2Short-SellingExample: Suppose you short-sell 100 IBM shares for $90 a share. After 90 days, you close your position at a time in which as share costs $92. If you pay a lease fee of $0.50 per share, what is your return over the 90 day period?
3Transactions Costs Buying and selling a financial asset Brokers: commissionsMarket-makers: bid-ask (offer) spreadExample: Buy and sell 100 shares of XYZXYZ: bid = $49.75, offer = $50, commission = $15
4Forward ContractsDefinition: a binding agreement (obligation) to buy/sell an underlying asset in the future, at a price set todayFutures contracts are the same as forwards in principle except for some institutional and pricing differences.A forward contract specifiesThe features and quantity of the asset to be deliveredThe delivery logistics, such as time, date, and placeThe price the buyer will pay at the time of delivery
5Payoff on a Forward Contract Payoff for a contract is its value at expirationPayoff forLong forward = Spot price at expiration – Forward priceShort forward = Forward price – Spot price at expirationExample 2.1: S&R (special and rich) index:Today: Spot price = $1,000, 6-month forward price = $1,020In six months at contract expiration: Spot price = $1,050Long position payoff = $1,050 – $1,020 = $30Short position payoff = $1,020 – $1,050 = ($30)
6Long Position of Crude Oil March 2009 Contract Spot Crude January, 2009: $73Future March, 2009: $75Payoff at expirationCrude price at expiration$75-$75
7Short Position of Crude Oil March 2009 Contract Spot Crude January, 2009: $73Future March, 2009: $75Payoff at expirationCrude price at expiration$75-$75
8Additional Considerations Type of settlementCash settlement: less costly and more practicalPhysical delivery: often avoided due to significant costsCredit risk of the counter partyMajor issue for over-the-counter contractsCredit check, collateral, bank letter of creditLess severe for exchange-traded contractsExchange guarantees transactions, requires collateral
10Payoff Diagram for Forwards Long and short forward positions on the S&R 500 indexFigure 2.2 Long and short forward positions on the S&R 500 index.
11Table 2.1 Payoff after 6 months from a long S&R forward contract and a short S&R forward contract at a forward price of $1020. If the index price in 6 months is $1020, both the long and short have a 0 payoff. If the index price is greater than $1020, the long makes money and the short loses money. If the index price is less than $1020, the long loses money and the short makes money.
12Forward Versus Outright Purchase Figure 2.3 Comparison of payoff after 6 months of a long position in the S&R index versus a forward contract in the S&R index.Forward payoffBond payoffForward + bond = Spot price at expiration – $1,020 + $1, = Spot price at expiration
13Figure 2.4 Payoff diagram for a long S&R forward contract, together with a zero-coupon bond that pays $1020 at maturity. Summing the value of the long forward plus the bond at each S&R index price gives the line labeled “Forward + bond.”
14Call OptionsA non-binding agreement (right but not an obligation) to buy an asset in the future, at a price set todayPreserves the upside potential, while at the same time eliminating the unpleasant downside (for the buyer)The seller of a call option is obligated to deliver if asked
15Examples Example 2.3: S&R index Example 2.4: S&R index Today: call buyer acquires the right to pay $1,020 in six months for the index, but is not obligated to do soIn six months at contract expiration: if spot price is$1,100, call buyer’s payoff = $1,100 – $1,020 = $80$900, call buyer walks away, buyer’s payoff = $0Example 2.4: S&R indexToday: call seller is obligated to sell the index for $1,020 in six months, if asked to do so$1,100, call seller’s payoff = $1,020 – $1,100 = ($80)$900, call buyer walks away, seller’s payoff = $0Why would anyone agree to be on the seller side?
16Definition and Terminology A call option gives the owner the right but not the obligation to buy the underlying asset at a predetermined price during a predetermined time periodStrike (or exercise) price: the amount paid by the option buyer for the asset if he/she decides to exerciseExercise: the act of paying the strike price to buy the assetExpiration: the date by which the option must be exercised or become worthlessExercise style: specifies when the option can be exercisedEuropean-style: can be exercised only at expiration dateAmerican-style: can be exercised at any time before expirationBermudan-style: Can be exercised during specified periodsPremium – the cost of the option to the option buyer.Settlement type - either money settlement or delivery of good.
18Table 2.2 Closing prices, daily volume, and open interest for S&P 500 options, listed on the Chicago Board Options Exchange, on August 14, The S&P 500 index closed that day at
19Payoff/Profit of a Purchased Call Payoff = Max [0, spot price at expiration – strike price]Profit = Payoff – future value of option premiumExamples 2.5 & 2.6:S&R Index 6-month Call OptionStrike price = $1,000, Premium = $93.81, 6-month risk-free rate = 2%If index value in six months = $1100Payoff = max [0, $1,100 – $1,000] = $100Profit = $100 – ($93.81 x 1.02) = $4.32If index value in six months = $900Payoff = max [0, $900 – $1,000] = $0Profit = $0 – ($93.81 x 1.02) = – $95.68
20Diagrams for Purchased Call Payoff at expirationProfit at expirationFigure 2.5 The payoff at expiration ofa purchased S&R call with a $1000 strike price.Figure 2.6 Profit at expiration for purchase of 6-month S&R index call with strike price of $1000 versus profit on long S&R index forward position.
21Table 2. 3 Payoff and profit after 6 months from a purchased 1 Table 2.3 Payoff and profit after 6 months from a purchased strike S&R call option with a future value of premium of $ The option premium is assumed to be $93.81 and the effective interest rate is 2% over 6 months. The payoff is computed using equation (2.3) and the profit using equation (2.4).
22Payoff/Profit of a Written Call Payoff = – max [0, spot price at expiration – strike price]Profit = Payoff + future value of option premiumExample 2.7S&R Index 6-month Call OptionStrike price = $1,000, Premium = $93.81, 6-month risk-free rate = 2%If index value in six months = $1100Payoff = – max [0, $1,100 – $1,000] = – $100Profit = – $100 + ($93.81 x 1.02) = – $4.32If index value in six months = $900Payoff = – max [0, $900 – $1,000] = $0Profit = $0 + ($93.81 x 1.02) = $95.68
23Figure 2.7 Profit for writer of 6-month S&R call with strike of $1000 versus profit for short S&R forward.
24Put OptionsA put option gives the owner the right but not the obligation to sell the underlying asset at a predetermined price during a predetermined time periodThe seller of a put option is obligated to buy if askedPayoff/profit of a purchased (i.e., long) putPayoff = max [0, strike price – spot price at expiration]Profit = Payoff – future value of option premiumPayoff/profit of a written (i.e., short) putPayoff = – max [0, strike price – spot price at expiration]Profit = Payoff + future value of option premium
26Put Option Examples Examples 2.9 & 2.10 S&R Index 6-month Put Option Strike price = $1,000, Premium = $74.20, 6-month risk-free rate = 2%If index value in six months = $1100Payoff = max [0, $1,000 – $1,100] = $0Profit = $0 – ($74.20 x 1.02) = – $75.68If index value in six months = $900Payoff = max [0, $1,000 – $900] = $100Profit = $100 – ($74.20 x 1.02) = $24.32
27Figure 2.8 Profit on a purchased S&R index put with strike price of $1000 versus a short S&R index forward.
28Profit for a Long Put Position Profit tableTable 2.4 Profit after 6 months from a purchased 1000-strike S&R put option with a future value of premium of $75.68.
29Figure 2.9 Written S&R index put option with strike of $1000 versus a long S&R index forward contract.
30Figure Profit diagrams for the three basic long positions: long forward, purchased call, and written put.
31Figure Profit diagrams for the three basic short positions: short forward, written call, and purchased put.
32Uses of DerivativesThe two most common cited reason for the use of derivativesRisk management - HedgingSpeculation – Leveraging
33Using Options to Enhance Risk (Speculation) The price of an IBM is $100, a three month option of IBM with an exercise price of $100 (a naïve value of zero) costs $10. If you have $100 to invest, compare the payoff of buying a share of IBM compared to the purchase of 10 options.
34Options and Insurance Homeowner’s insurance as a put option Figure Profit from insurancepolicy on a $200,000house.
35Table 2.6 Forwards, calls, and puts at a glance: a summary of forward and option positions.
36Option and Forward Positions: A Summary Figure The basic profit diagrams:long and short forward, long and short call, and long and short put.
376. Bond Cash Flows, Prices, and Yields TerminologyBond certificateMaturity date, termCouponFace value (principal, par value)Coupon rateZero-coupon bond - Treasury billsTraded at discount (premium), pure discount bondsYield to maturity (YTM)
38Yields for Different Maturities The following table summarizes prices of various default-free zero-coupon bonds (expressed as a percentage of face value):Maturity (years)12345Price (per $100 face value)95.5191.0586.3881.6576.51Compute the yield to maturity for each bond.Plot the zero-coupon yield curve.Is the yield curve upward sloping/downward sloping or flat?
39Computing forward rates A forward interest rate (or forward) rate is an interest rate that we can guarantee today for a loan or investment that will occur in the future.Using the prices below of the 1-3 years default-free zero-coupon bonds, find f1,1 f2,1 f1,2. Notation is fstart,lengthMaturity (years)123Price (per $100 face value)95.5191.0586.38YTM4.70%4.80%5.00%Calculate the forward rates for years 1-3.
40Yields for Different Maturities Solve using the prices below of the various default-free zero-coupon bonds,Maturity (years)12Price (per $100 face value)95.5191.05YTM4.70%4.80%You need to borrow $1000 a year from now for a period of one year. How can you secure a fixed borrowing rate for the loan and what will the borrowing rate be?
42The Yield Curve and Bond Arbitrage Assume zero-coupon yields on default-free securities are as summarized in the following table:Maturity12345Zero coupon YTM4.00%4.30%4.50%4.70%4.80%Consider a five-year, default-free security with annual coupon payments of 5% and a face value of $1000.Without doing any calculation, determine whether this bond is trading at a premium or at a discount. Explain.What is the YTM on this bond?If the YTM on this bond increased to 5.2%, what would the new price be?
43Figure 8.3 Corporate Yield Curves for Various Ratings, February 2009 Source: Reuters