Lecture 5

Derivatives

Derivatives – Definition and Uses

A derivative is a financial instrument that derives its performance from the performance of an
underlying asset. The underlying need not even be an asset itself. Although common
derivatives underlyings are equities, fixed income securities, currencies, and commodities,
other derivatives underlyings include interest rates, credit, energy, weather, and even other
derivatives, all of which are not generally thought of as assets.
Derivatives are created in the form of legal contracts. They involve two parties—the buyer and
the seller (sometimes known as the writer)—each of whom agrees to do something for the
other, either now or later. The buyer, who purchases the derivative, is referred to as the long
or the holder because he owns (holds) the derivative and holds a long position. The seller is
referred to as the short because he holds a short position.
Derivative markets create beneficial opportunities that do not exist in their absence.
Derivatives can be used to create strategies that cannot be implemented with the underlyings
alone. For example, derivatives make it easier to go short, thereby benefiting from a decline
in the value of the underlying. In addition, derivatives, in and of themselves, are characterized
by a relatively high degree of leverage, meaning that participants in derivatives transactions
usually have to invest only a small amount of their own capital relative to the value of the
underlying. As such, small movements in the underlying can lead to fairly large movements in
the amount of money made or lost on the derivative. Derivatives generally trade at lower
transaction costs than comparable spot market transactions, are often more liquid than their
underlyings, and offer a simple, effective, and low-cost way to transfer risk. Derivatives are
also often used as risk management tools. In fact, derivatives are similar to insurance in that
both allow for the transfer of risk from one party to another.
There are two general classes of derivatives. Some provide the ability to lock in a price at
which one might buy or sell the underlying. Because they force the two parties to transact in
the future at a previously agreed-on price, these instruments are called forward
commitments. The various types of forward commitments are called forward contracts,
futures contracts, and swaps. Another class of derivatives provides the right but not the
obligation to buy or sell the underlying at a pre-determined price. Because the choice of
buying or selling versus doing nothing depends on a particular random outcome, these
derivatives are called contingent claims. The primary contingent claim is called an option.
Opponents of derivatives claim that the very benefits of derivatives (low cost, low capital
requirements, ease of going short) result in an excessive amount of speculative trading that
brings instability to the market. They argue that speculators use large amounts of leverage,
thereby subjecting themselves and their creditors to substantial risk if markets do not move

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in their hoped-for direction. Defaults by speculators can then lead to defaults by their
creditors, their creditors’ creditors, and so on. These effects can, therefore, be systemic and
reflect an epidemic contagion whereby instability can spread throughout markets and an
economy, if not the entire world. Given that governments often end up bailing out some banks
and insurance companies, society has expressed concern that the risk managed with
derivatives must be controlled.

Forward contracts
A forward contract is an over-the-counter derivative contract in which two parties agree that
one party, the buyer, will purchase an underlying asset from the other party, the seller, at a
later date at a fixed price they agree on when the contract is signed.
A forward contract is a commitment. Each party agrees that it will fulfill its responsibility at
the designated future date. Failure to do so constitutes a default and the non-defaulting party
can institute legal proceedings to enforce performance.
As an example, a buyer enters a forward contract to buy gold at a price of F 0(T) = $1,312.90
per ounce four months from now. The spot price of gold is S0 = $1,207.40 per ounce. Four
months in the future, the price of the underlying gold is ST = $1,275.90 per ounce. The buyer’s
gain from the forward contract, the payoff from the contract, is the value of gold (at maturity)
less the forward price: ST ‒ F0(T) = 1,275.90 – 1,312.90 = –$37.00 per ounce. Because the value
of gold when the contract matures is less than the forward price, ST < F0(T), the buyer has
incurred a loss. Notably, the forward contract seller has a contract payoff, +$37.00, that is the
negative of that of the contract buyer. The gain on owning the underlying, which is S T ‒ S0 =
1,275.90 – 1,207.40 = $68.40, differs from the gain (–$37.00) on the forward contract.
The buyer also enters a forward contract to buy oil at a price of F0(T) = $71.86 per barrel four
months from now. The spot price of oil is S0 = $71.11 per barrel. Four months in the future,
the price of the underlying oil is ST = $80.96 per barrel. The buyer’s gain from the forward
contract, the payoff from the contract, is the value of oil less the forward price: S T ‒ F0(T) =
80.96 – 71.86 = $9.10 per barrel. Unlike the forward contract on gold above, because the value
of oil when the contract matures is greater than the forward price, ST > F0(T), the buyer of the
forward contract realizes a gain.
An important element of forward contracts is that no money changes hands between parties
when the contract is initiated. Unlike in the purchase and sale of an asset, there is no value
exchanged at the start. The buyer does not pay the seller some money and obtain something.

Futures
A futures contract is a standardized derivative contract created and traded on a futures
exchange in which two parties agree that one party, the buyer, will purchase an underlying
asset from the other party, the seller, at a later date and at a price agreed on by the two parties
when the contract is initiated and in which there is a daily settling of gains and losses and a
credit guarantee by the futures exchange through its clearinghouse.

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Futures contracts first require the existence of a futures exchange, a legally recognized entity
that provides a market for trading these contracts. These exchanges specify that only certain
contracts are authorized for trading. These contracts have specific underlying assets, times to
expiration, delivery and settlement conditions, and quantities. The exchange offers a facility
in the form of a physical location and/or an electronic system as well as liquidity provided by
authorized market makers.
Probably the most important distinctive characteristic of futures contracts is the daily
settlement of gains and losses and the associated credit guarantee provided by the exchange
through its clearinghouse. When a party buys a futures contract, it commits to purchase the
underlying asset at a later date and at a price agreed upon when the contract is initiated. The
counterparty (the seller) makes the opposite commitment, an agreement to sell the
underlying asset at a later date and at a price agreed upon when the contract is initiated. The
agreed-upon price is called the futures price.
Identical contracts trade on an ongoing basis at different prices, reflecting the passage of time
and the arrival of new information to the market. Thus, as the futures price changes, the
parties make and lose money. Rising (falling) prices, of course, benefit (hurt) the long and hurt
(benefit) the short. At the end of each day, the clearinghouse engages in a practice called mark
to market, also known as the daily settlement. The clearinghouse determines an average of
the final futures trades of the day and designates that price as the settlement price. All
contracts are then said to be marked to the settlement price. For example, if the long
purchases the contract during the day at a futures price of £120 and the settlement price at
the end of the day is £122, the long’s account would be marked for a gain of £2. In other
words, the long has made a profit of £2 and that amount is credited to his account, with the
money coming from the account of the short, who has lost £2. Naturally, if the futures price
decreases, the long loses money and is charged with that loss, and the money is transferred
to the account of the short.
The account is specifically referred to as a margin account. With futures margin accounts, both
parties deposit a required minimum sum of money, but the remainder of the price is not
borrowed. This required margin is typically less than 10% of the futures price. In the example
above, let us assume that the required margin is £10, which is referred to as the initial margin.
Both the long and the short put that amount into their respective margin accounts. It is simply
an amount of money put into an account that covers possible future losses. Associated with
each initial margin is another figure called the maintenance margin. The maintenance margin
is the amount of money that each participant must maintain in the account after the trade is
initiated, and it is always significantly lower than the initial margin. Let us assume that the
maintenance margin in this example is £6. If the buyer’s account is marked to market with a
credit of £2, his margin balance moves to £12, while the seller’s account is charged £2 and his
balance moves to £8. The clearinghouse then compares each participant’s balance with the
maintenance margin. At this point, both participants more than meet the maintenance
margin.
Let us say, however, that the price continues to move in the long’s favor and, therefore, against
the short. A few days later, assume that the short’s balance falls to £4, which is below the

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maintenance margin requirement of £6. The short will then get a margin call, which is a
request to deposit additional funds. The amount that the short has to deposit, however, is not
the £2 that would bring his balance up to the maintenance margin. Instead, the short must
deposit enough funds to bring the balance up to the initial margin. So, the short must come
up with £6. The purpose of this rule is to get the party’s position significantly above the
minimum level and provide some breathing room. If the balance were brought up only to the
maintenance level, there would likely be another margin call soon. A party can choose not to
deposit additional funds, in which case the party would be required to close out the contract
as soon as possible and would be responsible for any additional losses until the position is
closed.
As with forward contracts, neither party pays any money to the other when the contract is
initiated. Value accrues as the futures price changes, but at the end of each day, the mark-to-
market process settles the gains and losses, effectively resetting the value for each party to
zero. The clearinghouse moves money between the participants, crediting gains to the
winners and charging losses to the losers. By doing this on a daily basis, the gains and losses
are typically quite small, and the margin balances help ensure that the clearing house will
collect from the party losing money. If the losing party cannot pay, the clearinghouse provides
a guarantee that it will make up the loss, which it does by maintaining an insurance fund.
Unlike forward markets, futures markets are highly regulated at the national level. National
regulators are required to approve new futures exchanges and even new contracts proposed
by existing exchanges as well as changes in margin requirements, price limits, and any
significant changes in trading procedures. Violations of futures regulations can be subject to
governmental prosecution. In addition, futures markets are far more transparent than forward
markets. Futures prices, volume, and open interest are widely reported and easily obtained.
Futures prices of nearby expiring contracts are often used as proxies for spot prices,
particularly in decentralized spot markets, such as gold, which trades in spot markets all over
the world.
In spite of the advantages of futures markets over forward markets, forward markets also have
advantages over futures markets. Transparency is not always a good thing. Forward markets
offer more privacy and fewer regulatory encumbrances. In addition, forward markets offer
more flexibility. With the ability to tailor contracts to the specific needs of participants,
forward contracts can be written exactly the way the parties want. In contrast, the
standardization of futures contracts makes it more difficult for participants to get exactly what
they want, even though they may get close substitutes. Yet, futures markets offer a valuable
credit guarantee.
Like forward markets, futures markets can be used for hedging or speculation. For example, a
jewelry manufacturer can buy gold futures, thereby hedging the price it will have to pay for
one of its key inputs. Although it is more difficult to construct a futures strategy that hedges
perfectly than to construct a forward strategy that does so, futures offer the benefit of the
credit guarantee. It is not possible to argue that futures are better than forwards or vice versa.
Market participants always trade off advantages against disadvantages. Some participants
prefer futures, and some prefer forwards.

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Swaps
A swap is an over-the-counter derivative contract in which two parties agree to exchange a
series of cash flows whereby one party pays a variable series that will be determined by an
underlying asset or rate and the other party pays either a variable series determined by a
different underlying asset or rate or a fixed series.
As with forward contracts, either party can default but only one party can default at a
particular time. The money owed is always based on the net owed by one party to the other.
Hence, the party owing the lesser amount cannot default to the party owing the greater
amount. Only the latter can default, and the amount it owes is the net of what it owes and
what is owed to it, which is also true with forwards.
The most common swap is the fixed-for-floating interest rate swap. In fact, this type of swap
is so common that it is often called a “plain vanilla swap” or just a “vanilla swap,”
Let us examine a scenario in which the vanilla interest rate swap is frequently used. Suppose
a corporation borrows from a bank at a floating rate. It would prefer a fixed rate, which would
enable it to better anticipate its cash flow needs in making its interest payments. The
corporation can effectively convert its floating-rate loan to a fixed-rate loan by adding a swap
as shown in the exhibit below.

Whatever the terms of the loan are, the terms of the swap are typically set to match those of
the loan. Thus, a Libor-based loan with monthly payments based on the 30/360 convention
would be matched with a swap with monthly payments based on Libor and the 30/360
convention and the same reset and payment dates. Although the loan has an actual balance
(the amount owed by borrower to creditor), the swap does not have such a balance owed by
one party to the other. Thus, it has no principal, but it does have a balance of sorts, called the
notional principal, which ordinarily matches the loan balance.
As with futures and forwards, no money changes hands at the start; thus, the value of a swap
when initiated must be zero.

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As with forward contracts, swaps are subject to default, but because the notional amount of
a swap is not typically exchanged, the credit risk of a swap is much less than that of a loan.
The only money passing from one party to the other is the net difference between the fixed
and floating interest payments. In fact, the parties do not even pay each other. Only one party
pays the other, as determined by the net of the greater amount owed minus the lesser
amount. This does not mean that swaps are not subject to a potentially large amount of credit
risk. At a given point in time, one party could default, effectively owing the value of all
remaining payments, which could substantially exceed the value that the non-defaulting party
owes to the defaulting party. Thus, there is indeed credit risk in a swap. This risk must be
managed by careful analysis before the transaction and by the potential use of such risk-
mitigating measures as collateral.
Example
Chloe and Madison enter into a two year interest rate swap. Under the swap, Chloe will pay a
fixed rate on a notional amount of 500,000 while receiving payments based on a floating
interest rate. The fixed rate is 3.5% with annual settlement periods. The floating rate is SOFR
plus 25 basis points. The SOFR rate for the first year is 3.1% and for the second year it turns
out to be 3.7%. Determine the net swap payment that will occur between Chloe and Madison
at the end of the first year and at the end of the second year.
At the end of the first year, Chloe will pay the fixed rate while Madison will pay the floating
rate. Therefore, Chloe would pay (500,000)(0.035) = 17,500. Since Madison is paying the
floating rate, she will pay (500,000)(0.031 + 0.0025) = 16,750. These two payments would be
netted so the net swap payment would be 17,500 – 16,750 = 750 from Chloe to Madison. At
the end of the second year, Chloe would again pay (500,000)(0.035) = 17,500 as the fixed rate
has not changed. Since Madison is paying the floating rate, she will pay (500,000)(0.037 +
0.0025) = 19,750. These two payments would be netted so the net swap payment would be
19,750 – 17,500 = 2,250. This time the net swap payment would be paid by Madison to Chloe.
If one of the counterparties to the swap has a loan, then the net swap payment combined
with the interest that the counterparty must make on the loan results in a net interest
payment on the loan. The net interest payment is the interest paid on the loan plus any net
swap payment made by the loan holder less any net swap payment received by the loan
holder.
We extend the above example, so that in addition to the swap, Chloe also has a 500,000 loan
from Anderson Bank, which charges a floating interest rate of SOFR plus 25 basis points.
Calculate the net interest payment required by Chloe at the end of each of the two years. At
the end of the first year, Chloe must pay Anderson Bank the interest based on the floating
rate. Therefore, Chloe must pay Anderson Bank (500,000)(0.031 + 0.0025) = 16,750. We also
know from Example 8 that Chloe must pay 750 to Madison at the end of the first year.
Therefore, Chloe’s net interest payment is 16,750 + 750 = 17,500. At the end of the second
year, Chloe must again pay Anderson Bank the interest based on the floating rate, which would
be (500,000)(0.037 + 0.0025) = 19,750. We also know from the first example that Chloe will

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receive a payment of 2,250 from Madison at the end of the second year. Therefore, Chloe’s
net interest payment is 19,750 – 2,250 = 17,500. We note that in both years, Chloe’s net
interest payment is 17,500. Since Chloe has swapped the floating interest rate on the loan
with Anderson Bank for a fixed interest rate, we should expect the interest paid to be the same
in both years. Also, note that the net interest payment is equal to (500,000)(0.035) = 17,500.
That is, the net interest payment is just the amount of the loan multiplied by the fixed interest
rate. This will be true as long as the notional amount of the swap is equal to the amount of
the loan and the floating rate on the loan is the same as the floating rate being swapped.

Options
An option is a derivative contract in which one party, the buyer, pays a sum of money to the
other party, the seller or writer, and receives the right to either buy or sell an underlying asset
at a fixed price either on a specific expiration date or at any time prior to the expiration date.
Options can be created in the OTC market and customized to the terms of each party, or they
can be created and traded on options exchanges and standardized. As with forward contracts
and swaps, customized options are subject to default, are less regulated, and are less
transparent than exchange-traded derivatives. Exchange traded options are protected against
default by the clearinghouse of the options exchange and are relatively transparent and
regulated at the national level.
The right to buy is one type of option, referred to as a call or call option, whereas the right to
sell is another type of option, referred to as a put or put option.
As with forwards and futures, an option can be exercised by physical delivery or cash
settlement, as written in the contract. For a call option with physical delivery, upon exercise
the underlying asset is delivered to the call buyer, who pays the call seller the exercise price.
For a put option with physical delivery, upon exercise the put buyer delivers the underlying
asset to the put seller and receives the strike price. For a cash settlement option, exercise
results in the seller paying the buyer the cash equivalent value as if the asset were delivered
and paid for. The fixed price at which the underlying asset can be purchased is called the
exercise price (also called the “strike price,” the “strike,” or the “striking price”). This price is
somewhat analogous to the forward price because it represents the price at which the
underlying will be purchased or sold if the option is exercised.
As noted, the buyer pays the writer a sum of money called the option premium, or just the
“premium.” It represents a fair price of the option, and in a well-functioning market, it would
be the value of the option.
In contrast to forwards and swaps, in which either party could default to the other, default in
options is possible only from the short to the long.

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Payoffs for Options: Calls and Puts
Calls
The buyer of a call option pays the option premium in full at the time of entering the contract.
Afterward, the buyer enjoys a potential profit should the market move in his favor. There is no
possibility of the option generating any further loss beyond the purchase price. This is one of
the most attractive features of buying options. For a limited investment, the buyer secures
unlimited profit potential with a known and strictly limited potential loss.
If the spot price of the underlying asset does not rise above the option strike price prior to the
option’s expiration, then the investor loses the amount they paid for the option. However, if
the price of the underlying asset does exceed the strike price, then the call buyer makes a
profit. The amount of profit is the difference between the market price and the option’s strike
price, multiplied by the incremental value of the underlying asset, minus the price paid for the
option.
For example, a stock option is for 100 shares of the underlying stock. Assume a trader buys
one call option contract on ABC stock with a strike price of $25. He pays $150 for the option.
On the option’s expiration date, ABC stock shares are selling for $35. The buyer/holder of the
option exercises his right to purchase 100 shares of ABC at $25 a share (the option’s strike
price). He immediately sells the shares at the current market price of $35 per share.
He paid $2,500 for the 100 shares ($25 x 100) and sells the shares for $3,500 ($35 x 100). His
profit from the option is $1,000 ($3,500 – $2,500), minus the $150 premium paid for the
option. Thus, his net profit, excluding transaction costs, is $850 ($1,000 – $150). That’s a very
nice return on investment (ROI) for just a $150 investment.
Selling Call Options
The call option seller’s downside is potentially unlimited. As the spot price of the underlying
asset exceeds the strike price, the writer of the option incurs a loss accordingly (equal to the
option buyer‘s profit). However, if the market price of the underlying asset does not go higher
than the option strike price, then the option expires worthless. The option seller profits in the
amount of the premium they received for the option.
An example is portrayed below, indicating the potential payoff for a call option on RBC stock,
with an option premium of $10 and a strike price of $100. In the example, the buyer incurs a
$10 loss if the share price of RBC does not increase past $100. Conversely, the writer of the
call is in-the-money as long as the share price remains below $110.

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Puts
A put option gives the buyer the right to sell the underlying asset at the option strike price.
The profit the buyer makes on the option depends on how far below the spot price falls below
the strike price. If the spot price is below the strike price, then the put buyer is “in-the-money.”
If the spot price remains higher than the strike price, the option will expire unexercised. The
option buyer’s loss is, again, limited to the premium paid for the option.
The writer of the put is “out-of-the-money” if the spot price of the underlying asset is below
the strike price of the contract. Their loss is equal to the put option buyer’s profit. If the spot
price remains above the strike price of the contract, the option expires unexercised, and the
writer pockets the option premium.
The figure below shows the payoff for a hypothetical 3-month RBC put option, with an option
premium of $10 and a strike price of $100. The buyer’s potential loss (blue line) is limited to
the cost of the put option contract ($10). The put option writer, or seller, is in-the-money as
long as the price of the stock remains above $90.

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Applications of Options: Calls and Puts
Options: calls and puts are primarily used by investors to hedge against risks in existing
investments. It is frequently the case, for example, that an investor who owns stock buys or
sells options on the stock to hedge his direct investment in the underlying asset. His option
investments are designed to at least partially compensate for any losses that may be incurred
in the underlying asset. However, options may also be used as standalone speculative
investments.
Hedging – Buying puts
If an investor believes that certain stocks in their portfolio may drop in price but they do not
wish to abandon their position for the long term, they can buy put options on the stock. If the
stock does decline in price, then profits in the put options will offset losses in the actual stock.
Investors commonly implement such a strategy during periods of uncertainty, such as earnings
season. They may buy puts on particular stocks in their portfolio or buy index puts to protect
a well-diversified portfolio. Mutual fund managers often use puts to limit the fund’s downside
risk exposure.
Speculation – Buy calls or sell puts
If an investor believes the price of a security is likely to rise, they can buy calls or sell puts to
benefit from such a price rise. In buying call options, the investor’s total risk is limited to the
premium paid for the option. Their potential profit is, theoretically, unlimited. It is determined
by how far the market price exceeds the option strike price and how many options the investor
holds.
For the seller of a put option, things are reversed. Their potential profit is limited to the
premium received for writing the put. Their potential loss is unlimited – equal to the amount
by which the market price is below the option strike price, times the number of options sold.
Speculation – Sell calls or buy puts on bearish securities
Investors can benefit from downward price movements by either selling calls or buying puts.
The upside to the writer of a call is limited to the option premium. The buyer of a put faces a
potentially unlimited upside but has a limited downside, equal to the option’s price. If the
market price of the underlying security falls, the put buyer profits to the extent the market
price declines below the option strike price. If the investor’s hunch was wrong and prices don’t
fall, the investor only loses the option premium.

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