Anh Tran

FIN 436-401
Dr. Susan Flaherty

Chapter 7: BASIC Derivatives

This is primarily a repeat from FIN333. As such, you might take this as a test for yourself to see what you
remember. You complete everything in blue.

Learning Objectives:
-describe a derivative instrument and its attributes
-Identify and understand the basics features and functions of options contracts
-understand premium concepts and data
-complete basic speculation
-explain the importance for an MNC
-compare the forward and futures contracts and the terminology

I. Fundamentals:
A. Describe/define the attributes of a derivative instrument:
1. Underlying asset
Is the security on which a derivative contract is based on, it can be stock, commodity,
index, currency, or even other derivatives, directly correlated (call option) or inversely
correlated (put option)
2. Ownership of the asset
Ownership of derivative does not mean ownership of the asset, the value of derivative
derives on the value of the asset
3. Balance sheet position
Value of the derivative (asset) = equity + maintenance margin (liability). The holder must
maintain initial margin level when the account drop (margin call)
4. Zero sum game outcome
Derivative is zero sum game because for every winner or amount won, there is equivalent loser
or sum lost. Loser is the counterparty to the profitable trader.

B. Define hedging versus speculation:

Speculation is use of financial futures to increase profits. Speculators take on increased risks by
gambling on interest movements

Hedging is the use of the financial futures to reduce risk exposure.

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 II. Options
A. Options: Basic Features

1. Define an option contract

Unlike futures and forwards, options give the holder the right, but not the obligation, to either buy
or sell the underlying commodity at a fixed price called the exercise or strike price.

2. Why would this contract be useful in hedging FOREX risk?

Because it will give the trader probability partly or totally offset the exchange rate risk. They can be
profitable as well.

3. Attributes: every option has three different price elements- define them:

a. The strike price or exercise price (we use the terms price and rate interchangeably):

The strike price is the price at which the holder of an options can buy (in the case of a call option) or sell
(in the case of a put option) the underlying security when the option is exercised. Therefore, strike price
is also known as exercise price.

b. The underlying or actual spot rate in the market: (explain why this is important and how it is
used in relation to the contract)

For example, you are a holder of a call option with a strike of $1.65/€ to buy € from $

If the underlying or actual spot rate in the market is $1.78/€

Your option is in the money (intrinsic value > 0), so you will exercise this by paying a strike of $1.65/€

If the underlying or actual spot rate in the market is $1.60/€

Your option is out of money (no intrinsic value), so you certainly don’t exercise this option

c. The premium: define

 Who pays it? The buyer, holder of the option

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  What happen to the premium if the contract expires?

Become the cash inflow of the issuer or writer of the option

 Calculate it: The premium (cost)= contract size x (cost/unit), or

The premium (cost)= contract size x premium rate(%) x spot.

B. Basic terms: define each

1. Option premium and participants:

Buyer or holder: who pay premium when buying option

Writer or issuer: who receive premium when selling option

2. An options contract can be traded:

over-the-counter: European option

organized exchanges: American option

3. Based on the exercise date, an option can be:

American: can exercise anytime between purchased date and expiration date

European1: only allow to exercise at the expiration date

C. Different types of options contracts

1. Two types of currency option (define):

call option: option holding a right to buy

put option: option holding a right to sell

An investor (trader) can be ____(long or short) in options:

long: if one buys options contract, assumes price will__increase__(increase or decrease)

short: if one sells options contract, assumes price will__decrease__(increase or

decrease)

2. Basic Option terminology

- Based on the profitability (does not include the premium), an options contract can be:

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For our class, we will only consider European style options.

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Define each term below Fill in the blank with >, <, or =. Fill in the blank with >, <, or =.
Position: Holder of a CALL Holder of a PUT
in-the-money (ITM):
Strike price____<__Spot price Strike price____>__Spot price

out-of-money (OTM):
Strike price____>__Spot price Strike price____<__Spot price

at- the-money (ATM):

Strike price______Spot price Strike price______Spot price

D. The premium: EXAMPLE Swiss Franc

Premium presentation for USDCHF (SFr/$). Standard Contract Size: SFr 62,500.
SPOT RATE

1. Premium presentation oddities:

Traders have traditionally used short cuts to communicate a lot of information in small or
altered form; premiums are an example of this. The above exchange rate should look strange to
you given that the value of the spot rate and strike rate are so large. ALL VALUES MUST BE
MULTIPLIED BY .01 to get the actual rates.

Let’s take a look at the available option contract highlighted in yellow in the table above:

The spot rate (or Option & Underlying) means that 58.51 cents, or $0.5851 was the price of
one Swiss franc.

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 The strike price means the price per franc for the option. The August call or put option of
58 ½ means a strike price of $0.5850/SFr.

The premium cost of the August 58 ½ options was 0.50 per franc or $0.0050/SFr. The chart
provides the price as the “cost/unit” of currency.

a. What is the premium cost for one August call contract?

$0.0050/SFr x 62500 SFr = $312 premium cost for on one August call option contract

b. What do you notice about the premium as you move from left to right in each box?

For both the call and put option, the longer the maturity, the higher the premium

For the put option, the longer the maturity, the higher the Why? (HINT: Notice the month increases,
that is, maturity increases)

For the put option, the longer the maturity, the higher the premium because longer maturity means
more uncertainty as well as riskiness, more difficult to forecast, so the issuer or writer of the option
need higher premium to compensate for the higher risk.

c. What do you notice about the premium as you move from top to bottom per month in each
box? Why? (HINT: examine the relationship between the spot and the strike)

For the call option, the higher the strike price, the lower the premium because the higher strike price
which means the option will not be exercised (strike > spot) so the writer does not need higher
premium to offset or compensate for the possible loss.

For the put option, the higher the striker price, the higher the premium because the higher strike price
which means the option will be exercised (strike > spot ) so the writer need higher premium to offset or
compensate for the possible loss.

2. What three elements determine the size of the premium?

a. Time to maturity. Why?
Because the longer the maturity, the longer time, the longer time which means more
uncertainty as well as risk level and harder to predict so issuer need more compensation
(higher premium)

b. Volatility of the underlying asset. Why?

Because the more volatility the underlying asset, the more riskiness the asset provide,
so the issuer need higher premium to compensate

c. The relationship of the spot and strike at issuance. Why?

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 Because this relationship between them will decide the probability of the exercising of
the option. Depending on the type of option (call or put) and the spread between the
spot and strike price, the issuers will increase or decrease premium to appropriately
compensate for them.

III. Option Speculation: Let’s try some problems with Hans, a currency
speculator.

We will use four scenarios to represent each possible options position (holder of a call or put, writer of a
call or put).

If Hans were to speculate in the options market, his viewpoint would determine what type of option to
buy or sell.

For each speculation position, answer the questions below the data. I have completed
the first one for you.

As a note, MNCs do not typically write contracts; they are buyers of contracts. However,
you should understand the positioning of the writer.

A. Speculation I: holder of a call option (right to buy)

Assume Hans believes the rate will increase in 3 months.
current spot rate: $0.5851/SFr
strike rate: $0.5850/SFr
Standard Contract Size: SFr62,500
Hans’ E[S90] rate: $0.6000/SFr
Hans’ Premium rate: $0.0050/SFr
Actual Spot(90): S90 ?

a) What does Hans want the relationship of the spot rate and strike price at maturity? spot _>__strike
b) What are the positions on the important dates? (i.e., what does Hans do?)
Position on:
Day 1) Lock in the contract to buy SFr by paying the premium of Sfr62,500 x
$0.0050/Sfr = $312.50
Day 90) If S90= $0.5950/SFr, then Hans executes and makes money by buying
cheap through the contract and selling high in the market.

Breakeven amount. Why?

CALL OPTION/ HOLDER Profit formula:
Profit = Spot rate – (Strike price + Premium)
= $0.595/Sfr – ($0.585/Sfr + $0.005/Sfr)

= $0.005/Sfr

In dollar terms: $0.005/Sfr x SFr62,500= $312.50 profit

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 i. What happens to the writer of the option if they are uncovered in the market? That is, they
are not holding SFr in inventory.
If the writer is uncovered and the client executes, the writer is obliged to fulfill the contract.
In this case, the writer would suffer a loss because they would have to buy high at the spot
($0.595) and sell low according to the contract ($0.585).

c) What if the spot < strike on day 90?

Hans would not execute and would buy in the market losing the premium.
d) Why use this contract? Potential for unlimited gains and limited losses.

B. Speculation II: holder of a put option

Assume Hans believes the rate will decrease in 3 months.
current spot rate: $0.5851/SFr
strike rate: $0.5850/SFr
Standard Contract Size: SFr62,500
Hans’ E[S90] rate: $0.5500/SFr
Hans’ Premium rate: $0.0050/SFr
Actual Spot(90): S90 ?

a) What does Hans want the relationship of the spot rate and strike price at maturity? spot __<_strike
b) What are the positions on the important dates? (i.e., what does Hans do?)
Position on:
Day 1) Lock in the contract to sell SFr by paying the premium of Sfr62,500 x
$0.0050/Sfr = $312.50

Day 90) If S90= $0.5750/SFr, then Hans executes and makes money by selling
expensive through the contract

PUT OPTION/HOLDER Profit formula:

Profit = Strike price – (Spot rate + Premium)
= $0.5850/SFr – ( $0.5750/SFr + $0.0050/SFr)

= $0.005/ SFr

In dollar terms:

c) What if the spot > strike on day 90?

Certainly, Hans will not exercise the contract, he only loose the premium.

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d) Why use this contract?

To make profit from speculation according his good ability on exchange rate movement

C. Speculation III: writer of a call option

Assume Hans believes the spot rate will decrease in 3 months.
current spot rate: $0.5851/SFr
strike rate: $0.5850/SFr
Standard Contract Size: SFr62,500
Hans’ E[S90] rate: $0.5500/SFr
Hans’ Premium rate: $0.0050/SFr
Actual Spot(90): S90 ?

a) What does Hans want the relationship of the spot rate and strike price at maturity? spot _<__strike
b) What are the positions on the important dates? (i.e., what does Hans do?)
Position on:
Day 1) sell a call option and receive the premium of $0.0050/SFr from the buyer

Day 90) If S90= $0.5950/SFr, then Hans (explain as though Hans is uncovered)

Have to sell the cheap contract to the buyer and incur a lost because spot >
strike as unexpected

CALL OPTION/WRITER Profit formula:

Profit = Premium – (Spot rate - Strike price)

= $0.0050/SFr – ( $0.5950-SFr - $0.5850/SFr) = $-0.005/SFr (loss!)

In dollar terms:

c) What if the spot > strike on day 90?

The buyer will exercise the option for sure to make profit (buying cheap) and willing to pay the premium
and Hans will incur the lost. This is a zero sum game.

d) Here the writer of a call option has limited profit and unlimited losses if uncovered.

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 D. Speculation IV: writer of a put option
Assume Hans believes the rate will increase in 3 months.
current spot rate: $0.5851/SFr
strike rate: $0.5850/SFr
Standard Contract Size: SFr62,500
Hans’ E[S90] rate: $0.6000/SFr
Hans’ Premium rate: $0.0050/SFr
Actual Spot(90): S90 ?

a) What does Hans want the relationship of the spot rate and strike price at maturity? spot _>__strike
b) What are the positions on the important dates? (i.e., what does Hans do?)
Position on:
Day 1) sell a put option and receive the premium of $0.0050/SFr from the
buyer

Day 90) If S90= $0.5750/SFr, then Hans has to sell the cheap contract to the
buyer and incur a lost because spot < strike as unexpected.

PUT OPTION/ WRITER Profit formula:

Profit* = Premium – (Strike price – Spot rate)
= $0.0050/SFr – ( $0.5850-SFr - $0.5750/SFr) = $-0.005/SFr (loss!)
In dollar terms:

*Pay attention to whether the option is exercised or not!

c) What if the spot < strike on day 90?

The buyer will exercise the option for sure to make profit (selling expensive) and willing to pay the
premium and Hans will incur the lost. This is a zero sum game.

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IV Futures and Forward Contracts
(Describe the differences between a forward contract and a futures contract)
A. Define a forward contract:
1. List the characteristics:

B. Define a futures contract:

1. List the characteristics:

MNCs favor the forward contract while speculators favor the futures contract. Why?

C. Terminology
1. Speculation strategies using Futures contracts:

Short position

________ (sell or buy) a futures contract based on view that currency will ______ (increase or decrease)
in value

Long position

________ (sell or buy) a futures contract based on view that currency will ______ (increase or decrease)
in value– purchase a futures contract based on view that currency will rise in value

D. Data Presentation
1. You are given the following data peso futures data (released January 1) to create a
speculation strategy:

Mexican Peso (CME) (MXN 500,000; $ per 10MXN or MXNUSD or $/₱)

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 A few things to note about the futures data chart:
-The standard contract size is ₱500,000.00
-The contract is about the ₱ NOT the $. Remember that the contract is always (99.9% of the time)
about the denominator currency. The denominator currency is the “underlying asset.”
-The SETTLE price represents the FORWARD rate that will appear on the contract.
-Notice there is no distinction of buying or selling the currency associated with the rate. What you
do with the currency is determined by what you do with the contract.
-Open interest notes the number of outstanding contracts for that maturity.
What is the relationship between maturity and the number of open contracts? Why?

E. Examples/Applications
1. Short Position

Amber, our international trader, believes the Mexican peso will fall in value against the US dollar.
Due to this belief:

The SHORT position on the Mexican peso locks-in the right to sell 500,000 Mexican pesos at
maturity at a set price above their prevailing spot price and buy dollars.

a. Using the quotes from the table above,

DAY 1: Amber sells one March contract for 500,000 pesos at the settle price: $.10958/₱

-Notice the language is very specific: action, number of contracts, maturity

-She basically “signs on the dotted line.”

Does she own the currency on Day 1 that she will sell at maturity?

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 DAY 90: Spot of $.09500/₱

-What does Amber do at maturity? Amber will make two transactions, one in the spot
market and one in the futures: Notice the negative
SPOT Market: Buy ₱ at $0.0950 sign!!!! This is added to
make sure that you get
FUTURES Market (contract): Sell ₱ at $0.10958 a positive number when
you earn a profit
because the formula is
To calculate the value of Amber’s position we use the following formula: set up as Spot-Forward.
Value at maturity (Short position) = - Notional principal  (Spot – Forward)

Value = -Ps 500,000  ($0.09500/ Ps - $.10958/ Ps) = $7,290

b. Amber earned a profit because she was able to BUY LOW and SELL HIGH across the two
markets.

2. Long Position

Amber, our international trader, believes the Mexican peso will rise in value against the US dollar.
Due to this belief:

The LONG position on the Mexican peso locks-in the right to buy 500,000 Mexican pesos at maturity
at a set price below their prevailing spot price and sell dollars.

a. Using the quotes from the table above,

DAY 1: Amber buys one March contract for 500,000 pesos at the settle price: $.10958/₱

DAY 90: Spot of $.1100/₱

-What does Amber do at maturity? Amber will make two transactions, one in the spot
market and one in the futures:
Notice NO negative
SPOT Market: Sell ₱ at $0.1100 sign…because the
formula is set up as
FUTURES Market (contract): Buy ₱ at $0.10958
Spot-Forward which will
be a positive if her
speculation is correct.
To calculate the value of Amber’s position we use the following formula:

Value at maturity (Long position) = Notional principal  (Spot – Forward)

Value = Ps 500,000  ($0.11000/ Ps - $.10958/ Ps) = $210

b. Amber earned a profit because she was able to BUY LOW and SELL HIGH across the two
markets.

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V. For you to try!
A. Name and Describe th55555555555555555555555e differences and similarities among Options,
Forwards, and Futures

B. Jacques Clouseau trades currency for a Swiss bank. He has $1,000,000 to invest. The current spot rate
is $0.5820/SF, the three-month forward rate is $0.5640/SF.
a. If he expects the spot rates to reach $0.6250/SF in three months, how would he speculate?
b. If he expects the spot rates to reach $0.5521/SF in three months, how would he speculate?
For parts a) and b), calculate Jacques expected profit assuming he buys or sells SF three months
forward to speculate. Show the profit from the speculation. (Do not use a buy and hold strategy.)

Make sure your language is specific about the actions you will take along with the calculations.

C. You purchase a call option on pounds for a premium of $.03 per unit, with an exercise price of $1.64;
the option will not be exercised until the expiration date, if at all. If the spot rate on the expiration date
is $1.65, what is your net profit per unit?

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D. Explain the following statements:
a. The holder of a call option has the potential of unlimited profits and limited losses.
b. The writer of a call option has the potential of limited profits and unlimited losses.
c. The holder of a put option has the potential of unlimited profits and limited losses.
d. The writer of a put option has the potential of limited profits and unlimited losses.

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