Swaps
Futures Options Trading Book by Selzer-McKenzie SelMcKenzie
ISBN
978-1-4717-0983-8 Price Euro 79
Author
D.Selzer-McKenzie
Video
FORWARD
CONTRACTS
A forward contract is a particularly
simple derivative security. It is an agreement to buy or sell an asset at a
certain future time for a certain_pripe. The contract is usually between two
financial institutions or between a financial institution and one of its
corporate clients. It is not normally traded on an exchange.
One of the parties to a forward contract
assumes a long position and agrees to buy the underlying asset on
a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to seil the asset on
the same date for the same price. The specified price in a forward contract
will be referred to as the delivery. price. At the time the
contract is entered into, the delivery price is chosen so that the value of the
forward contract to both parties is
zerci,1 This means that it costs
nothing to take either a long or a short position. _ -
- _
A forward contract is settled at maturity. The
holder of the short position delivers the asset to the holder of the long
Position in return for a cash amount equal to the delivery price. A key
variable determining the value of a forward contract is the market_p_rice of
the asset. As already mentioned, a forward contract is worth zero when it is
first entered into. Later it can have a positive or a negative value depending
on movements in the price of the asset. For example, if the price of the asset
rises sharply soon after the initiation of the contract, the value of a long
position in the forward contract becomes positive and the value of a short
position in the forward contract becomes negative.
7'HE
FORWARD PRICE
The forward price for a certain
contract is defined as the delimprice which would make that contract have zero
value. The forward price and the delivery price are therefore equal at the time
the contract is entered into. As time passes, the forward price is liable to
change while the delivery ,price, of course, remains the same. t The two are
not therefore equal, except by chance, at any time after the start of the
contract. Generally, the forward price at any given time varies with the
maturity of the contract being considered. For example, the forward price for a
contract to buy or sell in 3 months is typically different from that for a
contract to buy or sell in 6 months.
'
and hedged. In this opening chapter, we take a
first look at forward contracts, futures contracts, and options. In later
chapters, these securities and the way they are traded will be discussed in
more detail.
FORWARD CO1VTRACTS
A forward contract is a particularly
simple derivative security. It is an agreement to buy or sell an asset at a
certain future time for a certain_price. The contract is usually between two
financial institutions or between a financial institution and one of its
corporate clients. It is not normally traded on an exchange.
One of the parties to a forward contract
assumes a long position and agrees to buy the underlying asset on
a certain specified future date for a certain specified price. The other
party assumes a skort position and agrees to seil the asset on
the same date for the same price. The specified
price in a forward contract will _
be referred to as the delivery price.
At the time the contract is entered into, the delivery price is chosen so
that the value of the forward contract to both parties is zerd,1
This means that it costs nothing to take either a long or a short position.
A forward contract is settled at maturity. The
holder of the short Position delivers the asset to the holder of the long
position in retum for a cash amount equal to the delivery price. A key variable
determining the value of a forward contract is the marketpnce of the asset. As
already mentioned, a forward contract is worth zero when it is first entered
into. Later it can have a positive or a negative value depending on movements
in the price of the asset. For example, if the price of the asset rises sharply
soon after the initiation of the contract, the value of a long position in the
forward contract becomes positive and the value of a short position in the
forward contract becomes negative.
FORWARD
PRICE
The forwardprice for a certain
contract is defined as the delivery price which would make that contract have
zero value. The forward price and the delivery price are therefore equal at the
time the contract is entered into. As time passes, the forward price is liable
to change while the delivery_price, of course, remains the same. *The two are
not therefore equal, except by chance, at any time after the start of the
contract. Generally, the forward price at any given time varies with the
maturity of the contract being considered. For example, the forward price for a
contract to buy or sell in 3 months is typically different from that for a
contract to buy or sell in 6 months.
'In
Chapter 3 we explain the way in which this delivery price can be calculated.
and hedged. In this opening chapter, we take a
first look at forward contracts, futures contracts, and options. In later
chapters, these securities and the way they are traded will be discussed in
more detail.
FORWARD
CONTRACTS
A forward contract is a particularly
simple derivative security. It is an agreement to buy or sell an asset at a
certain future time for a certain_price. The contract is usually between
two financial institutions or between a financial institution and one of its
corporate clients. It is not normally traded on an exchange.
One of the parties to a forward contract
assumes a long position and agrees to buy the underlying asset on
a certain specified futtre date for a certain specified price. The other party
assumes a short position and agrees to sell the asset on the same
date for the same, price. The specified price in a
forward contract will be referred to as the delivegp—rice. At the time the contract is entered into, the
delivery price is chosen so that the value of the forward contract to both
parties is zerg ,1 This means that it costs nothing to take either a
long or a short position.
A forward contract is settled at maturity. The
holder of the short position delivers the asset to the holder of the long
Position in retum for a cash amount equal to the delivery price. A key variable
determining the value of a forward contract is the marketprice of the asset. As
already mentioned, a forward contract is worth zero when it is first entered
into. Later it can have a positive or a negative value depending on movements
in the price of the asset. For example, if the price of the asset rises sharply
soon after the initiation of the contract, the value of a long position in the
forward contract becomes positive and the value of a short position in the
forward contract becomes negative.
THE FORWARD
PRICE
The forward price
for a certain contract is defined as the delitezprice which would make that
contract have zero value. The forward price and the delivery price are
therefore equal at the time the contract is entered into. As time passes, the
forward price is liable to change while the deliveryrice, of course, remains
the same. eThe two are not therefore equal, except by chance, at any time after
the start of the contract. Generally, the forward price at any given time
varies with the maturity of the contract being considered. For example, the
forward price for a contract to buy or seil in 3 months is typically different
from that for a contract to buy or sell in 6 months.
'In
Chapter 3 we explain the way in which this delivery price can be calculated.
TABLE
1.1 Spot and
Forward Foreign Exchange
Quotes, September 11. 1991
Forward Foreign Exchange
Quotes, September 11. 1991
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1.7280
|
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30-day forward
|
1.7208
|
|
90-day forward
|
1.7090
|
|
180-day forward
|
1.6929
|
Corporations frequently enter into forward
contracts on foreign exchange. Consider the quotes shown in Table 1.1 for the
pound sterling—U.S. dollar exchange rate on September 11, 1991. The first quote
indicates that, ignoring commissions and other transactions costs, sterling can
be bought or sold in the spot market (that is, for virtually immediate
delivery) at the rate of $1.7280 per pound; the second quote indicates that the
forward price (or forward exchange rate) for a contract to buy or sell sterling
in 30 days is $1.7208 per pound; the third quote indicates that the forward
price for a contract to buy or sell sterling in 90 days is $1.7090 per pound;
and so on.
PAYOFFS
FROM FORWARD CONTRACTS
The payoff from a long
position in a forward contract on one unit of an asset is
ST
— K
where K is the delivery price and ST is the spot price of the asset at
maturity of the contract. This is because the holder of the contract is
obligated to buy an asset worth ST for K. Similarly, the payoff from a short
position in a forward contract on one unit of an asset is
K
— ST
These payoffs can be positive or negative. They
are illustrated in Figure 1.1. Since it costs nothing to enter into a forward
contract, the payoff from the contract is also the investor's total gain or
loss from the contract.
FUTURES
CO/VTRACTS
A futures contract, like a forward
contract, is an agreement between two parties to buy or sell an asset at a
certain time in the future for a certain price. Unlike forward contracts,
futures contracts are normally traded on an_ exchange. To make trading
possible, the exchange specifies certain standardized features of the contract.
As
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4 Introduction Chapter 1
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Long Position
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Short Position
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Payoff Payoff
|
ST = price
of asset at maturity
Figure 1.1 Payoffs
from Forward Contracts.
the two parties
to the contract do not necessarily know each other, the exchange also provides
a mechanism which gives the two parties a guarantee that the contract will be
honored.
The largest
exchanges on which futures contracts are traded are the Chicago Board of Trade
(CBOT) and the Chicago Mercantile Exchange (CME). On these and other
exchanges, a very wide range of commodities and financial assets form the
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4
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nderlying assets in the various
contracts. The commodities include pork bellies, ive cattle, sugar, wool,
lumber, copper, aluminum, gold, and tin. The financial assets include stock
indices, currencies, Treasury bills, and bonds.
One way in
which a futures contract is different from a forward contract is that an exact
delivery date is not usually_specified. The contract is referred to
by its delivery month, and the exchange specifies the period during the month
when delivery must be made. For commodities, the delivery period is often the
whole month. The holder of the short position has the right to cftoose the time
during the de5ery period when he or she will make delivery. Usually, contracts
with several different delivery months are traded at any one time. The exchange
specifies the amount of the asset to be delivered for one contract; how the
futures price is to be quoted; and, possibly, limits on the amount by which the
futures price can move in any one day. In the case of a commodity, the exchange
also specifies the product quality and the delivery location. Consider, for
example, the wheat futures contract currently traded on the Chicago Board of
Trade. The size of the contract is 5,000 bushels. Contracts for five delivery
months (March, May, July, September, and December) are available for up to one
year into the future. The exchange specifies the grades of wheat that can be
delivered and the places where delivery can be made.
Futures prices are
regularly reported in the financial press. Suppose that, on September 1, the
December futures price of gold is quoted at $500. This is the price, exclusive
of commissions, at which investors can agree to buy or sell gold for December
delivery. It is determined on the floor of the exchange in the same way as
other prices (that is, by the laws of supply and demand). If more investors want
to go long than to go short, the price goes up; if the reverse is true, the
price goes down.2
Further details on issues such as margin
requirements, daily settlement procedures, delivery procedures, bid-ask
spreads, and the role of the exchange clearinghouse will be given in the next
chapter.
1.3
OPTIONS
Optiops on stocks were first traded on an
organized exchange in 1923. Since then, there has been a dramatic growth in options
markets. Options are now traded on many different exchanges throughout the
world. Huge volumes of options are also traded overthe counterby_banks and
other financial institutions. The (underlying assets include stocks, stock
indices, foreign currencies, debt instruments, 'commodities, and futures
contracts.
There are two basic types of options. A call
option gives the holder the right to buy the underlying asset by a
certain date for a certain price. A put option gives the holder the
right to seil the underlying asset by a CPrtaip date for,a certairkprice. The
price in the contract is known as the exercise price or strike price;
the date in the contract is known as the expiration date, exercise date,
or maturity. American options can be exercised at any time up to the
expiration date. European options can only be exercised on the
expiration date itself.3 Most of the options that are traded on
exchanges are American. However, European options are generally rasier to
analyze than American options, and some of the properties of an American option
are frequently deduced from those of its European counterpart.
It should be emphasized that an option gives
the holder the right to do somedüng. The holder does not have to exercise this
right. This fact distinguishes options from forwards and futures where the
holder is obligatecl to buy or sell the underlying asset. Note that, whereas it
costs nothing to enter into a forward or futures contract, an investor Müstpa51
to purchase anöption contract.
2As we will see in
Chapter 3, a futures price can sometimes be related to the price of the
undcrlying asset (gold, in this case).
-Note that the terms American
and European do not refer to the location of the option or the
exchange. Some options trading on North American exchanges are European.
EXAMPLF—S
Consider the situation of
an investor who buys 100 European call options on IBM stock with a strike price
of $140. Suppose that the current stock price is $138, the expiration date of
the option is in 2 months, and the option price is Since the options are
European, the investor can exercise only on the expiration date. If the stock
price on this date is less than $140, he or she will clearly choose not to
exercise. (There is no point in buying for $140 a stock that has a market value
of less than $140.) In these circumstances the investor loses the whole of the initial
investment of $500. If the stock price is above $140 on the expiration date,
the options will be exercised. Suppose, for example, that the stock price is
$155. By exercising the options, the investor is able to buy 100 shares for
$140 per share. If the shares are sold immediately, the investor makes a gain
of $15 per share or $1,500, ignoring transactions costs. When the initial cost
of the options is taken into account, the net profit to the investor is $10 per
option, or $1,000. (This calculation ignores the time value of money.) Figure
1.2 shows the way in which the investor's net profit or loss per option varies
with the terminal stock price. Note that in some cases the investor exercises
the options but takes a loss overall. Consider the situation when the stock
price is $142 on the expiration date. The investor exercises the options but
takes a loss of $300 overall. This is better than the loss of $500 that would
be incurred if the options were not exercised.
Whereas the purchaser of a can_ option
is hoping that the stock price will incre2e, the purchaser of a put option is
hoping that it will decrease. Consider an investor who buys 100 European put
options on Exxon with a strike price of $90. Suppose that the current stock
price is $86, the expiration date of the option is in
Figure 1.2 Profit from Buying
an IBM European Call Option. Option Price = $5; Strike Price = $140.
months, and the option price is $7. Since the
options are European, they will be exercised only if the stock price is
below$90 at the expiration date. Suppose that the stock price is $65 an this
date. The investor can buy 100 shares for $65 per share and, under the terms of
the put option, sell the same stock for $90 to realize a gain of $25 per share,
or $2,500. (Again, transactions costs are ignored.) When the initial cost of
the option is taken into account, the investor's net profit is $18 per option, or
$1,800. Of course, if the final stock
price is above $90, the put option expires worthless and the investor loses
$7 per option, or $700. Figure 1.3 shows the way in which the investor's profit
or loss per option varies with the lermitial)Stock price.
As already mentioned, stock options are
generally American rather than European. This means that the investors in the
examples just given do,..not ttav_e to wait until the expiration
date before exercising the options. We will see later that there are some
circumstances under which it is optimal to exercise American options prior to
maturity.
OPTION
POSITIONS
There are two sides to
every option contract. On one side is the investor who
has taken theot1 has
bought the option). On the other side is the
investor who has taken a short has
sold or written the option). The
writer of an option receives cash up front but
haipotential7liaidlities later. His or her profit or loss is the reverse of
that for the purchaser of the option. Figures 1.4 and 1.5 show the variation of
the profit and loss with the final stock price for writers of the options
considered in figures 1.2 and 1.3.
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