise cash more easily at home than abroad. The companies can
borrow money at home and then do a swap.
The automakers set up a swap on a principal of 100 million for 5 years. Unlike with an
interest swap, the principal actually changes hands in most foreign currency swaps, both
at the start and also at the end. All they are doing is exchanging each-others borrowings
at a fair price.
Currencies are converted at the spot rate: GM raises $95 million and gives it to BMW,
who, in turn, raises 100 million for GM.
Every year, GM will pay BMW 10% of the 100 million as an interest payment in Euro.
BMW will pay GM 8% of the $95 million that they got in dollars. In practice, the
companies will pay each other the difference in interests after converting them at the spot
interest rates; some swaps however involve full interest payment in relevant currency to
the counterparty.
The swap ends after 5 yearly payments, and the principals are handed back. Figure 2-8
shows these cash payments.
FIGURE 2-8
EXAMPLE OF A PLAIN VANILLA FOREIGN CURRENCY SWAP
TRANSFORMING A DOLLAR LOAN INTO A EURO LOAN (AND VICE-VERSA)
AT THE START OF THE SWAP
GM
Raised $95 million
Cost 8%
$95 million
BMW
100 million
Raised 100 million

Cost 10%
Chapter 2, Page 23
AEM 421, Fall
AT THE END OF EACH YEAR (FOR 5 YEARS)

GM
$7.6 million
BMW
10 million
$7.6 million
10 million
AT MATURITY OF THE SWAP

GM
$95 million
BMW
100 million
2.3
Long and Short in Different Markets
We have been using (Wall) street jargons long and short throughout the text. But what do
they mean in different markets?
In the case of futures and forwards, both a long and a short have obligations to trade at a
future datethe long agrees to buy the asset, which the short agrees to sell. By market
convention, no money changes hands when the contract is negotiated.
For options, no matter whether its a call or a put, the buyer who is long has an option
while the writer who holds a short position has an obligation. For this situation, the buyer
pays the writer a premium at the start. It doesnt matter whether the long is acquiring a right
to buy or a right to sell. The short collects a premium but faces the possibility of a future
negative payoff.
The long and short work differently in the stock market. Unlike in the options or futures
and forwards markets, a long doesnt necessarily generate a short. Going long simply means
buying (in the primary or secondary market) one of the shares that the company sold in the
primary market at the time of their initial public offering. A short seller borrows shares from
another and sells them. She has the obligation to buy back those shares in the future and
7
One way of seeing this is to think of a short position holder in the futures market as a seller who is short of
the underlying asset, which she has to come up with on the maturity date.
Chapter 2, Page 24
AEM 421, Fall
return them to the lender in addition owing any dividends paid. Interestingly, short sellers can
artificially create more long shares than were originally issued in the primary market. Short
selling may appear quite weird like money creation by the Federal Reserve Banks. But
believe us, the more you think about it, the more it grows on you. Lets walk through an
example and understand it with the help of a diagram (see books like Walker (1991) for a
discussion of the history, mechanics, and different strategies associated with short-selling.)
Example 2-7 Short selling in the New York Stock Exchange (Figure 2-9)
Suppose Archie owns 100 shares of IBM that are held in his account at Mr. Goodmans
firm. To make them available for short selling, the shares are held in street name.
Archie doesnt gain anything from thishe is just helping Mr. Goodman earn some
commissions. For simplicity, lets assume that Mr. Goodman is the only broker in town.
Suppose Bob wants to sell short 100 shares of IBM. First, he cannot sell short when IBM
is going down. The New York Stock Exchange (NYSE) where IBM trades allows short
selling only on an up-tick or a zero-plus tick. [The tick is the direction in which the price
of a stock moved on its last sale]. An up-tick happens when the last trade was at a price
higher than the previous. For example, say the first price was at $100, and the next price
was at $100.05. This is an up-tick. Zero-plus occurs when the last trade was at the same
price as the previous, which in turn was an up-tick. Suppose the first was at $100, the
next was at $100.05, and the next was also at $100.05. This is zero-plus. Likewise, a
down-tick means the last sale price was lower than the one before it.
8
FIGURE 2-9
SHORT SELLING OF BUG SHARES
CHRISTINE
Owns 100 IBM
Dividends from IBM
Has voting rights
Short sells
Borrows
ARCHIE
Owns 100 IBM
shares in street name
Loses voting rights
8
BOB
Short sold 100 IBM shares
Will buy IBM in future
As NYSE wouldnt allow short selling when IBM is going down, Bob is happy to use the options market,
which doesnt have such restrictions. He either buys put options or sells calls.
Chapter 2, Page 25
AEM 421, Fall
Pays dividends
2.4
Suppose the technicalities are satisfied. Mr. Goodman will borrow 100 shares from
Archie, lend them to Bob, and help Bob sell them to Christine. In the future, Bob will
have to buy 100 IBM shares, no matter what the price is, and give them back to Archie.
He owes any dividends paid over this period to Mr. Goodman, who credits them to
Archies account.
The market is now long 200, short 100 IBM stocks. Still, from IBMs perspective, there
are only 100 outstanding shares owned by Christine. The other 100 shares that are held
long by Archie and the 100 shares that were short sold by Bob are artificial creations, for
they cancel one another. Christine gets dividends from IBM and has the voting rights.
Strangely, Archies original shares became artificial shares during the short selling
process. These artificial shares are Bobs babies, and Bob has to take care of them. Thus,
Bob has to make good any cash dividends, stock dividends, stock splits, etc., which
Archie would have rightfully gotten.
In fact, dividends lower a stocks value and benefits Bob for he can now buy them
cheaper. A dollar dividend on a $100 stock will lower its value to $99, which will help
Bob earn a dollar if he now buys back the stock. Paying Archie this dollar will keep
everyone happy by making things fair.
The only thing that Archie loses is voting rights, for IBM will not recognize an extra
owner. Thats O.K. if Archie is not planning to thrust major changes on big blue (a
popular name for IBM) with proxy fights.
If Archie decides to sell IBM, then Mr. Goodman has to borrow IBM shares from
someone, perhaps Daphne or Eugene. If he cannot find it anywhere, then the shares will
become scarceBob may have to buy them from some other source at a steep price.
Is short selling in the stock market as risky as short selling in the derivatives market?
You bet. How does the profit/loss diagram look for a long or a short in the stock market?
It looks exactly like the long and the shorts payoffs in the forward marketFigure 2-3
will give you the answer. Interestingly, Mark Twain said in Puddnhead Wilsons tale in
1894, October. This is one of the peculiarly dangerous months to speculate in stocks in.
The others are July, January, September, April, November, May, March, June, December,
August, and February. Wonder what he would have said about short selling.
Financial Engineering and Risk ManagementBreak & Build Approach in

Practice
Chapter 2, Page 26
AEM 421, Fall
Now that you are familiar with basic securities like stocks and bonds as well as simple
derivatives like forwards and options, let us use this knowledge to analyze more complex
derivatives. This takes us to financial engineering, a new discipline that has emerged only a
few years back but has won huge acceptance at a wide range of educational institutions
around the world (See University programs and courses in Insert 2-1).
Financial Engineering
Financial engineering applies engineering methods and techniques to finance problems
(See Definition in Insert 2-1). A financial engineer designs financial contracts to meet the
needs of a business, builds and tests complicated derivative pricing models, studies
econometric properties of security prices, and explores related issues. You may view it as a
special kind of risk management.
9
INSERT 2-1
FINANCIAL ENGINEERING
What is financial engineering? Cornell Universitys Master of Engineering Program in

the School of Operations Research and Industrial Engineering offers a Financial
Engineering option. On the homepage of this program, it states: Financial engineering
is the application of engineering methods to finance. One important area of study is the
design, analysis, and construction of financial contracts to meet the needs of enterprises.
This field is experiencing an increased demand for professionals, especially those who
are trained in both the underlying mathematics/computer technologies and finance.
International Association of Financial Engineers: IAFE (http://www.iafe.org/) is an
organization dedicated to defining and fostering the profession of financial engineering.
It has over 2,000 members worldwide and counts among its senior fellows five Nobel
Laureates and several well known finance academics and practitioners. IAFE provides
internet links to a wide range of universities that teach financial engineering.
Financial engineering core body of knowledgeThe IAFE lists the following topics in
financial engineering: Term Structure of Interest rates, Valuation of Cash Flows,
Valuation of Contingent Claims, Portfolio Theory, Asset Pricing (CAPM and beyond),
International Finance, Performance Measures, Credit Risk Evaluation, Derivative
Instruments and Securities, Forwards, Futures, and Swaps, Options, Hybrid Securities,
Asset-Backed Securities (particularly Mortgage-Backed Securities), Experience in
Structuring (Engineering and Reverse Engineering Structures), Markets and Processes,
Such material is treated in advanced textssee references at the end of this chapter. Another way to study the
subject is through financial engineering cases: see relevant Harvard Cases, Dryden Cases, South-Western Cases,
etc.
Chapter 2, Page 27
AEM 421, Fall
Understanding of the Global Markets, Debt Issuance Process, Arbitrage, and Micro and
Macroeconomics.
University programs and courses: A wide range of universities teach financial
engineering. For example, graduate degrees in financial engineering are offered by (in
alphabetical order) the University of California (Berkeley), Carnegie Mellon University,
the University of Chicago, City University of Hong Kong, Claremont Graduate
University, Columbia University and so on. And, individual courses in financial
engineering are offered by universities including University of Vienna, University of
Virginia, University of Washington, and University of the Witwatersrand (Johannesburg).
Financial engineering programs often utilize faculty members from the business school,
the economics department, the engineering school, and the mathematics and statistics
departments. Courses tend to be more rigorous than those in a typical MBA finance
curriculum and often put heavy emphasize on mathematical and statistical tools and
techniques.
There is a growing interest in financial risk management among serious practitioners

and researchers. Global Association of Risk Professionals (GARP) caters to this clientele.
Established in 1996, GARP is a nor-for-profit, internet based independent organization with
over 15,000 members. Every year, GARP gives Financial Risk Manager Examination.
Successful candidates can write the acronym FRM after their name.
At a basic level, financial engineering and risk management put our break & build
approach to work. We will only see the tip of the iceberg. But before we do that, let us
summarize the outflows and the inflows from the securities that we have considered so far.
Figure 2-10 gives the payoffs from the basic securities bonds, stocks, forwards, and options.
These payoffs are expressed in accordance with the sign convention that would be used
throughout the book.
10
Sign Assignment to a Commodity or a Securitys Cash Flows at Different Dates

Finance studies prices or values. These are reflected on a firms balance sheet, which keeps
track of assets and liabilities. To do financial engineering and build pricing models, we need
to find the cash flows associated with buying or short selling various assets, derivatives, and
other financial securities. We will use such cash flows in Example 2-9 and throughout the
book.
Our sign convention considers outflows as positive today and inflows as positive at later
dates (see Insert below). This may raise some eyebrowswhy distinguish cash outflows
10
Certification as a Financial Risk Manager (FRM) also requires that the candidate must be an active member
of the GARP and possess a minimum of two years work experience in financial risk management or a related
field.
Chapter 2, Page 28
AEM 421, Fall
and inflows? Why not simply consider them as cash flows, positive for an asset and negative
for a liability, just as accountants do and some other authors have done? When computing
net present values, a staple for finance students, dont we apply positive signs to assets and
negatives to the liabilities?
Sign Convention
Starting date (today): Outflows (like prices) are positive and inflows (like proceeds
from short selling) are negative. This is consistent with prices being positive.
Ending date (future): Inflows (like amount your get by selling an asset) are positive
and outflows (like liabilities) are negative. This is consistent with assigning positive
values to assets and negative values to liabilities on a balance sheet.
The signs remain same through time.
Actually, our system is an extension of the familiar sign convention and has some
benefits. If you consider cash flows only once, then assigning positive number to assets and
negative number to liabilities make sense. But most of our exercises create a portfolio and
see what happens at a later date. So we take two snapshots, once when creating and the
other when unwinding the portfolio. For example, suppose that at the models starting date
you purchase a stock by paying a price (a positive number); at the models ending date you
liquidate this asset and get cash (also a positive number). But if you short sell a stock today,
then you get cash (a negative number) that reduces net price you have to pay for other assets
in the portfolio; but this becomes a liability (again a negative number) in the future because
you have to give up its price to buy it back from the market and return it to the person from
whom you originally borrowed. So our sign convention makes intuitive sense. Moreover, as
the signs remain the same through time, you dont have to worry about changing signs at the
starting and the ending date. This makes life easier in later chapters when we create payoff
tables and build pricing models.
The sign convention is illustrated in Example 2-8.
Example 2-8 Short selling in the New York Stock Exchange (Figure 2-9)
Suppose you create a portfolio by buying one stock of IBM for $100 and short selling one
stock of GE for $60:
- IBMs contribution is a positive outflow. It enters the portfolio with a positive sign
because it is a price paid. Arent we accustomed to seeing prices as positive
numbers in day-to-day life?
- Money you get by short selling GE is a negative outflow (or a positive inflow). It is
negative because the money comes in and reduces the price paid.
- Portfolio value is 100 60 = $40. This net outflow is the price paid for its creation.
At a later date, suppose IBM stock is trading for $110 and GE stock is priced at $65.
Signs remain the same but the interpretation changes:
Chapter 2, Page 29
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IBM stock retains its positive sign in the portfolio because it is an asset that you are
holding. You will get $110 if you sell it and thats a positive inflow.
GE stock also retains its sign because it is a liability that you are carryingyou have
to buy it from the market and return it to the trader who originally loaned the stock to
you. This negative inflow reduces your portfolios worth.
Portfolio value is 110 65 = $45. This net inflow is your portfolio value.
We now use the sign convention to build a payoff table, which gives the cash flows
from buying or short selling securities (bonds, stocks, forwards and options) at starting as
well as ending dates. This is done in Figure 2-10, where the payoffs are self-explanatory and
summarize what we have been discussing before. Just as a reminder, (1) a bond is a fixed
income security and you know for sure the interest you are going to get, (2) a stocks value
at the future date, S(T), is unknown, and stock position has the same sign at both current and
the future date, (3) a forwards cash flow is 0 at start and the mirror opposite of each other
for long and short, and (4) option payoffs retain the sign at current date and expiration date
and the payoffs are asymmetric.
FIGURE 2-10
PAYOFF TABLE FOR CASH FLOWS FROM BOND, STOCK, FORWARD, AND OPTIONS
PORTFOLIO
(1) BONDS
Buy $X worth of bonds
(lending or long position in
bond)
Sell (short) bond so as to pay
$Y in the future (borrow
present value of $Y)
PORTFOLIO
(2) STOCK
Buy stock (long)
Sell stock (short selling)
PORTFOLIO
(3) FORWARD
Buy (long) forward with a
Time 0 (starting date)

NET OUTFLOW
Time T (ending/maturity
date)
NET INFLOW
X(1 + interest)
Y/(1 + interest)
Time 0 (current date)

NET OUTFLOW
Time T (future date)

NET INFLOW
S(t)
S
S(T)
S(T)

NET OUTFLOW
Time T (delivery date)

NET INFLOW
[S(T) F]
forward price F
Sell (short) forward
PORTFOLIO
0
NET OUTFLOW
(4) OPTIONS
Buy (long) call with
strike price K
Sell (short) call
Buy (long) put
Sell (short or write) put
c(0)
c
p(0)
p
Chapter 2, Page 30
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[S(T) F]
Time T (expiration date)
NET INFLOW
S(T) Strike K < S(T)
price, K
0
[S(T) K]
0
[K S(T)]
[K S(T)]
[S(T) K]
0
0
In the following examples (Example 2-9, 2-10), we kill two birds with one stonewe
familiar ourselves with the sign convention and also see how financial engineering works in
real life. These examples show how a firm can design derivative securities to solve practical
problems and exploit economic opportunities. More applications of financial engineering will
come later in the text.
Example 2-9 Gold mining company sells a derivative indexed to gold price
Goldminers Inc. (a fictitious name) mines and refines ore and sells pure gold in the global
market. It benefits from a rise in gold prices and suffers from a fall. To raise funds, it sells
a derivative security whose payoff is as follows:
- Part of the security is a zero coupon bond (which is sold at a discount and makes no
interest payments) that pays the principal $1,000 at maturity time T.
- Goldminers also pays an additional amount that is indexed to gold price (per ounce)
at maturity S(T):
0
if S(T) < $350,
10[S(T) 350]
if $350 S(T)
The payoff at maturity could also be written as

PAYOFF AT MATURITY AS ORIGINALLY STATED
PORTFOLIO
Bond payoff
Additional amount
Time T (maturity date)

NET INFLOW
S(T) < 350
350 S(T)
1,000
1,000
0
10[S(T) 350]
NET PAYOFF
1,000
Chapter 2, Page 31
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1000+10[S(T) 350]
The graph of this derivatives payoff at maturity is given in Figure 2-11.

We may analyze this derivative as:
- When spot price of gold is less than 350, this derivative has a bond-like payoff.
- When spot price of gold is more than 350, the derivatives payoff looks like that of a
long call position. You can get this by buying 10 calls with strike price 350.
FIGURE 2-11
PAYOFF DIAGRAM FOR DERIVATIVE INDEXED TO GOLD (SEE EXAMPLE 2-9)
Payoff
slope = 10[S(T) 350]
1,000
0
350
S(T), spot price of gold at maturity
So the derivative can be broken down as:

PAYOFF BROKEN DOWN INTO BASIC SECURITIES
PORTFOLIO
Long bond (face value 1,000)
Time 0
(todays date)
NET OUTFLOW
1,000B
Time T (maturity date)

NET INFLOW
S(T) <350
350 S(T)
1,000
1,000
Long 10 calls (strike price 350)

NET PAYOFF
10c
1,000B + 10c
0
1,000
Chapter 2, Page 32
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10[S(T) 350]
1000+10[S(T) 350]
To sum up, this derivative may be expressed as a combination of (1) long zero coupon
bond worth 1,000B that has a face value $1,000 (B is what is called a zero-coupon bond
when you invest this amount, which is less than $1, you get no interests but get back
$1 when the bond matures), (2) long 10 European calls, each with a price of c and strike
price $350. This is assigned as an exercise in Questions and Problems at the end of this
chapter. This can be done either by visual inspection or by using put-call parity
relationship for European options which is discussed in Chapter 10.
Why would Goldminers sell something like this? It will raise more money upfront. At
maturity, if gold prices are high, it parts with some of its profitsthats not too bad. If
gold prices are down, they dont pay an additional amount and the extra cash that they
raised stays with them. Interestingly, the company has hedged its overall exposure to gold
price fluctuations by issuing this security, and reduced some pre-existing business risk.
How would you price this security? Its fair price is the sum of prices of zero coupon
bonds (which you will learn to price in chapter 3) and call options (which you will learn
to price with the binomial model in Chapter 10 and the Black-Scholes-Merton model in
Chapter 11).
These securities come with many variations and added featuresthe example that we just
discussed is a commodity indexed note, which has its return tied to the performance of a
physical commodity (like platinum, gold, silver, oil) or a commodity index (like
Bridge/CRB Futures Index, a commodity futures index that goes back to 1957). Sometimes
the holder can get unlimited benefits from price rises (as in this example), but at other times
the returns are capped.
Alternately, Goldminers could have issued a commodity interest-indexed bond or note,
which would be a regular debt but with a coupon rate linked to the price of the commodity.
Close cousins of these derivative are equity-linked notes (ELN). An ELNs is a combination
of a zero-coupon (or a low coupon) bond with a return component that may be based on the
performance of a single stock or a basket of stocks or a stock index; see Gastineau and
Kritzman (1996) for definitions and discussions. These come in numerous variations and go
by fancy trade names like ASPRINs, EPICs, GRIP, MINE, PIN, SIR, SUPER, and so on.
This extra kicker that comes from the equity component makes these securities attractive to
buyers, helps the issuers raise more cash upfront, and also hedge some of the inherent risks in
their business.
Example 2-10 Hybrid securities for tax-efficient disposal of appreciated stock
Suppose you are the Chief Executive Officer of Excelteam Co. (a fictitious name, like
other names in this example) that has bought 1 million shares in a startup company
Starttofly Inc. at $3 per share. The startup has done very well and is about to go public.
Because Excelteam bought these shares through a private placement, securities laws
prevent selling those shares for two years. But you think that its high time to dispose off
these shares because finance academics report that the high price achieved around the
Chapter 2, Page 33
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time of the initial public offering (ipo) doesnt last long, and in most cases settle at a
significantly lower level six months after the ipo.
What should you do? One option for Excelteam is to issue a hybrid debt (also called a
structured note), which is a combination of a bond and an equity or a derivative like a
forward, an option, or a swap. Your investment banker Invybank Inc. can design a
Premium Equity Participating Securities (PEPS, a type of hybrid debt) which would
allow you to get the benefits of a sale without actually selling Starttoflys stock!
How would this work? Suppose Invybank designs a 3-year bond which pays interest at
the annual coupon rate of 6% per year on the PEPS selling price of $20. The buyer of
each PEPS also gets a share of Starttofly after 3-years. Many investors would love this
securitythey like the idea of buying Starttofly for $20 in the future (and build castles in
the air and dream that they have identified the next Microsoft or Cisco; and who knows,
the dream may come true) and getting the coupon payments over the years. Excelinvy
sells 1 million PEPS, raises $20 million upfront. Moreover, it will pay capital gains tax
only when it actually sells Starttofly stock, which could be 3 years from now. And it gets
to deduct the interest payments $800,000 from current taxes every year (warning: the
example is for illustration purposes only; we are not qualified to give tax advice). Based
on what you have learned, you can easily break down this PEPS into a bond and a stock.
And if the terms are slightly changed and the conditions read that there will be zero
payment if the stock price is less than say $10, and full payment equivalent to Starttofly
shares if stock price is more than $10, then you have just added a call option to the
existing bond. You can even design the security so as to give the investors only a
percentage of the gains. There are endless ways of doing financial engineering.
Who has sold hybrid securities? Hybrids have been sold in America, Asia, Europe, and
Australia! Two representative examples of PEPS are:
- In March 1996, Media giant Times Mirror Co. issued 1,305,000 shares of Premium
Equity Participating Securities (PEPS) due in five years; the security paid a low
annual interest rate of 4.25% of the $39.25 Issue Price, or $1.668 per year, payable
quarterly. The security participation came from an amount determined by a formula
based on the fair market value of AOL Common Stock at the redemption time.
- On September 29, 1999, Kansas City-based UtiliCorp United sold through
underwriters 10,000,000 units of PEPS at $25 per unit with a yield of 9.75 percent.
Holders of PEPS units will receive UtiliCorp stock on Nov. 16, 2002, based on the
then current common stock price. The PEPS units will mature two years after that
date. UtiliCorp will use the net proceeds of about $250 million to reduce short-term
debt and other short-term obligations incurred for acquisitions, construction and
repayment of long-term debt and for general corporate purposes (reported in First
Mover, UtiliCorp Uniteds newsmagazine, 1999 third quarter).
So non-financial firms can use derivatives (and contracts that look like derivatives) and
risk management techniques to advance their strategic goals. The knowledge of financial
engineering can help in many finance related jobs: as a corporate financial manager issuing
securities and using a wide array of derivative contracts; as a banker designing, pricing, and
trading securities; as an investment manager running an actively managed securities
portfolio; and as a financial regulator overseeing markets, understanding firms behavior and
preventing financial catastrophes. Risk managers are in demand these days, and their
Chapter 2, Page 34
AEM 421, Fall
importance is likely to increase in the foreseeable future. Our break & build approach
prepares you for that path.
2.5
Buying HouseDerivatives, Modern Finance and an American Dream
Planning to buy a house? You have just found a job, you like the city and are thinking about
getting settled. Typically, you work with a real estate broker who will show you different
houses that will fit your needs and desires. You find your dream house. A flurry of activity
now begins.
Through your broker, you submit an offer to buy the house for $100,000. If the seller
agrees, the two of you have just created a derivative security. The sellers broker usually
requires you to place some earnest money, say $1,000, with them. Suppose that there are 45
days between bid submission and closing of the sale of the house. Should you decide to back
out from the deal, $1,000 will be forfeited. Otherwise, it will be used for buying the house. If
a new housing project is announced nearby which will drastically lower the value of this
house, and you decide to back out of the deal, you only lose $1,000. The $1,000 loss gives
you the flexibility to change your mind.
You now go to a bank or a mortgage broker to arrange a loan. Thanks to modern finance,
they will run a credit check on you. A credit report will tell them how you have handled debt
in the pastcredit card and other loan payments. Late payments on past debt will raise red
flags.
Suppose the lender evaluates your earnings and obligations and decides to loan you
$90,000 for the house. This loan is called a mortgage on the house. You have to pay this
mortgage back in 15 or 30 years with interest paid in monthly installments over its lifetime.
You have to come up with a $10,000 down payment of your own money, which provides
them with a cushion against a decline in the houses value if you decide to give up your
house and leave the town without a forwarding address! Unless you make a 20% down
payment, the lender will also force you to pay for mortgage insurance, which will give them
a put option on the house.
Suppose the lender offers you a choice between a fixed-rate mortgage (FRM) or an
adjustable-rate mortgage (ARM). A FRM charges a fixed rate for the entire periodyou have
to pay back the loan in equal monthly installments over 15 or 30 years. An ARM usually
charges a lower initial rate for one to five years. The payments later get adjusted according to
a formula depending on then prevailing interest rates. Again, your expertise in modern
finance will come in handy. If you are planning to stay for a short period or if you are betting
that the interest rates will remain low, an ARM may make sense. Otherwise an FRM allows
you to lock in a rate for 15 or 30 years. Nowadays, loans rarely come with a prepayment
penaltyso you can choose to pay back the loan faster. If the interest rates fall, you also
have the option of refinancing your home and locking in a cheaper interest rate.
In years past, the major players in the market for mortgages were banks and Savings and
Loan Associations (S&Ls). The money was raised and lent in local markets. Thanks to
modern financemoney for buying the house can now be borrowed from anywhere in the
US. A mortgage broker will lend you the money for a house mortgage and immediately sell
that loan in the national market. Typically, they will split the loan in two partsthe rights to
Chapter 2, Page 35
AEM 421, Fall
service the loan is sold to an entity like the Chase Manhattan bank who will regularly collect
your mortgage checks and try to coax you to buy insurance products, while the loan itself
may be pooled with other mortgage loans and sold in the Mortgage backed securities (MBS)
market.
Wall Street wizards will then combine different loans in to a pool to diversify the risks,
and then sell bonds, which are backed by the cash flows from these loans. The resulting
security can be quite safe. Combining illiquid house mortgage loans into an easily traded
liquid security was first done at Salomon Brothers in the 1970s. This is called an assetbacked security. The asset-backed security market enjoyed tremendous growth ever since.
And you thought the mortgage business was staid and stodgy, bereft of action!
2.6
Summary
We emphasize a break & build approach where derivatives can be broken down into
simpler parts or combined with other securities to create new ones. This book will help
you learn how to price derivatives, custom design them, and spot derivative like features
in real world situations.
The buyer and the seller in a forward contract agree to trade a commodity at a fixed
delivery price on the maturity date. A futures contract is similar to a forward. Unlike
forwards, futures are regulated, trade in organized exchanges, are settled daily, are
guaranteed by the clearinghouse, and have an elaborate system of margins to minimize
default risk. The long position holder in both these contracts agrees to buy the
commodity, while the short agrees to sell. The forward or the futures prices are set so that
no money changes hand when these contracts are created.
A call option gives the buyer the right to buy an asset from the seller until an expiration
date by paying an exercise price. A put gives the holder the right to sell the asset to the
writer at the strike price until the expiration date. Unlike futures and forwards, options
give the buyer a right but no obligation. The writer is paid a premium for selling such
rights. The Black-Scholes-Merton model gives a closed-form analytical solution for these
premiums on the basis of some known parameter values.
A European option can only be exercised at the maturity date of the option, whereas an
American option can be exercised at any time up to and including its expiration date. The
names American and European do not depend on where the option trades. Most
exchange-traded options in the U.S. are of the American type.
Options can be used for gambling, leverage, or insurance. Many portfolio managers buy
put options for portfolio insurance, a procedure that protects a portfolio that has racked
up gains from a market downturn.
A swap is an agreement between counterparties to exchange a series of cash payments
over its life. Swaps transform one kind of cash flows to another. A plain vanilla interest
rate swap changes a fixed rate loan to a floating rate loan and vice versa. A plain vanilla
foreign currency swap exchanges a loan denominated in one currency to another.
Market participants often use the terms long and short to denote buying and selling.
But these terms have specific meanings in specific markets. The short sellers in
derivatives markets agree to sell at or until a future date. The short seller in the stock
market does something more complexshe borrows shares, sells them, and buys back
those shares and returns them to the lender at a later date.
2.6
Chapter 2, Page 36
AEM 421, Fall
Once the potential of the building blocks are known, one can venture into financial
engineering, a new discipline that applies engineering methods to financial economics.
Among other things, it studies how firms can design derivative securities that solve
practical problems and exploit economic opportunities by altering the existing risk-return
tradeoff.
Further Information, Questions, and Problems
Information
You can find plenty of information on derivatives in textbooks, scholarly books, journal
articles, practitioner journals, magazines, etc. Some sources are:
The bibliography at the end of this chapter lists textbooks and other scholarly books. We
list with comments several books comparable to ours, and also suggest specialized books
for advanced studies.
The Wall Street Journal and other business newspapers and magazines. Risk is an
excellent magazine for up-to-date information on derivatives markets.
There is a wealth of information available on the internet. Exchanges, government
agencies, investment banking companies and many other entities disseminate information
through their websites. Use Yahoo! or some other search engine to find the Chicago
Board of Trades (CBOT), the Chicago Mercantile Exchanges (CME), or the National
Futures Associations (NFA) websites for information on futures. The Chicago Board
Options Exchanges (CBOE) or the Options Industry Councils (OIC) website gives
information on options. The International Swaps and Derivatives Associations (ISDA)
website provides information on swaps. Interested in knowing the regulators? Go to the
Commodity Futures Trading Commissions (CFTC) or Securities and Exchange
Commissions (SEC) websites. You can reach a huge selection of finance websites by
clicking on Yahoos Business & Economy, and then clicking on Finance. Other search
engines offer similar services.
There are many excellent books on financial engineering. A small list that includes many
of the best books available in the market is listed below under the References.
References
Campbell, J. C., A. Lo, and C. MacKinlay, 1996. Econometrics of Financial Markets.
Princeton: Princeton University Press.
Duffie, D., 2001. Dynamic Asset Pricing Theory, 3rd Edition. Princeton: Princeton
University Press.
Gastineau, G. L. and M. P. Kritzman, 1996. The Dictionary of Financial Risk Management.
New York: Frank J. Fabozzi Associates.
Chapter 2, Page 37
AEM 421, Fall
Jarrow, R. A., and S. Turnbull, 2000. Derivative Securities, 2nd edition. Cincinnati: South
Western Publishing.
Jarrow, R. A, 2002. Modelling Fixed Income Securities and Interest Rate Options, 2nd
edition. Stanford: Stanford University Press.
Mason, S. P., R. C. Merton, A. F. Perold, and P. Tufano, 1995. Cases in Financial
Engineering: Applied Studies of Financial Innovation. Englewood Cliffs: Prentice Hall.
Sundaresan, S., 2001. Fixed Income Markets and Their Derivatives, 2nd edition. Cincinnati:
South Western Publishing.
Twain, M., 1894. Pudd'nhead Wilson, A Tale. American Publishing Co.
van Deventer, D. R., and K. Imai, 1997. Financial Risk Analytics. Chicago: Irwin.
Walker, J. A., 1991. Selling Short: Risks, Rewards, and Strategies for Short Selling Stocks,
Options, and Futures. Wiley.
Questions and Problems

1. Explain and carefully describe the following four security positions, drawing diagrams
wherever necessary to support your answer:
a) short forward contract with a delivery price of $100,
b) short futures with a futures price of $100,
c) short selling a stock at $100, and
d) going short on an option with a strike price of $100.
2. The current price of platinum is $400 per ounce. You think that in three months, the price
will go up to $425. But you are also worried that there is a small chance that if platinum
falls below the support level of $390, it may slide down to $350 or below.
How would you place orders so as to speculate on the price of platinum?
3. Distinguish between the rights and obligations of option buyers and option writers.
4. Distinguish between a European and an American option. Why is an American option
worth at least as much an otherwise similar European option?
5. You call up your broker and ask the price quote for (a fictional company) Sunstar Inc.s
March 110 calls. She replies that these options are trading at 7.00 to 7.50. If you want to buy
Chapter 2, Page 38
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three contracts, what would be your total cost? Assume that the broker charges for these
options on common stocks a commission of a flat fee of $17 plus $2 per contract.
6. As call is a right to buy and put is a right to sell, a long call position will be canceled out
by a long put position. Do you agree with this statement? Explain your answer.
7. The short position holder in a put option has the obligation to buy. Isnt this counter to the
notion that a long position typically indicates a buy position and a short position indicates
a sell position? Explain your answer.
8. The following option prices are given for Sunstar Inc., which has a stock price of $50.00:
Strike Price
45
50
55
Call Price
5.50
1.50
1.00
Put Price
1.00
1.50
5.50
Compute intrinsic values for each of these options and identify whether they are in the
money, at the money, or out of the money.
9. Do you agree with the statement: An out of the money option has an intrinsic value of
zero and vice versa? Explain your answer.
10. Compute the profit or loss on the maturity date for the following:
a) A short forward position with forward price of $303 and the spot price at maturity of
$297.
b) December 45 call for which the buyer paid a premium of $3 and the spot price at maturity
of $47.
c) November 100 put for which the seller received a premium of $7 and the spot price at
maturity of $96.
11. Briefly describe a plain vanilla interest rate swap. How does it differ from a plain vanilla
currency swap?
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12. Esandel Bank enters into a plain vanilla interest rate swap with a swap facilitator
Londoner Inc. Esandel pays a fixed amount of 8% per year to Londoner who in turn pays a
floating amount LIBOR + 1.50%. The principal is $15 million. The swap lasts for five years
and the payments take place at the end of each year.
Is the swap facilitator acting as a dealer or a broker in this swap deal?
a) What is the notional principal? Does it change hands at the beginning and end of the
swap?
b) Who is in receive fixed situation? Who is in pay-fixed situation?
c) Calculate the net payments involved and indicate who pays what in this swap deal if the
LIBOR takes on values 7.00%, 6.50%, 7.00%, 7.50% and 6.00% at the end of first year,
second year, third year, fourth year, and fifth year respectively.
13. American Auto enters into a plain vanilla currency swap deal with European Auto.
American raises $30 million at 8% fixed interest rate while European raises an equivalent
amount 33 million Euro at 9%. Then they swap these two loans. The swap lasts for three
years and the payments take place at the end of each year.
a) What is the principal? Does it change hands at the beginning and end of the swap?
b) Calculate the gross payments involved and indicate who pays what in this swap deal.
14. Distinguish between
a) bull and bear markets
b) forward and futures contracts
c) delivery and expiration dates
d) spot and forward markets
e) physical delivery and cash settlement
f) European and American options
g) call and put options
h) plain vanilla interest rate swap and plain vanilla currency swap
i) long and short in the stock market
j) long and short in the option market/ option buyer and writer
k) long and short in forward and futures market
l) intrinsic and time values
m) delivery and strike prices
15. Long and short, roughly meaning buying and selling, takes on different meanings in
different markets. The following table sums up initial and final cash flows from investing in
some securities and derivatives in a payoff table. We assume that there are no cash flows or
Chapter 2, Page 40
AEM 421, Fall
dividends between now (time t) and the future (time T). You will later learn to modify these
cash flows for dividends.
Fill in the blanks in the following payoff table:
PAYOFF TABLE FOR CASH FLOWS FROM BOND, STOCK, FORWARD, AND OPTIONS
Portfolio

NET OUTFLOW
A) BONDS
Buy $X in bonds (lending or
long position in bond)
Borrow $100 (short bond or
sell bond)
Buy bond (lending) so as to
get $1,000 in the future
Sell (short) bond so as to pay
back $Y in the future
Portfolio
X(1 + interest)
100
1,000/(1 + interest)
Y
Time 0 (todays date)

NET OUTFLOW
B) STOCK
Long stock (buying)
Short stock worth $111
S(T)
Time 0 (starting date)
NET OUTFLOW
C) FORWARD
Long (buy) forward
Short (sell) forward with
delivery price $310
Time T (delivery date)

NET INFLOW
0
[S(T) 310]

NET OUTFLOW
D) OPTIONS
Long call (buy call)

NET INFLOW
S(0)
Portfolio
Portfolio

NET INFLOW
Time T (expiration date)

NET INFLOW
S(T) Strike K < S(T)
price, K
Chapter 2, Page 41
AEM 421, Fall
Short sell call worth $8;

exercise price is $90
Long (buy) put for $7;
strike price is $100
Short (sell or write) put
[S(T) 90]
0
7
p(0)
[K S(T)]
Multiple Choice Questions

16. Ariel holds some BUG stocks in street name. His broker Merrill helps Beryl borrow
those shares and short sell them to Cheryl. In the future
a) Ariel gets dividend from BUG and has voting rights on BUG shares
b) Beryl gets dividend from BUG and has voting rights on BUG shares
c) Cheryl gets dividend from BUG and has voting rights on BUG shares
d) Ariel gets dividend from Cheryl and has voting rights on BUG shares
17. Whenever you put $1,000 into a cup, it gives back $1,050 a year later. The term structure
is flat at 10%. Then the price of the cup is
a) $50.00
b) $45.50
c) $50.00
d) None of the above.

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Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Chapter 2 Basic Derivatives and an Introduction to Financial

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Forwards (and Futures), Options, and Swaps

Traders Choices: Now or Later? Obligation or Choice?

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Trade according to terms

Holder may buy

Holder buys when

Holder may sell

Holder sells when

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Forwards and Futures

We can now summarize a forward transaction as:

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Starting date (time t)

Delivery / maturity date (time T)

Negotiate delivery price, F(t,T)

Physical delivery or cash settlement.

Forward Transaction (see Figure 2-2)

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

S(T), spot price on

Example 2-2 Futures contract

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Starting date (time 0)

Broker matches buyer and seller.

Expiration date (time T)

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

PAYOFF AND PROFIT / LOSS DIAGRAMS FOR APRIL 95 CALL OPTION

Example 2-3 European call option

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Payoffs to long and short call at expiration

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

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S(T), spot price

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Options Transaction: European put option

Options Transactions: American call and put options

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

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Raised $10 million

Raised $10 million

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Your net cost is

(1st year, LIBOR = 4%)

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

Raised 100 million

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

AT THE END OF EACH YEAR (FOR 5 YEARS)

AT MATURITY OF THE SWAP

Long and Short in Different Markets

Jarrow, Turnbull, Chatterjea Basic Derivatives and an Intro to Financial Engineering

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What is financial engineering? Cornell Universitys Master of Engineering Program in

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