FINA3203 01 Introduction

Derivative Securities
FINA 3203
Introduction to Derivatives
Andrew Chiu, PhD

andrew.chiu@ust.hk
The Hong Kong University of

Science and Technology
FINA 3203: Derivative Securities

Andrew Chiu
Course Overview
Forwards &
Futures
Market
Mechanics
Hedging
Strategies
Options
Pricing
Market
Mechanics
Properties
Trading
Strategies
Pricing
Binomial
Tree
Greeks
Black-Scholes
Other Derivatives
Warrants, CBBC

Swaps
Convertible
Bonds
Structured
Products

Andrew Chiu


Andrew Chiu
History of Derivatives
In Ancient Mesopotamia
(~1750 BC), contracts were
inscribed on clay tablets.
Mr. Farmer will sell to Mr.
Buyer a certain quantity of
grain for a specified price on a
future date. (forward)
Trading took place at the
temples (clearinghouse)


Andrew Chiu
History of Derivatives
In Ancient Greece (~600 BC),
Thales predicted an unusually
large olive harvest, and he
paid a small deposit to
reserve the right, but not the
obligation, to rent all olive
presses in the region for a
pre-specified price for the
following autumn.
(call option)

Andrew Chiu
Derivatives
Derivatives are contracts that derive their
value from something else:
commodities (agriculture, meat, metal, energy)
stocks, bonds, indices, currency rates, volatility,
interest rate, debt, real estate, weather.
Basic types: forwards, futures, options, swaps


Andrew Chiu
Forward & Futures

A forward contract is an agreement to buy or sell a
certain quantity of an asset at a specific maturity
date for a fixed delivery price.
Each party is obligated to buy or sell.
The delivery price is chosen so that the initial value of
the contract is zero
No money is exchanged when the contract is written
Potential infinite return? (Return=Profit/Cost)

Andrew Chiu
Payoff of a Stock
70
60
Payoff
50
40
30
Payoff
20
10
0
0

10
20
30
40
Stock Price
50
60

Andrew Chiu
Profit of a Stock
Payoff / Profit
Stock purchased at $25

70
60
50
40
30
20
10
0
-10
-20
-30
Payoff
Profit

10
20 30 40
Stock Price
50
60

Andrew Chiu
Payoff of a Long Forward at Expiration

40
30
Payoff
20
10
0
-10
-20
-30
-40
0

10
20
30
40
50
Underlying Price at Expiration
60

Andrew Chiu
Payoff of a Short Forward at Expiration

40
30
Payoff
20
10
0
-10
-20
-30
-40
0

10
20
30
40
50
Underlying Price at Expiration
60

Andrew Chiu
Options
An European call option is the right to buy a certain quantity
of an underlying asset at a specific maturity date (aka.
expiration date) for a fixed strike price (aka. exercise price).
Similarly, an European put option is the right to sell.
The call option holder can choose to exercise its right to buy or
not to buy. But the option writer has to sell if the option is
exercised.
The option holder pays a premium for the option. The option
writer receives the premium.

Andrew Chiu
Payoff of a Long Call at Expiration

35
30
25
Payoff
20
15
10
Payoff
5
0
-5
-10
0

10
20
30
40
50
Stock Price at Expiration
60

Andrew Chiu
Profit of a Long Call at Expiration

35
30
Payoff / Profit
25
20
15
Payoff
10
5
Profit
0
-5
-10
0

10
20
30
40
50
60

Andrew Chiu
Profit of a Short Call at Expiration

10
5
Payoff / Profit
-5
-10
-15
Payoff
-20
Profit
-25
-30
-35
0

10
20
30
40
50
60

Andrew Chiu
Payoff of a Long Put at Expiration

35
30
25
Payoff
20
15
10
Payoff
5
0
-5
-10
0

10
20
30
40
50
60

Andrew Chiu
Profit of a Long Put at Expiration

35
30
Payoff / Profit
25
20
15
10
Payoff
Profit
0
-5
-10
0

10
20
30
40
50
60

Andrew Chiu
Profit of a Short Put at Expiration

10
5
Payoff / Profit
-5
-10
-15
Payoff
-20
Profit
-25
-30
-35
0

10
20
30
40
50
60

Andrew Chiu
Swaps
A swap is an agreement to exchange cash flows at specified
future dates according to certain specified rules in the
contract. Cash flows can be of different currencies.
Example: Microsoft and Intel enter into a swap to exchange
fixed interest rate with a floating interest rate based on LIBOR.
This is a 3 year contract on a notional principal of $100 million.
Payment occurs every 6 months.
Microsoft: Pay 5% fixed rate, Receives LIBOR rate
Intel: Pay LIBOR rate, Receives 5% fixed rate

Andrew Chiu
Uses of Derivatives
1. Hedging
Transferring risk (ex: commodity producers and buyers)
2. Speculation
Betting on a view
3. Arbitrage
Capturing a risk-free profit
4. Diversification
Gain exposure to non-traditional assets (ex: weather)

Trade non-traditional views (ex: long volatility)


Andrew Chiu
Hedging Example
You are holding 400 shares of HSBC and are worried it
might fall. S=$60. The 1-month put option (X=$60)
costs $3.
You buy 1 put contract (400 puts) for $1200.
In one month, HSBCs price falls to $50.
Loss from stock = 400 x ($50-$60) = -$4000

Payoff from put option = 400 x $10 = $4000
Cost of put option = -$1200

Andrew Chiu
Profit of each HSBC share with

and without Hedging
40
Profit at Expiration
30
20
10
0
Without Hedging
-10
With Hedging
-20
-30
-40
30
40 50 60 70 80

110

Andrew Chiu
Speculation Example
You are bullish about HSBC and you have $24000 to
invest. Current price S=$60. The 1-month call option
(X=$60) costs $4. Compare 2 strategies:
A) You buy 400 shares of HSBC
B) You buy 15 call contracts (6000 calls since multiplier=400)
In one month, HSBCs price rises to $68
A) Profit = $3200, Return = $3200 / $24000 = 13.3%
B) Profit = 6000 x ($8 - $4), Ret = $24000/$24000 = 100%
Derivatives are highly levered !

Be careful, what if HSBC falls?

Andrew Chiu
Disasters Involving Derivatives

Barings
This 200-year-old British bank was destroyed in 1995 by the
activities of one trader, Nick Leeson, in Singapore, who made big
bets on the future direction of the Nikkei 225 using futures and
options. The total loss was close to $1 billion.
Socit Gnrale
Jrme Kerviel lost over $7 billion speculating on the future direction
of European equity indices using futures in January 2008.
Sumitomo
A single trader working for this Japanese company lost about $2
billion in the copper spot, futures, and options market in the 1990s.
More from Hulls textbook (chapter 35.1)


Andrew Chiu
Disasters Involving Derivatives

A typical pattern
1) A trader is assigned to do hedging or arbitrage trades. These
are relatively dull, whereas speculation is exciting.
2) As time goes by, the trader thinks he or she can outguess the
market.
3) Slowly the trader becomes a speculator.
4) When a loss is made, the trader doubles up the bets in a
desperate attempt to recover the losses.
(Prospect Theory, Kahneman and Tversky 1979)
5) Losses become bigger and bigger.


Andrew Chiu
Derivatives: Good or Bad?

Investing in derivatives is a double-edged sword.
It can bring down companies if used irresponsibly.
But the main culprit is greed, not the derivative.
We have been using derivatives for thousands of
years and it has served the needs of its users.


Andrew Chiu
Lessons to Learn
There should be strict risk limits, and traders need to be
closely monitored
Are they taking excessive risk? Too much leverage?
Are traders speculating when theyre not supposed to?
Keep risk managers separate from traders
Consider liquidity risk in stress tests
Reduce your position when too many people are following the
same strategy.
Make sure you fully understand the trades you are doing. If
you cant value the instrument, dont trade it!


Andrew Chiu

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Derivative Securities

Andrew Chiu, PhD

The Hong Kong University of

FINA 3203: Derivative Securities

The Hong Kong University of

FINA 3203: Derivative Securities

The Hong Kong University of

FINA 3203: Derivative Securities

The Hong Kong University of

FINA 3203: Derivative Securities

FINA 3203: Derivative Securities

Basic types: forwards, futures, options, swaps

The Hong Kong University of

FINA 3203: Derivative Securities

Forward & Futures

FINA 3203: Derivative Securities

The Hong Kong University of

FINA 3203: Derivative Securities

Stock purchased at $25

The Hong Kong University of

FINA 3203: Derivative Securities

Payoff of a Long Forward at Expiration

The Hong Kong University of

FINA 3203: Derivative Securities

Payoff of a Short Forward at Expiration

The Hong Kong University of

FINA 3203: Derivative Securities

FINA 3203: Derivative Securities

Payoff of a Long Call at Expiration

The Hong Kong University of

FINA 3203: Derivative Securities

Profit of a Long Call at Expiration

The Hong Kong University of

FINA 3203: Derivative Securities

Profit of a Short Call at Expiration

The Hong Kong University of

FINA 3203: Derivative Securities

Payoff of a Long Put at Expiration

The Hong Kong University of

FINA 3203: Derivative Securities

Profit of a Long Put at Expiration

The Hong Kong University of

FINA 3203: Derivative Securities

Profit of a Short Put at Expiration

The Hong Kong University of

FINA 3203: Derivative Securities

FINA 3203: Derivative Securities

Transferring risk (ex: commodity producers and buyers)

Capturing a risk-free profit

Gain exposure to non-traditional assets (ex: weather)

The Hong Kong University of

FINA 3203: Derivative Securities

Loss from stock = 400 x ($50-$60) = -$4000

FINA 3203: Derivative Securities

Profit of each HSBC share with

The Hong Kong University of

FINA 3203: Derivative Securities

Derivatives are highly levered !

FINA 3203: Derivative Securities

Disasters Involving Derivatives

The Hong Kong University of

FINA 3203: Derivative Securities

Disasters Involving Derivatives

The Hong Kong University of