SECURITIES ANALYSIS FIN: 4003

UNIVERSITY OF TECHNOLOGY, JAMAICA

SCHOOL OF BUSINESS ADMINISTRATION

DERIVATIVE SECURITIES (3 Hours)

At the end of this unit students should be able to:

7.1.1 Explain the basic features of forward contract, future contract and option contracts
7.1.2 Calculate call and put option
7.1.3 Identify options trading strategies

CONTENTS
 Why Do Derivatives Exist?
 Forward Contracts
 Futures Contracts
 Options Option Trading Strategies
 Put/Call Parity
 Valuation of Call and Put Options
 Binomial Option Pricing Model
 Black-Scholes Option-Pricing Formula

Derivative Instruments

Value is determined by, or derived from, the value of another investment vehicle, called the
underlying asset or security.

Forward contracts are agreements between two parties - the buyer agrees to purchase an
asset, the seller agrees to sell the asset, at a specific date at a price agreed upon now.

Futures contracts are similar, but are standardized and traded on an organized exchange

Options offer the buyer the right, but not the obligation, to buy or sell and underlying asset at
a fixed price up to or on a specific date. The Buyer is long in the contract and the Seller or
“writer” is short the contract. The price at which the transaction would we made is the
exercise or strike price. The profit or loss on an option position depends on the market price.

Why Do Derivatives Exist?

Assets are traded in the cash or spot market. Sometimes have one’s fortunes dependent on
spot price movements leads to considerable risk.

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 – Various derivatives markets have evolved that allow some investors to manage
these risks, while also creating opportunities for speculators to invest in the same
contracts.
–
Potential Benefits of Derivatives

• Risk shifting
– Especially shifting the risk of asset price changes or interest rate changes to
another party willing to bear that risk
• Price formation
– Speculation opportunities when some investors may feel assets are mis-priced
• Investment cost reduction
– To hedge portfolio risks more efficiently and less costly than would otherwise be
possible.

Forward Contracts

Forward contract is an agreement between two parties to exchange an asset at a specified

price on a specified date. The Buyer is long, seller is short; symmetric gains and losses as
price changes, zero sum game
• Contracts trade OTC, have negotiable terms, and are not liquid
• Subject to credit risk or default risk
• Value realized only at expiration
• Popular in currency exchange markets

Futures Contracts
• Like forward contracts…
– Buyer is long and is obligated to buy
– Seller is short and is obligated to sell
• Unlike forward contracts…
– Standardized – traded on exchange
– More liquidity - can “reverse” a position and offset the future obligation, other
party is the exchange
– Less credit risk - initial margin required
– Additional margin needs are determined through a daily “marking to market”
based on price changes

Futures Contracts are traded on:

• Chicago Board of Trade (CBOT)
– Grains, Treasury bond futures
• Chicago Mercantile Exchange (CME)
– Foreign currencies, Stock Index futures, livestock futures, Eurodollar futures
• New York Mercantile Exchange (NYMEX)
– Crude oil, gasoline, heating oil futures

Futures Quotations

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 – One contract is for a fixed amount of the underlying asset
• 5,000 bushels of corn (of a certain grade)
• $250 x Index for S&P 500 Index Futures (of a certain maturity)
– Prices are given in terms of the underlying asset
• Cents per bushel (grains)
• Value of the index
– Value of one contract is price x contract amount
– Settle is the closing price from the previous day

Options
Option Terminology
• Option to buy is a call option
• Option to sell is a put option
• Option premium – price paid for the option
• Exercise price or strike price – the price at which the asset can be bought or sold under
the contract
• Intrinsic Value of Options
– Call Option Intrinsic Value = Max [0, V-X]
– Put Option Intrinsic Value = Max [0, X-V]
• V = Stock Value
• X = Strike Price
– Option values cannot be negative since they need not be exercised if it is not in
the owner’s interest to do so
• Expiration date
– European: can be exercised only at expiration
– American: exercised any time before expiration
• In-the-money: option has positive intrinsic value, would be exercised if it were expiring
• Out-of-the-money: option has zero intrinsic value, would not be exercised if expiring
– If not expiring, could still have value since it could later become in-the-money

Example 1:
Suppose you own a call option with an exercise (strike) price of $30.
• If the stock price is $40 (in-the-money):
– Your option has an intrinsic value of $10
– You have the right to buy at $30, and you can exercise and then sell for $40.
• If the stock price is $20 (out-of-the-money):
– Your option has an intrinsic value of zero
– You would not exercise your right to buy something for $30 that you can buy for
$20!
Example 2:
Suppose you own a put option with an exercise (strike) price of $30.
• If the stock price is $20 (in-the-money):
– Your option has an intrinsic value of $10
– You have the right to sell at $30, so you can buy the stock at $20 and then
exercise and sell for $30
• If the stock price is $40 (out-of-the-money):

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 – Your option has no intrinsic value
– You would not exercise your right to sell something for $30 that you can sell for
$40!

Chicago Board Options Exchange (CBOE)

– Centralized facility for trading standardized option contracts
– Clearing Corporation is the opposite party to all trades, allowing buyers and
sellers to terminate positions prior to expiration with offsetting trades
– Standardized expiration dates, exercise prices, and contract sizes
– Secondary market with standardized contracts
– Offer options on almost 1,400 stocks and also index options

Stock Option Quotations

– One contract is for 100 shares of stock
– Quotations give:
• Underlying stock and its current price
• Strike price
• Month of expiration
• Premiums per share for puts and calls
• Volume of contracts
• Premiums are often small
– A small investment can be “leveraged” into high profits (or losses)

Example 3:
Suppose that you buy a January $30 call option on Microsoft

What is the cost of your contract?

Cost = $.95 x 100 = $95

Is your contract in-the-money?

No. The current stock price is $28.48, so the intrinsic value is $0 per share.

What is your dollar profit (loss) if, at expiration, Microsoft is selling for $25?

Out-of-the-money, so Profit = ($95)

What is your percentage profit with options?

Return = (0-.95)/.95 = (100%)

What if you had invested in the stock?

Return = (25-28.48)/28.48 = (12.22%)

What is your dollar profit (loss) if, at expiration, Microsoft is selling for $30.50?

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Profit = 100(30.5-30) – 95 = ($45)

What is your percentage profit with options?

Return = (30.50-30-.95)/.95 = (47.37%)

What if you had invested in the stock?

Return = (30.50-28.48)/28.48 = 7.09%

What is your dollar profit (loss) if, at expiration, Microsoft is selling for $35?

Profit = 100(35-30) – 95 = $405

What is your percentage profit with options?

Return = (35-30-.95)/.95 = 426.32%

What if you had invested in the stock?

Return = (35-28.48)/28.48 = 22.89%

Payoff diagrams
– Show payoffs at expiration for different stock prices (V) for a particular option
contract with a strike price of X
– For calls:
• if the V<X, the payoff is zero
• If V>X, the payoff is V-X
• Payoff = Max [0, V-X]
– For puts:
• if the V>X, the payoff is zero
• If V<X, the payoff is X-V
• Payoff = Max [0, X-V]

Option Trading Strategies

There are a number of different option strategies:

• Buying call options
• Selling call options
• Buying put options
• Selling put options
• Option spreads

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Buying Call Options

Position taken in the expectation that the price will increase (long position)

Profit for a purchasing a Call Option:

Per Share Profit =Max [0, V-X] – Call Premium

• Note that profits on an option strategy include option payoffs and the premium paid for
the option
• The following diagram shows different total dollar profits for buying a call option with a
strike price of $70 and a premium of $6.13.

Buying Call Options

Selling Call Options

• Bet that the price will not increase greatly – collect premium income with no payoff
• Can be a far riskier strategy than buying the same options
• The payoff for the buyer is the amount owed by the writer (no upper bound on V-X)
• Uncovered calls: writer does not own the stock (riskier position)
• Covered calls: writer owns the stock
• Selling Call Options

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 • Buying Put Options
• Position taken in the expectation that the price will decrease (short position)
• Profit for purchasing a Put Option:
Per Share Profit = Max [0, X-V] – Put Premium
• Protective put: Buying a put while owning the stock (if the price declines, option gains
offset portfolio losses)
• The following diagram shows different total dollar profits for buying a put option with a
strike price of $70 and a premium of $2.25
• Buying Put Options
• Selling Put Options
• Bet that the price will not decline greatly – collect premium income with no payoff
• The payoff for the buyer is the amount owed by the writer (payoff loss limited to the
strike price since the stock’s value cannot fall below zero)
• Selling Put Options
• Option Spreads
Many other option strategies can be crafted using combinations of option positions
• Price spread (vertical spread)
– Buying and selling options on the same stock with the same expiration, but with
different strike prices
• Time spread (horizontal or calendar spread)
– Buying and selling options on the same stock with the same strike price, but with
different expirations
• Option Spreads
• Bullish spreads
– Buy a higher priced option and sell a lower priced option on the same stock
• Bearish spreads
– Sell a higher priced option and buy a lower priced option on the same stock
• Straddle
– Combination of a purchasing (long) or selling (short) a put and a call on the same
expiration
– Betting on a large price movement (long straddle) or little price movement (short
straddle)
• Option Spreads
• Strangle
– Combination of a call and put with the same expiration but different exercise
prices (long or short)
– Similar to straddle strategies
• Butterfly spread
– Combination strategy with 4 options, similar to straddles and strangles, but with
less risk of large losses
• The number of different strategies is potentially limitless
• Put/Call Parity
• Premiums for puts and calls are not completely independent otherwise arbitrage
opportunities would exist
• Two investments with equally risky payoffs should have similar costs

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 • Parity relationships exist between options, also between options and futures, options and
spot prices, and futures and spot prices

• Futures Valuation Issues

Cost of Carry Model
• Suppose that you needed some commodity in three months. You have at least the
following two options:
– Purchase the commodity now at the current spot market price (S0) and “carry” the
commodity for 3 months
– Buy a futures contract for delivery of the commodity in 3 months for the current
futures price (F0,3)
• Futures Valuation Issues
Cost of Carry Model
• The futures prices and spot prices must be related to one another in order for there to be
no arbitrage opportunities for investors.
• If the carrying cost only amounts to forgone interest at a risk-free rate (rf) for T time
periods, then the following relationship must hold:
F0,T = S0 (1+rf)T
• Futures Valuation Issues
Cost of Carry Model Example: Suppose that you can buy gold in the spot market for $300. The
monthly risk-free is .25%. You need the gold in three months.
• What should be the current futures price?
F0,T = 300 (1+.0025)3 = 302.26
• What if the futures price is $305?
– You have a risk-less profit opportunity. Buy gold at $300, sell futures at $305. In
three months, delivery the gold, pay the known interest, pocket the difference.
• Futures Valuations Issues
• Similar futures-spot price relationships can be derived when there are “market
imperfections” involved with carrying the commodity or financial asset
• Incorporating storage and insurance costs as a percentage of contract value (SI):
F0,T = S0 (1+rf +SI)T
• Incorporating ownership benefits lost with a futures position, especially dividends(d):
F0,T = S0 (1+rf +SI -d)T
• Futures Valuation Issues
• Basis
– Basis is the difference between the spot and futures prices.
– For a contract expiring at time T, the basis at time t is:
Bt,T = St – Ft,T
– Over time, the spot and futures prices converge, and basis becomes zero at
expiration
– Between time t and expiration, basis can change as the difference between spot
and futures prices vary (known as basis risk)
• Advanced Applications of Financial Futures
• Stock Index Arbitrage
– An example of a program trading strategy designed to take advantage of
temporarily “mis-pricing” of securities

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 – Monitor the parity condition (one period):
F0,T = S0 + S0 (rf - d)
– If it does not hold, construct a risk-free position to take advantage of the situation.
• Advanced Applications of Financial Futures
• T-Bond/T-Note Futures Spread
– “Note over bond” (NOB) spread
– Strategies based on speculating the changing slope of the yield curve
• Options on Futures
• Also known as Futures Options
• Options on Stock Index Futures
– Gives the owner the right to buy (call) or sell (put) a stock futures contract
• Options on Treasury Bond Futures
– Gives the owner the right to buy (call) or sell (put) a Treasury bond futures
contract
• Options on Futures
• Why would they be attractive?
– If exercised, it would seem to have been better to simply buy a futures contract
instead (no option premium to pay)
– One primary advantage can be found when looking at all the potential price
movements
• Futures contracts used for hedging offset portfolio value changes; thus,
advantageous price movements for a portfolio are offset by the futures
position
• Options give the right (but not the obligation) to purchase the futures
contract; thus, favorable price movements will be offset only by the option
premium rather than by a corresponding loss on the futures position
• Valuation of Options
• Factors influencing the value of a call option:
– Stock price (+)
• For a given exercise price, the higher the stock price, the greater the
intrinsic value of the option (or at least the closer to being in-the-money)
– Exercise price (-)
• The lower the price at which you can buy, the more value
– Time to expiration (+)
• The longer the time to expiration, the more likely the option will be
valuable
• Valuation of Options
• Factors influencing the value of a call option:
– Interest rate (+)
• Options involve less money to invest, lower opportunity costs
– Volatility of underlying stock price (+)
• The greater the volatility of the underlying stock, the more likely that the
option position will be valuable
• Valuation of Options
• Factors influencing the value of a put option:
– The same listed, but different directions for several items.

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 – Stock price (-)
– Exercise price (+)
– Time to expiration (+)
– Interest rate (-)
– Volatility of underlying stock price (+)
• The Binomial Option-Pricing Model
• Derives an option price using the principle of no riskless profit
• Find a portfolio of stock and call options that gives the same payoff in the future
regardless of whether the stock goes up or down
– Called a hedge portfolio
• The Binomial Option-Pricing Model
• If the hedged portfolio offers a risk-free return, we can determine the portfolio’s current
value by discounting this return at the risk-free rate
• Once we know the value of the portfolio, we can separate this value into two components
– The value of the stock
– The value of the option
• Binomial Option Pricing Model: Example 1
• Calculating Binomial Option Prices
• We will look at a three step procedure:
Step 1: Estimate the number of call options needed
Step 2: Determine the present value of the hedge portfolio
Step 3: Compute the price of a call option
• Calculating Binomial Option Prices: Step 1
• Calculate the option’s payoffs for each possible future stock price
– If stock goes to $65, option pays off $12.50
– If stock goes to $40, option pays off $0
• Calculating Binomial Option Prices: Step 1
• Determine the composition of the hedge portfolio
– It contains one share of stock and “n” call options
• Portfolio value = 1 share + n options
– If stock goes up, portfolio will pay:
$65 + [n x $12.50]
– If stock goes down, portfolio will pay:
$40 + [n x $0]
• Calculating Binomial Option Prices: Step 1
• To determine the composition of the hedge portfolio, find the number of options that
equates the payoffs
• $65 + $12.50n = $40 + $0n
– Implies n = -2
– Hedge portfolio is long one share of stock and short two call options
• Calculating Binomial Option Prices: Step 1
• Value of hedge portfolio today:
$50 - 2.00(C0)
• Calculating Binomial Option Prices: Step 2
• Next, we must determine the today’s value of the hedge portfolio
• We know the portfolio will pay $40 in one year with certainty

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 • Thus the value of that portfolio right now is
40/1.08 = $37.04
• Calculating Binomial Option Prices: Step 3
• Finally, separate the current value of the portfolio into its component parts
• The portfolio is worth $37.04 right now
– $50 of this value is the current price of the stock
– The difference between $37.04 and $50 is the revenue you would have received if
you sold the two call options
• Calculating Binomial Option Prices: Step 3
• Value of the Call Option:
$50 – 2 C0 x = $37.04
Call price = $6.48
• Black-Scholes Option Pricing Model
• Model for determining the value of American call options
• This work warranted the awarding of the 1997 Nobel Prize in Economics!
• Black-Scholes Option Pricing Formula
P0 = PS[N(d1)] - X[e-rt][N(d2)]
where:
P0 = market value of call option
PS = current market price of underlying stock
N(d1) = cumulative density function of d1 as defined later
X = exercise price of call option
r = current annualized market interest rate for prime commercial paper
t = time remaining before expiration (in years)
N(d2) = cumulative density function of d2 as defined later
• Black-Scholes Option Pricing Formula
P0 = PS[N(d1)] - X[e-rt][N(d2)]
The cumulative density functions are defined as:
• Using the Black-Scholes Formula
• Besides mathematical values, there are five inputs needed to use this model:
– Current stock price (Ps)
– Exercise price (X)
– Market interest rate (r)
– Time to expiration (t)
– Standard deviation of annual returns (s)
• Of these, only the last in not observable
• Also, using the put/call parity, we can value put options as well after calculating call
value
• Option-like Securities
• Several types of securities contain embedded options:
– Callable and Putable Bonds
– Warrants
– Convertible Securities
• Callable and Putable Bonds
• Callable Bonds contain a “call provision”

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 – The issuer has the option of buying the bonds back at the call (exercise) price
rather than having to wait until maturity
– Attractive option for issuers if interest rates fall, since they can purchase back old
bonds and refinance (refunding) with new, lower interest bonds
– Typically will trade at no more than the call price, since call becomes likely at that
point
• Callable and Putable Bonds
• Putable Bonds contain a “put provision”
– Investors may resell the bonds back to the issuer prior to maturity at the put
(exercise) price, often par value
– Puts can generally be exercised only when designated events take place
• Warrants
• Warrant is an option to buy a stated number of shares of common stock at a specified
price at any time during the life of the warrant
• Similar to a call option, but usually with a much longer life
• Issued by the company whose stock the warrant is for
• Warrants
• Intrinsic value is the difference between the market price of the common stock and the
warrant exercise price
Intrinsic Value = (Stock Price – Exercise Price) x Number of Share
• Speculative value is the value of the warrant above its intrinsic value
– Like other options, the value is higher than intrinsic value, except at maturity
• Convertible Securities
• Allows the holder to convert one type of security into a stipulated amount of another type
(usually common stock) at the investor’s discretion
• With convertible securities, value depends both on the value of the original asset and the
value if conversion takes place
– Value cannot fall below the greater of the two values
• Convertible Securities
Convertible Bonds
• Advantages to issuing firms
– Lower interest rate on debt
– Debt represents potential common stock
• Advantages to investors
– Upside potential of common stock
– Downside protection of a bond
• Convertible Securities
Convertible bonds
– Conversion ratio = number of shares obtained if converted
– Conversion price = Face Value/Number of shares
• Valuation of convertible bonds
– Combination value of stock and bond
– Two step process to determine minimum value
• Convertible Securities
Convertible Bonds
• Value of a convertible as a bond

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 – Determine the bond’s value as if it had no conversion feature
– This is the convertible’s investment value or floor value
• Value of a convertible as stock
– Compute the value of the common stock received on conversion
– This is the conversion value
• Convertible Securities
Convertible Bonds
• Minimum Value = Max (Bond Value, Conversion Value)
• Like other options, including embedded options, they typically only sell at their
minimum, intrinsic value only at maturity.
– Conversion Premium = (Market Price – Minimum Value)/Minimum Value
• Convertible Securities
Convertible Bonds
• Conversion Parity Price = Market Price/Conversion Ratio
– An risk-free profit opportunity would exist if the price of the convertible below
this price, since immediate conversion of the bond and then selling the stock
would yield a profit
• Conversion Arbitrage
– An attempt to take advantage of mis-priced convertible bonds relative to the
conversion ratio

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 SECURITIES ANALYSIS FIN: 4003
UNIT TUTORIAL–DERIVATIVE INSTRUMENTS

1. Describe put and call options. Are they issued like other corporate securities?

2. What are the main investment attractions of put and call options? What are the risks?

3. Briefly explain how you would make money on (a) a call option and (b) a put option. Do
you have to exercise the option to capture the profit?

4. How do you find the intrinsic (fundamental) value of a call? Of a put? Does an out-of-
the-money option have intrinsic value?

5. Name at least four variables that affect the price behaviour of listed options, and briefly
explain how each affects prices. How important are fundamental (Intrinsic) value and
time value to in-the-money options? To out-of-the-money options?

6. Describe at least three different ways in which investors can use stock options?

7. Consider a bond selling for $98 per $100 face value. A call option selling for $8 has an
exercise price of $105. Answer the following questions about a covered call.

A. Determine the value of the position at expiration and the profit under the following
outcomes:
i. The price of the bond at expiration is $110.
ii. The price of the bond at expiration is $88
B. Determine the following:
i. The maximum profit.
ii. The maximum loss.

8. Consider a put option selling for $4 in which the exercise price is $60 and the price of the
underlying is $62.
a. Determine the value at expiration and the profit for a buyer under the following
outcomes:
i. The price of the underlying at expiration is $62 or $55
b. Determine the value at expiration and the profit for a seller under the following
outcomes:
 The price of the underlying at expiration is $51 or $68
c. Determine the maximum profit to the buyer and maximum loss to the buyer.
Determine the breakeven price of the underlying at expiration.

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 9. June holds 600 shares of ISD. She bought the stock several years ago at 48.5 and the
shares are now trading at $75.00. June is concerned that the market is beginning to
soften. She doesn’t want to sell the stock, but she would like to be able to protect the
profits she’s made. She decides to hedge his position by buying 6 puts on LGL. The
three month puts carry a strike price $75.00 and are currently trading at $2.5.

a. How much profit or loss will June make on the deal if the price of LGL does
indeed drop to $60.00 a share by the expiration date on the puts?
b. How would she do if the stock kept going up in price and reached $90.00 a share
by the expiration date?
c. What do you see as the major advantages of using puts as hedge vehicles?

10. Find the value at expiration of the following options if the stock price at expiration is 41.

a. 40 call
b. 45 call
c. 40 put
d. 45 put

Value of a call option = Max [0, V - X]

Value of a put option = Max [0, X - V]

Where V is the current market price and X is the exercise price

11 .Consider a call option selling for $7 in which the exercise price is $100 and the price
0f the underlying is $98.

(a) Determine the value at expiration and the profit for the buyer under the following
outcomes:

i. The price of the underlying at expiration is $102

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 ii. The price of the underlying at expiration is $94

(b) Determine the value at expiration and the profit for the seller under the following
outcomes:

i. The price of the underlying at expiration is $91

iii. The price of the underlying at expiration is $101

NOTES

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