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IntroductionChapter 1
1
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008
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Coverage
Payoff in futures contracts
Payoff in options contracts
Hedging with futures and options
Speculation with futures and options Arbitrage and the law of one price
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 2
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Indian Shipping Decided to buy 10 DB ships (Cap budgeting decision made!) Price agreed upon viz. $600 mil Timeline for payment
◦ No upfront payment $600mil 12-month later
Financing decision can be made now or in future
◦ USD price movement creating price risk till Dec-2014
◦ Future FCFF (2015 - ) decide the timing and amount of Debt CF ISL can have INR debt for 10 years or more at about 11% p.a.
ISL can have $debt – floating rate (IR risk and price risk) or fixed rate
Whether to hedge or not is a different issue altogether!
How to hedge is the issue to be discussed! (time, instrument)
◦ Do nothing (Don’t manage the currency risk) – a base case◦ Some or all with forward contracts LOCK INTO PRICE
◦ Some or all with options contracts BUY INSURANCE
◦ Money market hedge (using USD deposits and INR loans)
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Layman’s view
BS on 26-Dec-2014
1. Risk can create problem of managing debt in future, if it arises
2. No price risk (transformed into a counterparty risk)
3. Gives best of both worlds (premium and interest on it has to be capitalized)
4. Mimics choice FORWARDS but costlier than FORWARDS (scope for arb!)
** premium capitalized is 60 * 2.50 * 1.09 = 13.50 + 150 = 163.50 crores
St = 56 St = 68 St = 56 St = 68
Loan in Dec-14 3,360 4,080 10 DB Ships 3,360 4,080
Loan in Dec-14 3,840 3,840 10 DB Ships 3,840 3,840
Loan in Dec-14 3,360 3,840 10 DB Ships 3,360 3,840
Loan in Dec-14 4,007 4,007 10 DB Ships 4,007 4,007
Do nothing
FORWARDS
OPTIONS
Money mkt.
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Terminology of futures contract
Underlying
Delivery price (Forward price)◦ The price that would make the contract worth exactly zero)
◦ This may be different for contracts of different maturities
Spot price
Trade date
Delivery date
Delivery instructions
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 5
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ISL in forward contract with HDFC
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 6
26-Dec-’13 26-Dec-’14
Negotiates qty, price,delivery instruction
ISL pays Rs.3,840 croreHDFC pays $600 mil
$ is the underlying asset
Delivery price today = 62;
Delivery price on 26-Dec-14 = 64
A contract got created but not a security!
ISL is holding LONG POSITION
RIGHT to receive $600M OBLIGATION to pay 3,840cr
HDFC has assumed the SHORT POSITION
RIGHT to receive 3,840cr OBLIGATION to pay $600M
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 7
Terminology
The LONG (a party!) receives UA
The SHORT (the other party)
delivers the UA
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Contracts with USD as underlying
Forward contracts
Futures contracts
Options contracts
Interest rate swap contracts Currency swap contracts
Others
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 8
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Other classes of derivatives
Credit derivatives
Electricity derivatives
Weather derivatives
Insurance derivatives
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 9
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Other classes of traded assets
Commodities
Equity stocks and indices
Interest rate products (Bonds!)
Energy and other underlyings
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 10
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Users of Derivatives
Banks and Financial Institutions
Fund managers (Asset management cos.)
Treasurers of manufacturing and service
companies
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 11
Any one who works in finance needs to understand how derivativeswork, how they are used, and how they are priced.
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 12
Ways Derivatives are Used
To hedge risks (to lock into price)
To speculate (take a view on the futuredirection of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment
without incurring the costs of selling oneportfolio and buying another
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Ways Derivatives are Used
To embed into securities to alter their payoffs (anapplication in corporate finance!)
◦ Convertible securities
Management compensation contracts with variablepay linked to the market
◦ ESOPs
Embedded in capital investment opportunities
◦ Option to expand
◦ Option to delay
◦ Option to abandon
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 13
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Markets and their structure
The securities and financial institutions cameinto existence as natural responses of investor
needsThese markets evolve to meet investor
needs.
This is HOW markets evolved over time!
◦ Direct search markets
◦ Brokered market
◦ Dealer market
◦ Auction market
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Direct search markets
Least organized◦ Buyers and sellers must seek each other out
directly. (Sale of used refrigerator )
Sporadic participation of players
◦ Trades does not get reported
Non-standard and low-priced goods
No one seeks to specialize in these goods
◦ Not worth the efforts and time involved
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Brokered Market
Least organized! Populated by brokers. Sufficient liquidity viz. trading in goods (market) is
sufficiently active
Economies of scale in searches makes it worthwhile
to pay to the broker to conduct searches◦ Seeks out customers and maintain the database of needs
◦ Profits are worth the efforts and time involved
◦ Offers the search services for a fee!
◦ Doesn’t maintain any inventory
◦ Keeps track of prices at which trades had taken place◦ Brokers develop specialized knowledge.
Examples are real estate market, IPO market, blocktransactions in secondary market.
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Dealer market (OTC market)
When trading activity in a particular type ofasset increases, Dealer markets arise. ◦ Sufficiently well-organized
◦ Many brokers transform into dealers to encash theirspecialized knowledge
Every dealer specializes in various assets◦ Assets are predominantly standardized
◦ Dealers bring in capital to maintain an inventory of assets
Purchases assets for their own inventory and selling
them for a margin Bid-ask spread is the profit margin.
Investors participate in this market because◦ saves the search costs and transaction costs
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Auction market
Very well organized (most integrated)◦ Populated with brokers and dealers
◦ Highly standardized assets
◦
Transactions converge at one place◦ One need not search to find the best price
Best offer price and best quote price are known
Market is deep and thin bid-ask spreads
If all participants converge, they can arrive at mutually
agreeable prices saves bid-ask spread.
Continuous vs. Periodic auction markets
◦ 09.00 AM – 09.15 AM (periodic)
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Continuous auction markets
Requires huge investment to set up thesystems for electronic trading
◦ Requires very heavy and frequent trading tocover the expense of maintaining the market
◦ Listing requirements is set to ensure above
◦ Separate section exhibits for BLOCK trades
◦ Real-time information is provided about the Recent trades taken place
Whole order book can be accessed
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Many assets trade in more than one
type of market. In which Market doesthese trade?
Used Cars
Paintings
Rare Coins
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 20
Are derivative instruments tradable?Does active markets exist for them?
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Active market does exist!
Derivative instruments are traded actively inOTC and ETC markets.
Institutions develop both spot and derivative
markets by acting as dealers◦ Provides two-ways quotes
◦ Bid price will always be less than ask price
Trades in OTC markets
◦ Easy to fill the order. If market is active, it will befilled at best price.
◦ Counterparty risk is a major issue in this market.
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Size of OTC and Exchange-Traded Markets(Figure 1.1, Page 3)
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 22
Source: Bank for International Settlements. Chart shows total principal
amounts for OTC market and value of underlying assets for exchange
market
0
50
100
150
200250
300
350
400
450
500
550
Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07
Size ofMarket
($ trillion)
OTCExchange
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Amount outstanding of ETC derivatives
Notional amount outstanding March 2010 % share
Interest Rates 74,882.274 91.69%
Futures 23,529.345
Options 51,352.929
Currency contracts 400.998 0.49%
Futures 195.310
Options 205.688
Equity index 6,388.004 7.82%
Futures 1,040.004
Options 5,348.000
All markets 81,671.276 100.00%
Source: BIS survey
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Amount outstanding of OTC derivativesNotional amount outstanding Dec. 2009 % share
Forwards and forex swaps 23,129.29
Currency swaps 16,509.01
Currency Options 9,558.07
Currency derivative contracts 49,196.37 8.00%
Forward rate agreements 51,749.26
Interest rate swaps 349,235.83
Interest rate options 48,807.61
Interest rate contracts 449,792.70 73.18%Forwards and swaps 1,829.87
Options 4,761.58
Equity-linked contracts 6,591.45 1.07%
Gold 423.18
Other commodities: Forwards & swaps 1,674.91
Other commodities: Options 845.92Commodity contracts 2,944.01 0.48%
Multi-name instruments 10,775.64
Single-nname instruments 21,917.06
Credit default swaps 32,692.70 5.32%
Unallocated 73,456.37 11.95%
Total contracts 614,673.60 100.00%
$billionsSource: BIS survey
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RECAP!
Futures/forward contracts are obligationsthat must be fulfilled at maturity.
Options contracts are rights, not obligations,
to either buy (call) or sell (put the underlyingfinancial instrument.
Swaps are the multi-period contracts
Derivatives are traded in auction markets
◦ Institutions make spot and derivative markets
◦ Develops new instruments to fill the gaps
◦ Trading volumes in OTC are much higher
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Role of Derivative Instruments
Protect against different types of investment risks,◦ Purchasing power risk, interest rate risk, currency risk.
Advantages:
◦ Lower transactions costs
◦ Faster to carry out transaction
◦ Greater liquidity
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 27
Foreign Exchange Quotes for € in INR,March 01, 2013 09.30 AM
OTC (Mumbai) NSE
Bid Offer Bid Offer
1-month
forward
66.4500 66.4800 66.4225 66.4575
2-monthforward
66.7600 66.8000 66.7450 66.7850
3-month
forward
67.0800 67.1300 67.0575 67.1025
6-monthforward
67.9300 68.0400 67.9045 67.9985
Spot 66.2500 66.2800
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 28
Profit from aLong Forward Position (SBI)
Profit
Price of Underlying
at Maturity, S T
K
Long forward = Agreeing to buy the Underlying
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 29
Profit from aShort Forward Position (SL)
Profit
Price of Underlying
at Maturity, S T
K
Short forward = Agreeing to SELL the Underlying
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Payoff on forward contract
ST ISL HDFC
56 -8 8
58 -6 6
60 -4 4
62 -2 2
64 0 0
66 2 -2
68 4 -4-10
-8
-6
-4
-2
0
2
4
6
8
10
56 58 60 62 64 66 68
Blue line is payoff of ISL (long position)
Pink line is payoff of HDFC (Short!)
They are mirror images!
Payoff table Payoff diagram
ST - F
F - ST
ST
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A-2 is base-case PLUS forwardcontract (perfectly hedged!)
ST ISL HDFC Do nothing Forward Total
56 -8 8 -3,360 -480 -3,840
58 -6 6 -3,480 -360 -3,84060 -4 4 -3,600 -240 -3,840
62 -2 2 -3,720 -120 -3,840
64 0 0 -3,840 0 -3,84066 2 -2 -3,960 120 -3,840
68 4 -4 -4,080 240 -3,840 -3,900
-3,850
-3,800
56 58 60 62 64 66 68
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Questions
Why a forward contract can be usedfor either speculation or hedging?
◦ Hedging: An exposure shall be present
such that gains in it will be offset by theloss in the forward contract and vice versa
◦ Thus a short position or a long positioncan be entered into for hedging purposes
◦ If trader has no exposure to UA, thenentering a forward is SPECULATION!
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Questions
ISL is hedging its exposure. Does HDFC isspeculating in USD?
◦ In proprietary transactions, Yes
◦ In dealer transaction, HDFC would hedge theacquired exposure either in
Futures market by taking long position
Forward market by taking long position in USD withInfosys
Gains the bid-ask spread
Counterparty risk exists in ISL or Infosys moves out
A FORWAD contract in BINDING on BOTH parties
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QUESTION
You have to receive C$ 5million in 6months. Explain how XR risk can behedged using forward ?
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Ex 1.26 (8e) GOLD forwards
A: Long in 12-m contract F@1000 B: Long in 12-m call option contract
with F@1000. Call premium is $100
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 36
Futures Contracts
Agreement to buy or sell an asset for acertain price at a certain time
Similar to forward contract Whereas a forward contract is traded OTC,
a futures contract is traded on an exchange
◦ Tick size
◦ Delivery date◦ Contract size
◦ Margining
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Forward vs. Futures contracts
Forward Contract Futures contract
Private contract betweentwo parties
Traded on an exchange
Contract terms notstandardized Standardized contract
Usually one specific deliverydate
Range of delivery dates
Settled at the end ofcontract period Settled daily
Delivery or final cashsettlement usually happens
Contract is usually closedout prior to maturity
Some credit risk Virtually no credit risk
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 38
Exchanges Trading Futures
Chicago Board of Trade Chicago Mercantile Exchange
LIFFE (London)
Eurex (Europe) BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see list at end of book)
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 39
Exchanges Trading Futures
Bombay Stock Exchange National Stock Exchange
MCX Stock Exchange
MCX NCDEX
United Stock Exchange
CCIL
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 40
Examples of Futures Contracts
Agreement to:
◦ Buy 100 oz. of gold @ US$1,280/oz. in Oct (NYMEX)
◦ Sell £62,500 @ 1.6500 US$/£ in June (CME)
◦ Sell 1,000 bbl. of oil @ US$114/bbl. in April (NYMEX)◦ Buy 100 shares of Infosys Limited at Rs.3,973 in 25-
Sep-2014 (NSE)
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 41
Types of Traders
• Hedgers : offset the exposure to price of UA.
• Speculators: No exposure to offset.
• Arbitrageurs: To lock in a arbitrage profit
Some of the largest trading losses in derivatives have
occurred because individuals who had a mandate to be
hedgers or arbitrageurs switched to being speculators (See
for example Barings Bank , Business Snapshot 1.2, page 15)
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 42
Are spot and forward prices related?
If the spot price of gold is S and the forward pricefor a contract deliverable in T years is F , then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-freerate of interest.
FT = S0 [(1+r INR)/(1+r $)]T
12-m USD price = 62 * 1.09/1.012 = INR 66.7787
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 43
Solve Ex 1.30 on Gold arb
You are a US citizen!
S = $1,000
12-m F = $1,200
1yr interest rate in USD = 10%
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 44
Does any arb opportunitypresent in ISL data?
Fair price of 12-m USD = 66.7787 vs. quoted price 64:
◦ 12-month forward contract is underpriced
Today: Take LONG position in 12-m F @ 64Borrow USD and sell them in currency mkt
Deposit the INR at 9% for 1 year
Dec-94: RECEIVE $ from counterparty at 64
Deliver them to the USD lender
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 45
Market efficiency
If more dealers are taking long position in USD than forshort position, what would happen to price? Vice versa?
O
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 46
Options
A call option is an option to buy a certainasset by a certain date for a certain price(the strike price)
◦ For a long, it is right to BUY
A put option is an option to sell a certainasset by a certain date for a certain price(the strike price)
◦
For a long, it is right to SELL
O i T i l
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 47
Options Terminology
Call option (c) Put option (p) 1.3795
Price of underlying (S) 66.25
Strike Price (K) 67.00 Expiry Date (T) 31-May
At-the-money Option (ATM)
In-the-money Option (ITM) Out-of-money Option (OOM)
Covered option; Naked option
O ti Ri ht & Obli ti
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 48
Options: Rights & Obligations
Holder (long position) Writer (Short position)
Right to receive UA Obligation to deliver UA
Obligation to pay K Right to receive K Obligation to deliver UA
Receive K
Obligation to receive UA
Pay K
Forward Exercises it only when
beneficial
Call
option
Put
option
Exercises it only when
beneficial
ON maturity date or expiration rate, do the following:
I t d E t ith
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Importers and Exporter withcomplete hedging
F @ 64 c @ 64 p @ 64 -ST + F -ST + C ST - F ST + P
56 -8 0 8 -64 -56 64 64
58 -6 0 6 -64 -58 64 64
60 -4 0 4 -64 -60 64 64
62 -2 0 2 -64 -62 64 64
64 0 0 0 -64 -64 64 6466 2 2 0 -64 -64 64 66
68 4 4 0 -64 -64 64 68
70 6 6 0 -64 -64 64 70
ST
Payoffs from contracts Importer Exporter
-10
-8
-6
-4
-2
0
2
4
6
8
10
56 58 60 62 64 66 68 70
Blue line is LONG in Forward
Pink line is LONG in Call option
Yellow Line is LONG in Put
I t d E t fil
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Importers and Exporter profilewith 50% hedging-ST + F -ST + C ST - F ST + P
56 -64 -56 64 64
58 -64 -58 64 64
60 -64 -60 64 64
62 -64 -62 64 64
64 -64 -64 64 64
66 -64 -64 64 66
68 -64 -64 64 68
70 -64 -64 64 70
ST
Importer Exporter
-ST + F -ST + C ST - F ST + P
56 -60 -56 60 60
58 -61 -58 61 61
60 -62 -60 62 62
62 -63 -62 63 63
64 -64 -64 64 64
66 -65 -65 65 66
68 -66 -66 66 68
70 -67 -67 67 70
ST
Importer: 50% hedge Exporter: 50% hedge
-6 8
-6 6
-6 4
-6 2
-6 0
-5 8
-5 6
-5 4
5658606264666870
IMPORTER: 50% vs. 100% hedge
58
60
62
64
66
68
70
72
5 6 5 8 60 62 6 4 6 6 6 8 7 0
EXPORTER: 50% vs. 100% hedge
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 52
Exchanges Trading Options
Chicago Board Options Exchange American Stock Exchange
Philadelphia Stock Exchange
Pacific Exchange LIFFE (London)
Eurex (Europe)
and many more (see list at end of book)
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Questions
Long F at $50 vs. long call at 50 Selling a CALL vs. buying a PUT
Suppose you have 500 shares of YES
bank. How to obtain insurance againsta decline in share value over 4 months
Payoff for [Long forward + long put]
Exercise 1.24
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 54
Is it naked or covered option
Covered option OOM option
Long Term Equity AnticiPation Security
◦
Options on long term until expiry than others◦ Available on approximately 2,500 equities and
20 indices
◦ LEAPS were created relatively recently and
typically extend for terms of 2 years out.◦ Equity LEAPS always expire in January.
◦ When LEAPS were first introduced in 1990, theywere derivative instruments solely for equities
Mi ft ff ith d ith t
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 55
Microsoft payoff with and withoutHedging (LONG PUT OPTION CONTRACTS)
20,000
25,000
30,000
35,000
40,000
20 25 30 35 40
Value of Holding($)
Stock Price ($)
No Hedging
Hedging
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Infosys Option Prices (March 01, 2013; S =2925)
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 57
StrikePrice
28-MarCall
25-AprCall
30-MayCall
28-MarPut
25-AprPut
30-MayPut
2,850 107.30 200.00 - 30.65 - -
2,900 78.50 150.00 - 48.00 120.00 -
2,950 53.00 - - 70.70 128.65 -
3,000 34.20 - - 103.00 - -
3,050 21.00 - - 151.40 - -
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 58
Options vs Futures/Forwards
A futures/forward contract gives the holderthe obligation to buy or sell at a certainprice
An option gives the holder the right to buyor sell at a certain price
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 59
Hedge Funds (see Business Snapshot 1.1, page 9)
Hedge funds are not subject to the same rules asmutual funds and cannot offer their securitiespublicly.
Mutual funds must◦ disclose investment policies,
◦ makes shares redeemable at any time,
◦ limit use of leverage
◦ take no short positions.
Hedge funds are not subject to these constraints.
Hedge funds use complex trading strategies; arebig users of derivatives for hedging, speculationand arbitrage
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Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©John C. Hull 2008 60
Hedge Funds strategies
Convertible Arbitrage Distressed Securities
Emerging Markets
Macro or global
Market neutral
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SUMMARY
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SUMMARY