1. Day 2: Overview of option, forward, and futures markets Selected discussion from Chapter 2 (all) & Chapter 8 (pp. 252 – 265)

2. What are option contracts (“options”)? Definition: –Right (but not obligation) to buy or sell underlying asset. Most options are formal contracts –Every option has a “buyer” and a “seller.” –“It takes two to tango” but it takes at least two to create an option contract! –In some cases, “options” don’t have to involve formal contract (example, “real options”).

3. Basic option terminology Call –Right to buy underlying. Put –Right to sell underlying. Writer (of option) –Options do not magically appear. “Writer” = seller. Premium –How much does writer receive from buyer? Exercise price –What is the fixed price at which option buyer buys or sells underlying (if option is exercised)? Expiration –At what date does the option contract expire?

4. The basics of option payoffs Hockey stick diagrams –Call –Put –Writer of call –Writer of put More terminology: –At-the-money. –In-the-money. –Out-of-the-money

5. “Where” does option trading happen? Organized exchanges –Standardized contracts –See “Major Options Exchanges” (Table 2.1) in Chance & Brooks. –Example: Chicago Board Options Exchange (http://www.cboe.com)http://www.cboe.com Over-the-counter (OTC) –Privately negotiated options –Data sources (ISDA & BIS surveys) Why do the two venues coexist? –Users differ in their need for contract standardization. –Advantages to each venue.

6. Option quotes & order process CBOE example –Use “Quotes” link, then “Delayed Quotes Beta” link, then “Option Chains” link, then specify stock ticker. Market order –Implies “buy @ ask” or “sell @ bid.” Limit order –Specifies specific price at which to buy or sell. Stop order –Useful in preventing catastrophic loss if market makes sudden turn. Day order vs. good-till-canceled order

7. Margin: Another aspect of trading on options (or futures) exchanges Credit risk is a major distinction between OTC and exchange-traded options Exchanges address credit risk by requiring “margin” deposits from seller. –Exchange “clearinghouse” administers margin. –A lot of potential players in this process (see Figure 2.2 in Chance and Brooks).

8. Margin on writing options - Examples See Appendix 2.A in Chance and Brooks Initial margin –Minimum funds deposited on transaction date. Maintenance margin –Minimum funds required after transaction date. Contrast margin on stock transactions vs. option transactions –Stock: 50% initial, 25% maintenance. –Option purchases: 100% margin unless longer-term options. –Uncovered call written at-the-money or in-the-money: Premium + 20% of stock’s value. –Uncovered call written out-of-the-money: Premium + 20% of stock’s value – (amount by which call is out-of-the-money). –Maintenance margin on above uncovered call transactions = option market value (i.e., current premium) + 10% of stock’s value. –Same rules apply in reverse for uncovered written puts with maintenance margin = option market value + 10% of aggregate exercise price. Index stock options have lower margin requirements…why? Margin requirements are periodically changed depending on volatility of underlying asset!

9. Exiting an option transaction Placing an offsetting order –Buy, then sell (or sell, then buy). –Exchange-traded options are more conducive to engaging in offsetting trades than OTC options. Exercising an option –Buyer chooses if and when to exercise (writer has no say). –Physical settlement vs. cash settlement. –Realizing option’s “intrinsic value” (NOTE: this is NOT the same “intrinsic value” mentioned by stock market investors!)

10. What are the underlying assets on which options are traded? Individual stocks (most popular example) Stock indices Currencies, interest rates, and commodities (primarily OTC-traded) Credit quality Options on futures contracts (see Chapter 8 for some discussion) Real assets (“real options” will receive some discussion when we cover the binomial option valuation model)

11. Closing comments on “option basics” Don’t start packing your bags just yet, we’re just transitioning to a different discussion! Options are similar (but not exactly like) insurance contracts. –Risk managers can use options to provide payoffs when “bad” outcomes occur. –Outcome necessary to receive payoff is very well- defined for options (unlike insurance). –Options are almost always valuable!

12. Basics of forward and futures contracts Forward contract definition: –Agreement between 2 parties calling for delivery of an asset at a specified future date with a price fixed at contract signing. Futures contract definition: –Agreement in which 1 party agrees to sell an asset at a price fixed at contract inception, and another party agrees to buy the asset at the fixed price. What’s the basic difference? –Futures contract is standardized by the exchange, is traded on the exchange, and follows daily settlement (mark-to-market) process. Forward and futures contracts vs. option contracts –Unlike with options (because buyer has right but not obligation), forward and futures contracts are OBLIGATIONS to buy or sell. –Like options, buyers & sellers can offset earlier trades (more so if using futures contracts).

13. Futures exchanges Historically, non-profits, but evolving into for-profit, publicly-held corporations. Constantly looking for assets (or more esoteric underlyings) that could generate sufficient trading interest as futures. Many exchanges around the world, trading wide array of products. –See Table 8.1 “Exchanges on Which Futures Trade, November 2005” in Chance & Brooks.

14. Detailed examples of a couple of futures contracts New York Mercantile Exchange (NYMEX) –http://www.nymex.comhttp://www.nymex.com –Recently acquired by Chicago Mercantile Exchange (CME)…also owns Chicago Board of Trade (CBOT) Light, sweet crude oil #2 Heating oil

15. Light sweet crude oil Underlying asset: crude oil –See “Specifications” then “Deliverable Grades.” –Cushing, OK. Exchange –New York, NY @ New York Mercantile Exchange (include website) Contract size –1,000 US barrels (i.e., 42,000 US gallons) Tick size –$0.01 per barrel (i.e., $10 per contract) Price limits –$10 per barrel triggers 5-minute trading halts. –No daily limit Available delivery dates –See “Specifications” then “Trading Months.” Expiration date –3 rd business day prior to the 25 th calendar day of the month. Margin –See “Margins.” Trading volume & Open Interest –See “Previous Expanded Table.”

16. Heating oil Underlying asset: #2 fuel oil –See “Specifications” then “Deliverable Grades.” –New York Harbor. Exchange –New York, NY @ New York Mercantile Exchange (include website) Contract size –1,000 US barrels (i.e., 42,000 US gallons) Tick size –$0.0001 per gallon (i.e., $4.20 per contract) Price limits –$0.25 per gallon triggers 5-minute trading halts. –No daily limit Available delivery dates –36 consecutive months. Expiration date –Last business day of the month preceding the delivery month. Margin –See “Margins.” Trading volume & Open Interest –See “Previous Expanded Table.”

17. Who are the players in futures markets? Also applies to option markets. Commission brokers –Fee-based Hedgers (i.e., risk managers) –Use futures contracts to offset correlated business risk. Speculators –Scalpers (similar to floor brokers) –Day traders –Position traders Spread traders –Could be a hedger or arbitrage trader Arbitrage traders –Might often be hedge funds

18. Next class Transacting in futures contracts –Chapter 8 (pp. 265 – 279). Basic principles of pricing and valuing forward and futures contracts –Beginning of Chapter 9 (pp. 284 – 292).