Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Eighth Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 20

Chapter 20 - An Introduction to
Derivative Markets and Securities
Questions to be answered:
What distinguishes a derivative security such as a
forward, futures, or option contract, from more
fundamental securities, such as stocks and bonds?
What are the important characteristics of forward,
futures, and option contracts, and in what sense can
the be interpreted as insurance policies?

Chapter 20 - An Introduction to
Derivative Markets and Securities
How are the markets for derivative securities
organized and how do they differ from other
security markets?
What terminology is used to describe transactions
that involve forward, futures, and option contracts?
How are prices for derivative securities quoted and
how should this information be interpreted?

Chapter 20 - An Introduction to
Derivative Markets and Securities
What are similarities and differences between
forward and futures contracts?
What do the payoff diagrams look like for
investments in forward and futures contracts?
What do the payoff diagrams look like for
investments in put and call option contracts?
How are forward contracts, put options, and call
options related to one another?

Chapter 20 - An Introduction to
Derivative Markets and Securities
How can derivatives be used in conjunction with
stock and Treasury bills to replicate the payoffs to
other securities and create arbitrage opportunities
for an investor?
How can derivative contracts be used to restructure
cash flow patterns and modify the risk in existing
investment portfolios?

An Overview of Derivatives
Value is depends directly on, or is derived from, the
value of another security or commodity, called the
underlying asset
Forward and Futures contracts are agreements
between two parties - the buyer agrees to purchase
an asset from the seller at a specific date at a price
agreed to now
Options offer the buyer the right without obligation
to buy or sell at a fixed price up to or on a specific
date

Why Do Derivatives Exist?

Assets are traded in the cash or spot market
It is sometimes advantageous enter into a
transaction now with the exchange of asset
and payment at a future time
Risk shifting
Price formation
Investment cost reduction

The Language and Structure of

Forward and Futures Markets
Forward contracts are the right and full
obligation to conduct a transaction involving
another security or commodity - the underlying
asset - at a predetermined date (maturity date)
and at a predetermined price (contract price)
This is a trade agreement

Futures contracts are similar, but subject to a

daily settling-up process

Forward Contracts
Buyer is long, seller is short
Contracts are OTC, have negotiable
terms, and are not liquid
Subject to credit risk or default risk
No payments until expiration
Agreement may be illiquid

Futures Contracts

Standardized terms
Central market (futures exchange)
More liquidity
Less liquidity risk - initial margin
Settlement price - daily marking to market

Options
The Language and Structure of Options
Markets
An option contract gives the holder the right-but
not the obligation-to conduct a transaction
involving an underlying security or commodity
at a predetermined future date and at a
predetermined price

Options
Buyer has the long position in the contract
Seller (writer) has the short position in the
contract
Buyer and seller are counterparties in the
transaction

Options
Option Contract Terms
The exercise price is the price the call buyer will pay
to-or the put buyer will receive from-the option seller
if the option is exercised

Option Valuation Basics

Intrinsic value represents the value that the buyer
could extract from the option if he or she she
exercised it immediately
The time premium component is simply the difference
between the whole option premium and the intrinsic
component

Option Trading Markets-options trade both in overthe-counter markets and on exchanges

Options

Option to buy is a call option

Option to sell is a put option
Option premium - paid for the option
Exercise price or strike price - price agreed
for purchase or sale
Expiration date
European options
American options

Options
At the money:
stock price equals exercise price

In-the-money
option has intrinsic value

Out-of-the-money
option has no intrinsic value

Investing With Derivative Securities

Call option
requires up front payment
allows but does not require future settlement
payment

Forward contract
does not require front-end payment
requires future settlement payment

Options Pricing Relationships

Factor

Call Option
Stock price
+
Exercise price
Time to expiration
+
Interest rate
+
Volatility of underlying stock price +

Put Option
+
+
+

Profits to Buyer of Call Option

3,000

Profit from Strategy

2,500

Exercise Price = $70

2,000

Option Price

= $6.125

1,500
1,000
500
0
(500)
(1,000)
40

Stock Price at
Expiration

50

60

70

80

90

100

Profits to Seller of Call Option

1,000

Profit from Strategy

Exercise Price = $70

500

Option Price

= $6.125

(500)
(1,000)
(1,500)
(2,000)
(2,500)
(3,000)
40

Stock Price at
Expiration

50

60

70

80

90

100

Profits to Buyer of Put Option

3,000

Profit from Strategy

2,500
2,000

Exercise Price = $70

1,500

Option Price

1,000

= $2.25

500
0
Stock Price at
Expiration

(500)
(1,000)
40

50

60

70

80

90

100

Profits to Seller of Put Option

1,000

Profit from Strategy

500
0
Exercise Price = $70

(500)

Option Price

(1,000)

= $2.25

(1,500)
(2,000)
(2,500)
(3,000)
40

Stock Price at
Expiration

50

60

70

80

90

100

The Relationship Between

Forward and Option Contracts
Put-call parity
Long in WYZ common at price of S0
Long in put option to deliver WYZ at X on T
Purchase for P0

Short in call option to purchase WYZ at X on T

Sell for C0

Net position is guaranteed contract (risk-free)

Since the risk-free rate equals the T-bill rate:
(long stock)+(long put)+(short call)=(long T-bill)

Creating Synthetic Securities

Using Put-Call Parity
Risk-free portfolio could be created using three
risky securities:
stock,
a put option,
and a call option

With Treasury-bill as the fourth security, any

one of the four may be replaced with
combinations of the other three

Adjusting Put-Call Spot Parity

For Dividends
The owners of derivative instruments do not
participate directly in payment of dividends to
holders of the underlying stock
If the dividend amounts and payment dates are
known when puts and calls are written those are
adjusted into the option prices
(long stock) + (long put) + (short call) = (long T-bill) +
(long present value of dividends)

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

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

An Introduction To The Use Of

Derivatives In Portfolio Management
Restructuring asset portfolios with forward
contracts
shorting forward contracts
tactical asset allocation to time general market
movements instead of company-specific trends
hedge position with payoffs that are negatively
correlated with existing exposure
converts beta of stock to zero, making a synthetic
T-bill, affecting portfolio beta

An Introduction To The Use Of Derivatives In

Portfolio Management
Restructuring Asset Portfolios with Forward Contracts
Based on the belief that it is possible to take advantage of
perceived trends at a macroeconomic level by switching funds
between current equity holding and other portfolios mimicking
different asset classes
Switching a portfolios composition in an attempt to time general
market movements instead of company-specific trends is known as
tactical asset allocation.
Protecting portfolio value with put options
purchasing protective puts

keep from committing to sell if price rises

asymmetric hedge
portfolio insurance
Either
hold the shares and purchase a put option, or
sell the shares and buy a T-bill and a call option

The Internet
Investments Online
http://www.cboe.com
http://www.cbot.com
http://www.cme.com
http://www.onechicago.com
http://www.euronext.com
http://www.schaeffersresearch.com
http://www.eurexus.com
http://www.iseoptions.com

End of Chapter 20
An Introduction to
Derivative Markets
and Securities

Future topics
Chapter 21
Forward and Futures Contracts