Professional Documents
Culture Documents
Introduction to Derivative
Financial Derivatives
Options
Suppose that the spot price of gold is $1000 per ounce and the risk-free interest rate for investments lasting one year is 5% per annum. What is a reasonable value for the one-year forward price of gold? Suppose first that the one-year forward price is $1300 per ounce. A trader can immediately take the following actions: 1. Borrow $1000 at 5% for one year. 2. Buy one ounce of gold. 3. Enter into a short forward contract to sell the gold for $1300 in one year The trader earns a riskless profit of?
The trader pays a total price for one ounce of gold = 1000 + (1000x5% interest) = $1050
The trader sell the gold for Rs. 1300 His riskless profit is = 1300-1050 = $250
The example shows that $1300 was too high a forward price
F Soe
rT
Example
Consider a four-month forward contract to buy a zero-coupon bond that will mature one year from today. The current price of the bond is Rs.930. (This means that the bond will have eight months to go when the forward contract matures.) Assume that the rate of interest (continuously compounded) is 6% per annum. T = 4/12 = .333 r = 0.06, and So = 930. The forward price,
rT
F Soe
930 e
.06*.333
948 .79
Since the forward contract holder does not receive dividend/interest on the underlying asset, but the present price So reflects the future income from the asset, the present value of dividends/interest should be deducted from So while calculating Forward price
F ( S o l )e
rT
Example
Consider a 10-month forward contract on Nishat Mills Ltd (NML) stock with a price of Rs.50. Assume that the risk-free rate of interest (continuously compounded) is 8% per annum for all maturities. Also assume that dividends of is 0.75 per share are expected after three months, six months, and nine months. The present value of the dividends
0.75e
0.08*3 /12
0.75e
0.08*6 /12
0.75e
0.08*9 /12
2.162
Example continued..
F ( S o l )e
rT 0.08*10 / 12
F (50 2.162)e
Rs.51.14
F ( S o U )e rT
Example
Consider a one-year futures contract on gold. Suppose that it costs $2 per ounce per year to store gold, with the payment being made at the end of the year. Assume that the spot price is $450 and the risk-free rate is 7% per annum for all maturities. This corresponds to r = 0.07, and S0 = 450, T=1
U 2e
0.07*1
1.865
Example continued..
F ( So U )e rT F (450 1.865)e0.07*1 484.63
If an asset pays income that can be expressed as a present yield on per annum continuous basis, the forward price of the asset can be determined as,
q = average yield per annum the asset underlying the forward contract Consider a six month forward contract on an asset that is expected to provide a yield of 3.96% p.a. with continuous compounding. Then price of a six month contract is????
F S o e ( r q )T
Example
A long forward contract on a non-dividendpaying stock was entered into some time ago. It currently has 6 months to maturity. The risk-free rate of interest (with continuous compounding) is 10% per annum, the stock price is $25, and the delivery price is $24. In this case,. So= 25, r = 0.10, T = 0.5, and K = 24. From the 6-month forward price, Fo, is given by
Pricing an option
Pricing an option means finding the amount that you pay to have the right/option Or pricing an option is finding the fair value of the agreement fair means the value that precludes any arbitrage opportunity Lets use an example to find the value of call option at expiration
Intrinsic Values
If a call is in the money, it will have positive intrinsic value. Intrinsic value is equal to the difference between current price and exercise price Example: FFC current price is Rs.65, a call option on FFC is Rs.60, the option is in the money IV = 65-60 = 5
Black-Schole model uses the five variables to value non-dividend paying call option
S = Current stock price E = Exercise price of call r = Annual risk-free rate of return, continually compounded 2 =Variance (per year) of the continuous return on the stock t = Time (in years) to expiration date
1. Exercise Price
An increase in the exercise price reduces the value of the call In the previous example, if exercise price was 32 instead of 30, the value of the call option will be 35 32 = 3 instead of 5
maturity, the higher will be the premium of both call and put option The reason is that the option holder has more time to exercise the option The extra time increases the probability of profit for option holder and loss for option writer
Stock Price: Other things being equal, the higher the stock price, the more valuable the call option will be. In our earlier example, if current market price of PTCL share was Rs. 40, then option value would have been 40 30 = 10 in stead of 5 If S>E -------high profit if call option is exercised-------high premium for call options If S>E------- loss if put option is exercised-----low premium for put options
The Interest Rate Call prices are also a function of the level of interest rates. Buyers of calls do not pay the exercise price until they exercise the option. The ability to delay payment is more valuable when interest rates are high and less valuable when interest rates are low. Thus, the value of a call is positively related to interest rates.
In future contracts money is needed on daily basis for marking to market the contract whereas in options money is only needed when the option is exercised Profits from the future contracts are linear whereas profits from the option contracts are non linear