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Chapter 9

Chapter 9. Futures and Options. Background. Derivatives are investments that derive their value from some underlying quantity (usually a stock, bond or commodity price) Forward contract—obligates the buyer to purchase the underlying security on a given date for a specified price

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Chapter 9

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  1. Chapter 9 Futures and Options Chapter 9: Futures and Options

  2. Background • Derivatives are investments that derive their value from some underlying quantity (usually a stock, bond or commodity price) • Forward contract—obligates the buyer to purchase the underlying security on a given date for a specified price • Arrangements between private parties • Not actively traded in any market • Futures contract—obligates the buyer to purchase a specified quantity of the underlying security on a given date at a specified price • Actively traded on futures exchanges until delivery date • Can earn gains/losses from simply trading the contract itself, without every taking delivery of underlying goods Chapter 9: Futures and Options

  3. Background • Option—agreement between an option writer (who sells the option) and buyer • Option buyer has right (but not obligation) to buy (call) or sell (put) underlying security at the pre-determined exercise price on a specified date • If option is exercised, option writer must follow through • Many options expire unexercised • Options actively traded at options exchanges and OTC markets Chapter 9: Futures and Options

  4. Forward Contracts • A forward contract is created when someone buys a commodity, security or other asset for future delivery • Delivery price is fixed when contract is created, but not paid until delivery date (which may be months or years after the contracting date) • Buyer and seller negotiate the • Price • Quantity • Quality of goods • Delivery location • Delivery date • Each forward contract is tailor-made to fit the needs and preferences of the buyer and seller • Counterparty risk arises due to the risk that the buyer or seller may default Chapter 9: Futures and Options

  5. Futures Contracts • Evolved from forward contracts • Contain improvements designed to • Reduce counterparty risk • Increase liquidity • Agricultural futures on corn and wheat traded on CBT in 1865 • Financial futures on stock, bonds, etc. began trading in 1970s Chapter 9: Futures and Options

  6. Futures Contracts • Basic characteristics • A futures contract is just a forward contract that has been standardized to increase its marketability • Taking Delivery • If you buy a futures contract you must • Sell the contract prior to the delivery date • Most common occurrence • Or take delivery of the underlying goods upon expiration of contract • Cash Settlement • Financial futures usually provide for cash settlement—receiving cash rather than the underlying good • Most agricultural futures allow for physical delivery of the underlying good Chapter 9: Futures and Options

  7. Futures Contracts • Trading Futures • Futures exchange • Members meet on exchange trading floor and use open outcry method to negotiate each transaction • Each time a futures contract is purchased and resold, the transaction can occur at a different price than the preceding transaction • Last buyer will receive delivery upon delivery date • If last seller fails to make delivery, clearinghouse makes delivery and sues defaulted seller • Removes counterparty risk Chapter 9: Futures and Options

  8. Types of Futures Contracts • Futures contracts have existed for many years for commodities such as • Gold • Silver • Soybeans • Corn • Wheat • Futures have been traded since the 1970s on financial products such as • Bonds • Foreign currencies • Stock market indexes • Volume of financial futures far exceeds aggregate trading of traditional commodities Chapter 9: Futures and Options

  9. Exchanges • Chicago Board of Options • Largest organized options exchange in the world • http://www.cboe.com • Chicago Mercantile Exchange • Large organized futures exchange • http://www.cme.com • Chicago Board of Trade (CBOT) • Largest, oldest futures exchange in the world • http://www.cbot.com Chapter 9: Futures and Options

  10. Gains & Losses in Futures Positions • An investor long in a future may • Wait until the contract expires and take delivery (or perhaps receive a cash settlement value) • Hold position and see what happens to price • Eliminate long position by offsetting (selling contract) • An investor short in a future may • Wait until the contract expires and make delivery (or make a cash payment) • Hold position and see what happens to price • Eliminate short position by offsetting (buying contract) Chapter 9: Futures and Options

  11. The Clearing House • A futures contract can be executed without the buyer and seller having to contact each other • Clearing house inserts itself into every transaction—buyer in every sale and seller in every purchase • Clear and settle transactions • Expedite the delivery process • Guarantee performance of every contract • Collect fees of a few pennies on every contract • Process thousands of contracts daily • Fees accumulate in a guarantee fund Chapter 9: Futures and Options

  12. Margin Requirements • To trade futures, client must open a margin account • Initial margins on futures are small—range from 3% to 12% of transaction’s value • Most futures traders trade on margin rather than pay for the entire transaction • If significant losses occur, will receive margin call Chapter 9: Futures and Options

  13. Speculating with Futures • Speculators hope to earn profits by aggressively trading futures • Example: A professor has been researching a new strain of bacteria which caused a rapidly-spreading blight in Illinois, destroying many acres of wheat. The professor believes that the blight could wipe out a significant part of the U.S.’s wheat crop if it is not contained before the end of May. If so, the price of wheat could rise rapidly. If the professor goes long in wheat futures, he could realize personal profit. Chapter 9: Futures and Options

  14. Speculating with Futures • The professor buys one September wheat future at a price of $3.50 per bushel in early May, for a total cost of $17,500 (CBT wheat contracts deal in 5,000 bushels of wheat per contract) • However, he is only required to put up a 10% margin, or $1,750 • Several days later the U.S. Department of Agriculture announces the wheat blight and the price of wheat rises • The professor sells his long position in wheat futures for $4.00 per bushel • Results in profit of $0.50 per bushel times 5,000 bushels, or $2,500 • This is a return of $2,500  $1,750 = 143% Chapter 9: Futures and Options

  15. Leverage • Low initial margin requirements on futures allow investors to make only small initial outlays on large amounts of contracts • This use of leverage enhances both profits and losses • Forward contracts cannot be purchased using leverage • Buyers must pay cash on delivery Chapter 9: Futures and Options

  16. Speculating with S&P500 Index Futures • CME began trading a futures contract on the S&P500 index in 1982 • One of the most successful futures contracts in the world • Underlying quantity on which the futures contract is based is the market value of the S&P500 index • Merc’s futures contract defines the futures price as • $250  Market Value of S&P500 index • Index owners are not entitled to any cash dividends • Futures contract is a cash settlement contract • Cash received is based on the difference between most recent market value of the index future and the contract’s purchase price Chapter 9: Futures and Options

  17. Speculating with S&P500 Index Futures • Example: You feel bullish about the stock market and you decide to purchase one September futures contract on the S&P500 Index • You call your broker and give him a market order to buy one contract • The order is executed when the S&P500 index was trading at 651 for a total of $162,750 • You have to put up a 3% margin, or 3% x 651 x $250 = $4,882.5 • Feeling satisfied with yourself you decide to go to lunch—upon returning from lunch you learn that the S&P500 index is now at 653 Chapter 9: Futures and Options

  18. Speculating with S&P500 Index Futures • You call your broker and give a market order to sell while the index is still at 653 • You earn a profit of: • $250 x 653 = $163,250 - $162,750 - $100 (commissions) = $400 • This represents a return of • $400  $4,882.5 = 8.19% for a holding period of several hours • What if the market had moved in the wrong direction? • Could have suffered substantial losses if the market had experienced a severe downturn Chapter 9: Futures and Options

  19. Speculating with S&P500 Index Futures • If you had bearishly sold S&P500 Index futures at 651 before lunch and the market rose to 653 during lunch you would have lost $600 • $162,750 - $163,750 - $100 (commissions) = -$600 Chapter 9: Futures and Options

  20. Hedging with Futures • Hedgers are more interested in avoiding risk than speculating to maximize gains • Selling hedge—used to avoid losses from price declines on physical inventory • Protect a farmer against a loss if the market value of his growing crop declines • Also limits his ability for potential profits if the market value of crop rises Chapter 9: Futures and Options

  21. Hedging with Futures • Example: Farmer Brown can profitably produce 20,000 bushels of wheat if he can sell the crop for $4.50 per bushel in July • In April, while he was planting his crops, the price of July wheat futures was $4.50 per bushel • By selling 4 wheat futures contracts (5,000 bushels each) short at $4.50 per bushel, Farmer Brown hedges the 20,000 bushels of physical wheat growing in the field • Locks in the $4.50 per bushel selling price and assures Farmer Brown that he can earn his desired profit Chapter 9: Futures and Options

  22. Hedging with Futures • Regardless of what happens to the price of wheat, Farmer Brown will receive a total value of $22,500 per contract as shown below Chapter 9: Futures and Options

  23. Hedging with Futures • It is now July and Farmer Brown harvests his wheat • At this time, the price of wheat is $4.25 per bushel • Farmer Brown sells his wheat in the cash (physicals) market for $4.25 per bushel • At the same time, he offsets his positions in the futures market by buying 4 wheat futures contracts at $4.25 per bushel • This eliminates (reverses, unwinds) his short futures position Chapter 9: Futures and Options

  24. Hedging with Futures • Farmer Brown receives • A net gain of $0.25 per bushel on his futures contract • A $0.25 per bushel loss on his physical wheat • Excluding brokerage commissions and taxes, Farmer Brown received the $4.50 per bushel he wanted Chapter 9: Futures and Options

  25. Perfect Hedges • The preceding example involved a perfect hedge • Rarely possible • Hedges are usually imperfect due to • The long and short positions may not coincide in time • For example, best harvest time may occur after delivery date of futures contract • Delivery may have to be made at an inaccessible location • Chicago may be too costly for a farmer in Oregon • The specified quality cannot be delivered • For example, due to a blight, Farmer Brown’s wheat is discolored Chapter 9: Futures and Options

  26. Futures Prices and Other Trading Data • New contracts originate every quarter, with expiration dates of March, June, September and December • Open interest represents the number of opened contracts that have not yet been offset Chapter 9: Futures and Options

  27. Regulating Financial Futures in the U.S. • Most futures exchanges operate their own clearing house • Commodity Futures Trading Commission Act of 1974 established an independent federal agency (CFTC) to oversee futures transactions in the U.S. • Options Clearing Corporation (OCC) is owned by the CBOE, AMEX, PHIX and PSE and is regulated by the SEC Chapter 9: Futures and Options

  28. Characteristics of Puts and Calls on Equities • Regardless of your view of the future price of a stock, it is possible to create a investment to take advantage of that expectation • Profit opportunities can be constructed using these basic building blocks • Buying a long position in the stock • Selling the stock short • Buying a call option on the stock • Selling a call option on the stock • Buying a put option on the stock • Selling a put option on the stock Chapter 9: Futures and Options

  29. Defining a Call Option • A call option • Gives the owner the right (not the obligation) to buy the underlying stock within a specified period of time at a specified price (exercise price) • One call deals with 100 shares of stock (a round lot) • Call writer gets paid to provide the buyer with the opportunity to buy underlying stock if the buyer chooses to do so Chapter 9: Futures and Options

  30. Characteristics of Stock Options • New options originate in the U.S. every month • Options exist on the same stock with different expiration dates • 3, 6, 9 and 12 months • AMEX started listing put and call options with expirations as long as 30 months • Long-term Equity Appreciation Securities (LEAPS) Chapter 9: Futures and Options

  31. Characteristics of Stock Options • Prior to an option’s expiration date, the owner of a put or call option can • Hold the option to see what happens to the stock’s price • Sell the option at the current market price and take the resulting gain or loss • Eliminates the option position • Exercise the option • Eliminates the option position • Let the option expire • Option is then worthless • Only about 10% of all exchange-listed options are exercised Chapter 9: Futures and Options

  32. Characteristics of Stock Options • Parties to an option contract • Option buyer • Pays premium to option seller to encourage seller to write the option • Said to be long options • Option seller • Receives premium from buyer for writing the option • Said to be short options Chapter 9: Futures and Options

  33. Characteristics of Stock Options • Prices associated with options • Price of the underlying assets • Fluctuating market price of the asset underlying the option contract • Exercise price (AKA strike price, contract price) • Price at which the option seller can be legally required to execute the option • Does not fluctuate over the life of the option • Option premium • Price the option buyer pays the seller • Fluctuates throughout the option’s life Chapter 9: Futures and Options

  34. Characteristics of Stock Options • Options buyers usually do not exercise the options • Because options buyers are usually price speculators and risk-averting hedgers • If an option seller writes an option that is never exercised, he receives money (option premium) for simply exposing himself to the risk that the option would be exercised and he would lose money • If options are exercised, the writer usually loses more than his premium income Chapter 9: Futures and Options

  35. Characteristics of Stock Options • European options can only be exercised on the expiration date • Trade in Europe and non-European countries • American options can be exercised any trading day up to and including the expiration date • Trade in U.S. and other countries Chapter 9: Futures and Options

  36. Markets for Options • Options exchanges include • Chicago Board Options Exchange (CBOE) • Chicago Board of Trade (CBOT) • Chicago Mercantile Exchange • American Stock Exchange (AMEX) • Philadelphia Stock Exchange (PHIX) • Pacific Stock Exchange (PSE) Chapter 9: Futures and Options

  37. Option Quotations Chapter 9: Futures and Options

  38. Gain-Loss Illustrations for Call Positions • If an investor expects a stock price increase, he could • Take a long position in the stock, or • Buy a call option on the stock • If stock price rises above exercise price, buyer can exercise option to buy stock then sell stock at the higher market price • If investor was wrong and stock price falls, buyer loses the premium paid for the option Chapter 9: Futures and Options

  39. Gain, $ Intrinsic value of call Break-even point, $43 which is Call premium + exercise price Gain or loss $10 $7 Price of the underlying stock, $ $0 $50 Premium paid, $3 -$3 Exercise price, $40 Loss, $ Gain-Loss Graph—Call Buyer Intrinsic Value of a call = Max[0, (Stock price – Exercise price)] If stock price is $50, the IV is Max[0, 50-40] = $10. Chapter 9: Futures and Options

  40. Example: A Call Option on KO • KO is currently selling for $30 per share. A call option with a strike price of $40 expires in six months and has a current premium of $3 per share • The intrinsic value of the call is $0, or the MAX of [0, $30-$40] • Over a range of KO’s stock prices, the intrinsic value of the option would be: Chapter 9: Futures and Options

  41. Illustration of Call Writer’s Position • If the stock’s price remains below the option’s strike price, the option will not be exercised and it will expire worthless • The call writer keeps the option premium for doing nothing • However, if the stock price rises above the exercise price, the call buyer will exercise the option and the call buyer’s gain will equal the call writer’s loss • Thus, the intrinsic value of a call writer's position is the minimum of • [0, (Exercise price – Stock price)] Chapter 9: Futures and Options

  42. Illustration of Call Writer’s Position • The call writer’s intrinsic gain is equal to the premium received when the option was sold plus the intrinsic value of the call Chapter 9: Futures and Options

  43. Gain, $ Premium income, $3 Exercise price, $40 $3 Price of the underlying stock, $ $50 $0 -$7 Gain or loss -$10 Break-even point, $43 which is Call premium + exercise price Intrinsic value of call Loss, $ Illustration of Call Writer’s Position Chapter 9: Futures and Options

  44. Example: Intel Call Option • In 1993 Intel’s price ranged from $21 to $37 • In 1993 Mr. Byer bought a call option on Intel, paying Ms. Rhyter a premium of $2.50 • The option had a strike price of $20 per share and six months until expiration • If the value of Intel rose to $75 prior to the expiration date, Mr. Byer could exercise the option and buy Intel for $20, then immediately sell the stock for $75 • His profit would be $75 - $20 - $2.50 = $52.50 per share • If the value of Intel rose to $75 and Mr. Byer exercised the option, Ms. Rhyter would have to buy shares of Intel for $75 and immediately deliver them to Mr. Byer who would pay her $20 for each • Her loss would be $20 - $75 + $2.50 = -$52.50 per share • Note that Mr. Byer’s profit exactly equals Ms. Rhyter’s loss Chapter 9: Futures and Options

  45. Example: Intel Call Option • If Intel’s price dropped below $20 a share, Ms. Rhyter’s position would become profitable while Mr. Byer would lose money (the call premium) Chapter 9: Futures and Options

  46. Put Options • A put option • Gives the owner the right (not the obligation) to sell (or put) a round lot of the underlying stock to the put seller within a specified period of time at a specified price (exercise price) • The intrinsic value of a put is • MAX[$0, Exercise price – Stock price] Chapter 9: Futures and Options

  47. Gain, $ Intrinsic value of put buyer Exercise price Price of the underlying stock, $ $0 Premium paid Intrinsic Profit Break-even point Loss, $ Gain-Loss Graph for Put Buyer Chapter 9: Futures and Options

  48. Gain, $ Break-even point Intrinsic Profit Price of the underlying stock, $ Premium income $0 Exercise price Intrinsic value of put writer Loss, $ Gain-Loss Graph for Put Writer Intrinsic Value of a put writer’s position is MIN[0, (Stock price – Exercise price)] Chapter 9: Futures and Options

  49. Example: Intrinsic Values for a Put Buyer • You buy a put for $2 per share for Speed.Com Corporation with an exercise price of $45 • What is your maximum loss? • The most you can lose is your premium of $2 per share • What is your maximum gain? • If the company goes bankrupt, you’ll still be able to sell the stock for $45—thus, your gain would be $45-$2=$43 • What will your gain be at expiration if the stock rises in value to $50? • The put would not be exercised and your loss would be the premium of $2 • What will your gain be at expiration if the stock falls in value to $40? • You would exercise the put and sell the stock for $45—thus your gain would be $45 - $40 - $2 = $3 Chapter 9: Futures and Options

  50. Perspectives on Options • Short sellers and buyers of put options both benefit from a stock price decline • Options buyers cannot lose more than the premium paid for the option—limited liability • Means that buyers of a put option are better off than short sellers if the stock price rises • Means that call buyers are better off than investors with long positions if the stock price falls • Call writers do not enjoy limited liability • If the price of the optioned stock rises to infinity, the writer’s losses rise in tandem Chapter 9: Futures and Options

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