Chapter 14 - An Introduction to Derivative Markets and Securities

What are equity collars?

an option-based hedging strategy that protects a stock position from price declines by purchasing a put option that is paid for the sale of a call option.

What are two ways in which an equity investor can use derivatives to protect himself against general declines in the stock market?

1. Shorting an equity index forward contract 2. Buying an equity index "collar" agreement

Options differ from forward contracts in what two fundamental ways?

1. The expense of purchasing either a put or call represeents a sunk cost to the investor, reducing the upside return relative to the comparable forward position 2. The investor receives expiration date payoffs that are decidedly asymmetric

What are the two parts of a forward contract?

1. The settlement date agreed to in the contract is purposefully set to be in the future. 2. the contract price - which is FoT, is usually different from the prevailing spot price

Derivative underlying assets have what in common?

1. Volatile price movements 2. Strong interest from buyers and sellers

The option premium can be divided into what two components?

1. intrinsic value 2. time premium

What is an important relationship in this?

Because the buyer of a call opton is never obligated to exercise, the contract should always be worth at least its instrinsic value

What is the last one?

Because they provide investors with more choices, American-style options are at least as valuable as otherwise comparable European-style contracts.

What is the time premium equation for the call option?

CoT - max(0, So - x)

What is arbitrage?

Created if two otherwise identical series of cash flows do not carry the same current price

What is the second relationship?

For call options having the same maturity and the same underlying asset, the lower the exercise price, the higher the contract's intrinsic value and the greater the premium.

What does this mean for forward contracts?

Forward contracts are zero-sum games because the long position gains must be paid by the short position and vice versa.

What kind of risk stems from this?

Forward contracts involve credit risk, which is one reason why banks are often market makers in these instruments.

What is a caveat to this?

Given an intital premium of CoT, the position does not generate a positive profit until St is greater than X by the amount of premium paid.

Where are forward contracts negotiated?

In the over-the-counter market, meaning that forward contracts are agreements between two private parties.

What is the third one?

Increasing the amount of time until any option expires will increase the contract's time premium/

What does a forward contract give its holder?

It gives its holder both the right and the obligation to conduct a transaction involving another security or commodity - the underlying asset - at a predetermined price.

The buyer of the call option is subject to what?

It has unlimited gain potential as the underlying security price could rise indefinitely but his losses are limited to the option premium.

What is a disadvantage of a forward contract?

It is often quite illiquid, meaning that it might be difficult for a counterparty to exit the contract before it matures.

The obligation in this sense is what?

It is one sided - buyers do as they please, but sellers are obligated to the buyers under the terms of the agreement.

What is the intrinsic value?

It represents the value that the buyer could extract from the option if she exercised it immediately.

What does the put-call parity equation suggest?

It suggests we can create a synthetic t-bill by purchasing the stock, purchasing the put, and selling the call

What happens when exchange traded?

Just the seller of the contract is required to post a margin account because he is the only one obligated to perform on the contract at a later date.

What is the put-call parity equation?

Long stock + long put + short call = long t bill

Option buyers have what?

Option buyers - whether a put or a call - always have limited liability since they do not have to exercise an out-of-the-money position.

Option sellers have what?

Option sellers have limited gain potential but considerable - infinite, for short call positions - loss potential

What is a put option?

Options to sell a security within a certain period at a specified price.

What about for a put option?

PoT - max(0 - x - So)

How can a short t bill be formed?

Short stock + short put + long call

Put it into terms:

So + PoT - CoT = (X / (1 + RFR)^-T))

They depend on what assumption?

That financial markets are free from arbitrage opportunities, meaning that securities offering identical payoffs with identical risks must sell for the same current price.

What is the long position in a forward contract?

The buyer of a commodity or security or, for a forward contract, the counterparty who will be the eventual buyer of the underlying asset.

The buyer of a contract receives a payoff when what happens?

The buyer of the contract receives a payoff whenever the terminal security price exceeds the contract exercise price of X.

What does a futures contract require?

The contract requires both counterparties to post collateral, or margin, to protect itself against the possibility of default.

Why does an option have a premium, but a forward contract does not?

The forward contract allows both the long and the short positions to win at Date T, but the option agreement will only be exercised in the buyer's favor. Therefore, the seller must be compensated.

What is the difference between engaging in a forward contract and buying a call option?

The forward position requires no initial payment or receipt by either party to the transaction, whereas the call buyer must pay a cash premium to the seller of the option.

What is the expiration date?

The future date on which the transaction is to be consummated.

When will an investor realize a net profit?

The investor will not realize a net profit until the September index level rises above the exercise price plus the call premium

What is something to note about the payoffs to both long and short positions in the forward contract?

They are symmetric, or two-sided around the contract price. This is a direct result of each party being fully obligated to complete the agreed-upon transaction, even at a financial loss.

How are options traded?

They trade both in over-the-counter markets and on exchanges.

What is different about these?

They trade on a centralized market, called a futures exchange.

A manager requires a hedge position that does what?

They want a hedge position that are negatively correlated with the existing exposure

What does put-call parity demonstrate?

This demonstrates that a risk-free portfolio could be created by combining three risky securities: stock, a put option, and a call opton

When does the long position benefit?

When the bond prices rise, whereas the short position will gain from falling bond prices.

What is the time premium?

the difference between an option's total market value and its intrinsic value

What does it mean for an option to be out of the money?

An option that has no intrinsic value.

What does it mean for an option to be in the money?

An option that has positive intrinsic value.

What is a call option?

An option to buy an asset within a certain period at a specified price called the exercise price.

The values of what five securities can be linked?

1. A risk-free bond 2. An underlying asset 3. A forward contract 4. A call option 5. A put option

What are the two basic types of derivatives?

1. Forward and futures contracts 2. Option contracts

What are the six types of derivatives?

1. Long Position in Forward/futures contracts 2. Short position in forward/futures contracts 3. Long position in calls 4. Short position in calls 5. Long position in puts 6. Short position in puts

What are European options?

An option contract that can only be exercised on its expiration date.

What are protective puts?

A trading strategy in which a put option is purchased as a supplement to a long position in an underlying asset or portfolio of assets

What is a forward contract?

An agreement between two counterparties that requires the exchange of a commodity or security at a fixed price in the future at a predetermined price.

What is an option contract?

An agreement that grants the owner the right, but not the obligation, to make a future transaction in an underlying commodity or security at a fixed price and within a predetermined time in the future

What are futures contracts?

An agreement that provides for the future exchange of a particular asset at a specified delivery date in exchange for a specified payment at the time of delivery.

What does it mean to hedge?

An approach to maintain current stock holdings but convert them into a synthetic risk-free position using a contract with a specific amount of hte stock index as the underlying asset

What is an American option?

An option contract that can be exercised at any time until its expiraton date.

What is open interest?

The number of oustanding contracts

What is trading volume?

The number of those contracts that changed hands that day.

What is a hedge position?

The price risk of the underlying asset is offset by a supplementary derivative transaction.

What is the exercise price?

The price the call buyer will pay to - or the put buyer will receive from - the option seller if the option is exercised.

What is the real key to understanding how and why derivatives are used?

The real key lies in a derivative's ability to modify the risk and expected return characteristics of existing investment portfolios.

What is put-call parity?

The relationship that must exist in an efficeint market between the prices for put and call options having the same underlying asset, exercise price, and expiration date.

What is the short position?

The seller of a commodity or security or, for a forward contract, the counterparty who will be the eventual seller of the underlying asset, who delivers the asset for the fixed price.

The short forward position can lose what?

The short forward position has the potential for unlimited loss, while the long forward position has the potential for unlimited gain.

What is the benefit to a private arrangement?

The terms of the contract are completely flexible; they can be whatever any two mutually consenting counterparties agree to.

What is the contract price?

The transaction price specified in a forward or futures contract.

What does this reinforce?

it reinforces the fundamental financial tenet that long positions benefit from rising prices while short positions benefit form falling prices.

For a call, what is this intrinsic value?

max[0, So - X]

What about for a put?

max[0, x - So]

What are derivative securities?

one for which the ultimate payoff to the investor depends directly on the value of another security or commodity

What is a key point about put and call options?

put and call options magnify the possible positive and negative returns of investing in the underlying security.

What is the option premium?

the initial price that the option buyer must pay to the option seller to acquire the contract.

What is the payoff to the long position in a bond forward if the spot price is $1,050 and the forward price is $1,000?

the long position will make $50, because the forward price is less than the spot price

What happens to the short position?

the short position must deliver the bond at date T and will lose $50.

What is another desirable feature?

these arrangements may not require collateral. The long and short positions sometimes trust each other.

What do options and futures allow?

they allow investors to hedge (or even increase) the risk of a collection of stocks in ways that go far beyond diversification.

Where are these margin accounts held?

they are held by the exchange's clearinghouse and are marked to market on a daily basis to ensure both end users always maintain sufficient collateral