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 over- the-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 Put Option Stock price +- Exercise price -+ Time to expiration ++ Interest rate +- Volatility of underlying stock price ++

Profits to Buyer of Call Option , ,500 2,000 2,500 3,000 (500) (1,000) Exercise Price = $70 Option Price = $6.125 Profit from Strategy Stock Price at Expiration

Profits to Seller of Call Option (1,000) (1,500) (2,000) (500) ,000 (2,500) (3,000) Exercise Price = $70 Option Price = $6.125 Stock Price at Expiration Profit from Strategy

Profits to Buyer of Put Option , ,500 2,000 2,500 3,000 (500) (1,000) Exercise Price = $70 Option Price = $2.25 Profit from Strategy Stock Price at Expiration

Profits to Seller of Put Option (1,000) (1,500) (2,000) (500) ,000 (2,500) (3,000) Exercise Price = $70 Option Price = $2.25 Stock Price at Expiration Profit from Strategy

The Relationship Between Forward and Option Contracts Put-call parity –Long in WYZ common at price of S 0 –Long in put option to deliver WYZ at X on T Purchase for P 0 –Short in call option to purchase WYZ at X on T Sell for C 0 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 portfolio’s 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

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End of Chapter 20 –An Introduction to Derivative Markets and Securities

Future topics Chapter 21 Forward and Futures Contracts