Investment and portfolio management

1. Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 21

2. Chapter 21 - An Introduction to
Derivative Markets and Securities
Questions to be answered:
• What distinguishes a derivative security such as
a forward, futures, or option contract, from
more fundamental securities, such as stocks and
bonds?
• What are the important characteristics of
forward, futures, and option contracts, and in
what sense can the be interpreted as insurance
policies?

3. Chapter 21 - An Introduction to
Derivative Markets and Securities
• How are the markets for derivative securities
organized and how do they differ from other
security markets?
• What terminology is used to describe
transactions that involve forward, futures, and
option contracts?
• How are prices for derivative securities quoted
and how should this information be interpreted?

4. Chapter 21 - An Introduction to
Derivative Markets and Securities
• What are similarities and differences between
forward and futures contracts?
• What do the payoff diagrams look like for
investments in forward and futures contracts?
• What do the payoff diagrams look like for
investments in put and call option contracts?
• How are forward contracts, put options, and call
options related to one another?

5. Chapter 21 - An Introduction to
Derivative Markets and Securities
• How can derivatives be used in conjunction with
stock and Treasury bills to replicate the payoffs
to other securities and create arbitrage
opportunities for an investor?
• How can derivative contracts be used to
restructure cash flow patterns and modify the
risk in existing investment portfolios?

6. Derivative Instruments
• Value is depends directly on, or is derived from,
the value of another security or commodity,
called the underlying asset
• Forward and Futures contracts are agreements
between two parties - the buyer agrees to
purchase an asset from the seller at a specific date
at a price agreed to now
• Options offer the buyer the right without
obligation to buy or sell at a fixed price up to or
on a specific date

7. Why Do Derivatives Exist?
• Assets are traded in the cash or spot market
• It is sometimes advantageous enter into a
transaction now with the exchange of asset
and payment at a future time
• Risk shifting
• Price formation
• Investment cost reduction

8. Derivative Instruments
• Forward contracts are the right and full
obligation to conduct a transaction involving
another security or commodity - the underlying
asset - at a predetermined date (maturity date) and
at a predetermined price (contract price)
– This is a trade agreement
• Futures contracts are similar, but subject to a
daily settling-up process

9. Forward Contracts
• Buyer is long, seller is short
• Contracts are OTC, have negotiable
terms, and are not liquid
• Subject to credit risk or default risk
• No payments until expiration
• Agreement may be illiquid

10. Futures Contracts
• Standardized terms
• Central market (futures exchange)
• More liquidity
• Less liquidity risk - initial margin
• Settlement price - daily “marking to market”

11. Options
• The Language and Structure of Options
Markets
– An option contract gives the holder the right-but
not the obligation-to conduct a transaction
involving an underlying security or commodity
at a predetermined future date and at a
predetermined price

12. Options
• Buyer has the long position in the contract
• Seller (writer) has the short position in the
contract
• Buyer and seller are counterparties in the
transaction

13. Options
• Option Contract Terms
– The exercise price is the price the call buyer will pay
to-or the put buyer will receive from-the option seller
if the option is exercised
• Option Valuation Basics
– Intrinsic value represents the value that the buyer
could extract from the option if he or she she
exercised it immediately
– The time premium component is simply the difference
between the whole option premium and the intrinsic
component
• Option Trading Markets-options trade both in over-
the-counter markets and on exchanges

14. Options
• Option to buy is a call option
• Option to sell is a put option
• Option premium - paid for the option
• Exercise price or strike price - price agreed
for purchase or sale
• Expiration date
– European options
– American options

15. Options
• At the money:
–stock price equals exercise price
• In-the-money
–option has intrinsic value
• Out-of-the-money
–option has no intrinsic value

16. Investing With Derivative Securities
• Call option
– requires up front payment
– allows but does not require future settlement
payment
• Forward contract
– does not require front-end payment
– requires future settlement payment

17. Options Pricing Relationships
Factor Call Option Put Option
Stock price + -
Exercise price - +
Time to expiration + +
Interest rate + -
Volatility of underlying stock price + +

18. Profits to Buyer of Call Option
40 50 60 70 80 90 100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise Price = $70
Option Price = $6.125
Profit from Strategy
Stock Price at
Expiration

19. Profits to Seller of Call Option
40 50 60 70 80 90 100
(1,000)
(1,500)
(2,000)
(500)
0
500
1,000
(2,500)
(3,000)
Exercise Price = $70
Option Price = $6.125
Stock Price at
Expiration
Profit from Strategy

20. Profits to Buyer of Put Option
40 50 60 70 80 90 100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise Price = $70
Option Price = $2.25
Profit from Strategy
Stock Price at
Expiration

21. Profits to Seller of Put Option
40 50 60 70 80 90 100
(1,000)
(1,500)
(2,000)
(500)
0
500
1,000
(2,500)
(3,000)
Exercise Price = $70
Option Price = $2.25
Stock Price at
Expiration
Profit from Strategy

22. The Relationship Between
Forward and Option Contracts
Put-call parity
– Long in WYZ common at price of S0
– Long in put option to deliver WYZ at X on T
• Purchase for P0
– Short in call option to purchase WYZ at X on T
• Sell for C0
• Net position is guaranteed contract (risk-free)
• Since the risk-free rate equals the T-bill rate:
(long stock)+(long put)+(short call)=(long T-bill)

23. Creating Synthetic Securities
Using Put-Call Parity
• Risk-free portfolio could be created using three
risky securities:
– stock,
– a put option,
– and a call option
• With Treasury-bill as the fourth security, any
one of the four may be replaced with
combinations of the other three

24. Adjusting Put-Call Spot Parity
For Dividends
• The owners of derivative instruments do not
participate directly in payment of dividends to
holders of the underlying stock
• If the dividend amounts and payment dates are
known when puts and calls are written those are
adjusted into the option prices
(long stock) + (long put) + (short call) = (long T-bill) +
(long present value of dividends)

25. Put-Call-Forward Parity
• Instead of buying stock, take a long position in a
forward contract to buy stock
• Supplement this transaction by purchasing a put
option and selling a call option, each with the
same exercise price and expiration date
• This reduces the net initial investment compared
to purchasing the stock in the spot market

26. Put-Call-Forward Parity
The difference between put and call
prices must equal the discounted
difference between the common
exercise price and the contract price of
the forward agreement, otherwise
arbitrage opportunities would exist

27. An Introduction To The Use Of
Derivatives In Portfolio Management
• Restructuring asset portfolios with forward
contracts
– shorting forward contracts
– tactical asset allocation to time general market
movements instead of company-specific trends
– hedge position with payoffs that are negatively
correlated with existing exposure
– converts beta of stock to zero, making a synthetic
T-bill, affecting portfolio beta

28. An Introduction To The Use Of
Derivatives In Portfolio Management
• Protecting portfolio value with put options
– purchasing protective puts
– keep from committing to sell if price rises
– asymmetric hedge
– portfolio insurance
• Either
– hold the shares and purchase a put option, or
– sell the shares and buy a T-bill and a call option

29. The Internet
Investments Online
www.cboe.com
www.cbot.com
www.cme.com
www.cme.com/educational/hand1.htm
www.liffe.com
www.options-iri.com

30. End of Chapter 21
–An Introduction to
Derivative Markets
and Securities

31. Future topics
Chapter 22
• Forward and Futures Contracts