CHAPTER 1.

INTRODUCTION

Chapter 1

Introduction
The stock market is a primary capital market. Firms raise finance through stock
markets by issuing new securities. The stock market is also a secondary capital
market where securities are traded. The volume of secondary business far exceeds
the primary. The secondary market provides services of great importance. The
market prices of the shares provide a measure of the economic value of firms.
This piece of information plays an important role in the capital market investment
process. It signals the return shareholders will receive by providing finance to
the firm as well as the cost of the capital to the firm. The existence of the stock
market provides liquidity so that the investors enter into the financing contract
with confidence that (s)he will be able to sell the security whenever (s)he wants
to withdraw. Although all the securities traded in the stock market represent
permanent or long-term finance, because the financing contract is in the form of
a security with a ready market, the investors do not see the securities as long-term
financing for a firm.
A share1 is a type of financial underlying assets (or underlyings) dealt in
financial market. Other underlyings include bonds2 , commodities, foreign cur1

A shareholder may gain dividends. If the company makes a profit, part of this may be paid

out to shareholders as a dividend.

2
Owning a bond, one receives a fixed set of cash payoffs. Each year until the bond matures,
an interest called a coupon may be payed out and then at maturity the face value of the bond,

CHAPTER 1. INTRODUCTION

rencies. In financial market not only underlyings but also their derivatives are
traded. A derivative is a financial instrument which promises some payment or
delivery in the future contingent on an underlying.
There are four (more but basically four) types of derivatives.
Options
An option gives the holder the right (but not the obligation) to buy or
sell an asset in the future at a price that is agreed upon today. Overthe-counter trading (OTC) in share options took off in 1973 when the
Chicago Board Options Exchange (CBOE) was established.
Futures
A futures contract is an order that one places in advance to buy or sell an
asset or commodity. The price is fixed when the order is placed but the
payment is not made until the delivery date. Futures markets have existed
for a long time in commodities such as wheat, soybeans and copper. The
major development of the 1970s occurred when the futures exchanges began
to trade contracts on financial assets, such as bonds, currencies and stock
market indices 3 . Futures contracts are traded OTC. To make trading possible, the exchange specifies certain standardised features of the contract.
As 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 honoured. This is called as marking to market the
account.
Forwards
Futures contracts are standardised products bought and sold on organised
exchanges. A forwards contract is a tailor-made futures contract that is not
known as the principal, is paid. There are two types of bonds: coupon-bearing bonds and
zero-coupon bonds.
3
For example, FTSE 100, S&P 100, S&P 500 and Nasdaq 100.

CHAPTER 1. INTRODUCTION

traded on an organised institution. For example, a multinational company

which needs to protect itself against a change in the exchange rate usually
buys or sells currency forwards through a bank.
Swaps
Swaps are private agreements between two companies to exchange cash
flows in the future according to a prearranged formula. Suppose that you
want to swap your sterling debt for US$ debt. In this case you can arrange
for a bank to pay you each year the sterlings that are needed to service
your sterling debt, and in exchange you agree to pay the bank the cost of
servicing a US$ loan. Such an arrangement is known as a currency swap.

Who would be interested in derivatives?

Hedgers
Hedgers are interested in reducing risk that they already face. If someone has a financial derivative, for example, an option, without owning any
amount of the underlying asset, (s)he is said to be in a naked position because (s)he may be hard hit with no protection when the asset price changes
sharply.
Speculators
Speculators are interested in earning money in the market.
Arbitrageurs
Arbitrageurs are interested in a risk-free profit by entering simultaneously
into transactions in two or more markets.
Example
Let us assume the exchange rate 1 Euro =$1.0500 while the exchange rates
1 = 1.5400 Euro and 1 = $ 1.5500. Here, how can an arbitrageur make
a risk-free profit? What can be problems to make such the profit?

CHAPTER 1. INTRODUCTION

Figure 1.1: Price change of FTSE 100 for the duration of six months between
August 2003 and January 2004.

Figure 1.2: Exchange rate between British sterling and US dollars between January 2003 and January 2004.
The worldwide derivatives market has been growing so hugely for the last three
decades. The worldwide volume of transactions in these financial derivatives
increased to some deci-trillion dollars. What do we do in the module Financial
Mathematics? The objective of the course is to provide an introduction to the
mathematical techniques which can be applied to pricing problems for financial
derivative products.
The theoretical studies of financial derivative products and risk management
involve some stochastic calculus because of the stochastic behaviour of the prices
of the underlying assets, for example, stocks and shares (See Fig.1.1) and foreign
exchange (see Fig.1.2) compared with a simulation of random walk (Fig. 1.3).

CHAPTER 1. INTRODUCTION

Figure 1.3: Simulation of random walk. Let steps of equal length be taken along
a line. The distribution of the distances dN = n1 n2 travelled after a given
number of steps N , is plotted against N . n1 is the number of steps taken to the
right and n2 the number of steps taken to the left. In the figure, taking a step to
the left is assumed equally likely to taking a step to the right.

CHAPTER 1. INTRODUCTION

1.1

Options and their history

Options are basically insurance contracts. An option gives the buyer the right
but not the obligation to sell or buy a particular asset at a given price on or
before a specified time in the future. Options help the stock market in providing
the important economic roles. First, because the holder does not have to exercise
the option, the maximum he loses is the premium while his profit does not have
a limit. Because of this asymmetric profit/loss structure the stock market can
attract more investors with option trading. Combinations of various types of
options and stocks can give tailor-made profit/loss structures which enhances the
role of the stock market. Second, investing in options can give a profit as much
as investing in stocks, which means an option can give a higher return than the
underlying stock as the option premium is much cheaper than the underlying
stock. Third, an option is a convenient tool to hedge risk. Because risk can be
easily hedged with an option, financial investors feel easy about investing in the
stock market.
The option was originally started as a financial instrument to hedge risk, that
is, to reduce risk. There were some types of options in history as early as in
ancient Greece and Rome. It is known that options on stocks were started in the
1690s in London and were introduced in New York in 1790s.
A relatively modern concept of the option market may be traced back to the
1840s in the United States, when options on agriculture commodities were traded
in New York. These option contracts gave the holders the right, but not the obligation, to purchase or to sell a commodity at a specific price on or possibly before
a specified date. This is still a definition of options. In particular, options that
can be exercised at any time up to the expiration date are American options
whereas options that can be exercised on the expiration date itself are European options. The option market on commodity trading was relatively thin.
The market grew marginally in the early 1900s when a group of investment firms
formed the Put and Call Brokers and Dealers Association to trade options on

CHAPTER 1. INTRODUCTION

stocks on the OTC market.

The OTC option market only barely existed because it failed to provide an adequate secondary market. The option market became to be recognised important
when the Chicago Board of Trade formed the Chicago Board Option Exchange
(CBOE) in 1973. The CBOE was the first organised exchange for option trading, and helped to increase the trading of options by standardising contracts,
establishing margin requirements to ensure delivery and setting up trading rules.
Since the creation of the CBOE, organised stock exchanges in the United States
and outside have begun offering markets for the trading options.

Major Exchanges
o London International Financial Futures & Options Exchange (LIFFE)
o Chicago Board of Trade (CBOT)
o New York Futures Exchange (NYFE)
o Hong Kong Futures Exchange (HKFE)

1.1.1

Types of options

Options can take on many different forms but there are common terminologies to
all options. The price paid by the buyer to the writer for the option is called the
premium. The exercise price or strike price is the price specified in the option
contract at which the underlying asset can be purchased or sold. The exercise
date or expiration date is the last day the holder can exercise. Every option has
its premium, strike price and exercise date.
The price of an underlying stock for immediate delivery is called as the spot
price.
There are two basic types of options. A call option gives the holder the right
to buy a specific asset or security whereas a put option gives the right to sell
one. The option is said to be exercised when the holder chooses to buy or sell

CHAPTER 1. INTRODUCTION

payoff
c
X

ST

premium

Figure 1.4: Long call. X: strike price. ST : spot value of the underlying at
maturity T .

payoff

ST
X
c

Figure 1.5: Short call. X: strike price. ST : spot value of the underlying at
maturity T .

CHAPTER 1. INTRODUCTION

payoff

ST
p

Figure 1.6: Long put. X: strike price. ST : spot value of the underlying at
maturity T .
the underlying stock. The other party to the holder of the option in the contract
is called the writer of the option. The holder (writer) is said to be in the long
(short) position of the option contract.4 It is also possible to categorise options
by the time of exercise. American options are options that can be exercised at
any time up to the expiration date, whereas European options are options that
can only be exercised on the expiration date itself. There are options based on
various types of underlying assets such as stocks, foreign currencies, stock indices,
futures and so forth.

1.1.2

Commissions

Commissions vary from broker to broker. The commission is usually calculated

as a fixed cost plus a proportion of the dollar amount of the trade. A typical
commission schedule is shown in the Table 1.1.
Example
An investor buys one call contract (for 100 shares) with a strike price of $55
4

The definition of long position, which is the opposite of a short position, is the state of

actually owning a security, contract, or commodity.

10

CHAPTER 1. INTRODUCTION

payoff

ST

Figure 1.7: Short put. X: strike price. ST : spot value of the underlying at
maturity T .

Table 1.1: Typical commission schedule.

Dollar amount of trade

Commission

<$2,500

$20+0.02 of the dollar amount

$2,500 to $10,000

$45+0.01 of the dollar amount

>$10,000

$120 + 0.0025 of the dollar amount

CHAPTER 1. INTRODUCTION

11

when the stock price is $50. Suppose the option price is $4. The commission is
$20 + 0.02 $400 = $28. The stock price reaches $60 and the option price goes
up to $9. If the investor sells the option, his net profit is
$900 ($20 + 0.02 $900) $400 $28 = $434

(1.1)

Assuming that 1.5% is paid as commission on stock trade, if the option is exercised, the commission payable is
0.015 $6, 000 = $90.

(1.2)

$500 $90 $400 $28 = $18,

(1.3)

Thus, investors profit is

which shows that the investor loses $18. In general, the commission system tends
to push investors in the direction of selling options rather than exercising them.

1.1.3

Option pricing

Options involve two basic questions. First, what price should an option carry?
Second, what is the best strategy for the writer to follow in order to minimise
his/her risk? Pricing an option is a tricky business as it involves putting a number
on the probability that a buyer will exercise his/her option. In 1973, Black and
Scholes turned the guessing game into a science. The Black-Scholes theory of
option pricing, which addresses the above two questions, was published in May
1973 and coincided with the opening of the worlds first options exchange in
Chicago. Within a year it was being used by every trader. The Black-Scholes
theory still serves as a common language for all participants in option markets,
and it underpins most of the software used in the business.
One of the important reasons why the Black-Scholes formula is so popular to
option traders is in its simplicity. The simplicity is resulted from the assumption
that the statistics of relative price changes is lognormal.5 This is very convenient
5

Black had a first degree in physics and a Ph.D. in applied mathematics at Harvard. He and

Scholes applied random Brownian motion of atoms in a gas to rising and falling of stock prices.

CHAPTER 1. INTRODUCTION

12

from a mathematical point of view because one can rely on a score of useful tools,
such as stochastic calculus to solve it. However, the distributions of market price
moves are complex and they change with time. In particular, Rubinstein and
others carefully studied that the real markets are far from lognormal. Moreover,
in the Black-Scholes world, option writing can be made a completely risk-free
operation, which is very specific to the lognormal model and is not true for more
realistic models.
There have been improvements and alternatives to the Black-Scholes formula.

1.1.4

Value of an option

The total value of an option is the sum of its intrinsic and time values. The
intrinsic value is the possible profit resulted from exercising the option at the
present time, that is the difference between the strike price and spot value of the
underlying asset. The intrinsic value, however, does not take a negative value
and when the present price of the underlying asset is lower than the strike price
the intrinsic value of the call option vanishes.
Intrinsic value of a call = max(St X, 0)
Intrinsic value of a put = max(X St , 0),
where St is the spot price of the underlying asset and X the strike price. An
American option must be worth at least as much as its intrinsic value. If it
is less, then an arbitrageur can get a risk-free profit. As discussed later, it is
often optimal for an American option holder to wait till maturity. The other
component of the value of an option is the time value. The time value of a call
is thus the difference between the price of the call and its intrinsic value. If the
call premium is $15 when the price of the underlying stock on a 50 call is $60,
the time value would be $5. The time value decreases as the time remaining to
expiration decreases. The time value of an option increases with the volatility of
the underlying exchange rate.

CHAPTER 1. INTRODUCTION

13

When an option has a non-zero intrinsic value the option is referred to as in

the money (ITM) and when the strike price is the same as the spot price of the
underlying asset the option is at the money (ATM). Otherwise the option is said
to be out of the money (OTM).

1.1.5

Example: Index options

Index options are based on stock indices so there is no underlying stock to hand
over on the exercise day. On the exercise day, the assigned writer pays the
exercising holder the difference between the strike price and the spot index at
the close of the trading. Trading in stock index options began in 1983, when the
CBOE introduced an option on the Standard and Poors 100 index (S&P 100).6
The S&P 100 index options are the most highly traded options in the United
States but their valuation is rather complicated. The size of an index option is
equal to a multiple of the index value. For example, the S&P 100 options have
contract multiples of $100. The exercise price on the May 420 call contract on
the S&P 100 is 420 $100 = $42,000.
The underlying security in an index option is a combination of various stocks
so that hedging index options is not a simple task. Hedging the S&P 100 options
would require the simultaneous purchase of the indexs 100 stocks, in their correct
proportions. Further, if dividends occur for the option period then their correct
reinvestment would also be required. In practice, many hedgers form smaller
proxy portfolios,

with the stock allocations determined so as to maximise the

correlation between the returns of the proxy portfolio and the spot index. The
6

Known by its ticker symbol OEX, the S&P 100 is a subset of the S&P 500 and tracks the

largest, most liquid stocks which have options contracts traded on them.
7
A collection of investments all owned by the same individual or organization. These investments often include various stocks, which are investments in individual businesses; bonds,
which are investments in debt that are designed to earn interest; and mutual funds, which are
essentially pools of money from many investors that are invested by professionals or according
to indices.

CHAPTER 1. INTRODUCTION

14

S&P 100 or S&P 5008 can also be hedged using S&P futures.
It is not an easy task for an individual investor to collect information on individual companies. Thus, investment in options on stocks can be risky because of
lack of information. For an individual investor it is normally easier to read the
market as a whole with the help of mass-media so that investing in index options
may be more attractive.
Like S&P100 in the US, FTSE100 (Financial Times Stock Exchange index of
100 main shares) is the prime stock index in the UK. Entries of the FTSE100
are reviewed regularly. In January 2003, companies in the FTSE100 include BP,
GlaxoSmithKlein, Vodaphone, Tesco and Sainsburys.

Note: Some regulations for FTSE100 options

Last Trading Day means in respect of any delivery month the third Friday
in that month provided that if it is not a business day then the Last Trading
Day shall be the last business day preceding the third Friday.
Settlement Day means in respect of a delivery month the first market day
after the Last Trading Day.
Price
, bids and offers shall be quoted in Index points and prices shall be
a whole number multiple of the minimum price fluctuation, as specified in
the Administrative Procedures.
One Index point shall be 1.0 and shall have a value of 10.00 per option.
Premium
The Premium payable in respect of an option shall be the product of the
8

The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry

group representation. It is a market-value weighted index (stock price times number of shares
outstanding), with each stocks weight in the Index proportionate to its market value. The
500 is one of the most widely used benchmarks of U.S. equity performance.

CHAPTER 1. INTRODUCTION

15

price of the option in Index points and the value of one Index point as
specified.
The Buyer shall pay the Premium to the Clearing House9 on the day and
by the time specified for this purpose in the Administrative Procedures and
the Clearing House shall pay the Premium to the Seller on the same day.

1.1.6

Example: Currency options

The foreign exchange market is the worlds largest market with its estimated
daily volume of a few trillion dollars. 95% currency trades involve US$ but the
UK has the largest market turnover.
Currency options are usually written vs. US$. This also means that they are
priced in US$. Options that do not involve the US$ are referred to as cross rate
options (e.g. a sterling vs. guilder option is traded in Amsterdam). A $/ option
is referred to as a sterling option and is priced in $. Similarly, a $/Euro call is
referred to as a Euro call, and is priced in $. Thus a Euro call gives the right
but not the obligation to buy Euro with $ at a given exercise price on or before
a given expiry date. A Euro put gives the corresponding right to sell Euro for
$. A sterling call against the dollar is in effect equivalent to a dollar put against
sterling. The only difference is that the $/ put (were such an instrument to
exist) would be priced in .
premium=intrinsic value + time value
As an example, let us consider that a $1.4000 sterling call has a premium of 7c,
and the corresponding $1.4000 put has a premium of 1c. The spot $/ rate =
1.4500. The call option is in the money and the put option is out of the money.
We decompose the premium into intrinsic value and time value as in Table 1.2.
9

The clearing house is an adjunct of the exchange and acts as an intermediary in derivatives

transactions. This is responsible for the collection of margin from the members, where the
margin is a sum of money which is held by the clearing house on behalf of the member.

16

CHAPTER 1. INTRODUCTION

Table 1.2: Intrinsic and time values of the premium.

Call

Put

Intrinsic value

5c

0c

Time value

2c

1c

Premium

7c

1c

Table 1.3: Call Euro/.

Call Euro/=

-Euro(sell Euro)

+ (buy )

Match with $

+$ (buy $)

-$ (sell $)

Result

$/Euro -

$/ +

Euro put option

Sterling call

cross rate options

A Euro/ call option (to buy with Euro) can be synthesised by means of
a $/ call (a sterling call) and a $/Euro put (a Euro put). If all options are
bought as near to the money as possible then no additional exposure will be
introduced in comparison with the cross-rate at the money. However, because
two contracts are being purchased for every one cross-rate contract, transaction
costs will be higher.
options hedging
A US firm is expecting a cash inflow of 1million from its UK subsidiary in
3-months time. The firms treasurer wishes to protect the dollar value of this
amount against exchange rate fluctuations.
To advise,

17

CHAPTER 1. INTRODUCTION
profit
exposure
put option

dollar pounds

Figure 1.8: Options hedging.

1. Draw a currency equation in the form:
end currency = start currency rate
i.e.
$ = ($/)
2. Consider what will happen to the firms profits in the end currency as the
exchange rate increases. In this example, they will increase.
3. Show the variation of profit with exchange rate on a graph and eliminate
the downside with a suitable option contract.
As $/ increases, the dollar is weakening against the (must be - you get
more $ for your ). This means that a given amount of will buy you more
dollars, which is good news for the firms profits in dollars. We therefore want to
hedge against the $/ rate going down, so we buy sterling put options.

1.2

Forwards and Futures

Forwards are the oldest actively traded derivative instruments. They were originally developed for agricultural and similar commodities. Before the harvest, a
wheat farmer cannot be sure of the price at which he will be able to sell his crop.

18

CHAPTER 1. INTRODUCTION

payoff

ST
K

Figure 1.9: Long forward. K: delivery price. ST : spot value of the underlying
at maturity T .
If he does not like this uncertainty, he can reduce it by selling wheat forwards.
In this case he agrees to deliver so many bushels of wheat in the future at a price
that is set today.
A forward contract is an agreement to buy or sell an underlying stock at a
certain future time for a certain price (delivery price). Initially, one needs no
money to enter into a forward contract. On the delivery day, the holder pays the
delivery price to buy the specified amount of the underlying stock. The forward
price and the delivery price are equal at the time the contract is entered into.
As time passes, the forward price is liable to change, whereas the delivery price
remains the same.
Unlike forward contracts, futures contracts are normally traded on an exchange.
To make trading possible, the exchange specifies certain standardised features of
the contract. As 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 honoured.

FTSE 100 Index Futures

Contract size: Valued at 10 per index point (e.g. value 65,000 at 6500.0)

19

CHAPTER 1. INTRODUCTION

payoff

ST

Figure 1.10: Short forward. K: delivery price. ST : spot value of the underlying
at maturity T .
Delivery months: March, June, September, December (nearest three available for trading)
Last trading day: 10:30:30 (London time) - Third Friday in delivery month10
Delivery day: First business day after the expiry date
Quotation: Index points (e.g.6500.0)
Minimum price movement: 0.5
Tick size & value: 5.00
Trading hours: 08:00 - 17:30 (London time)
Minimum Block Trade Threshold See Block Trade Facility - Contract Minimum Size Thresholds
Contract standard: Cash settlement based on the Exchange Delivery Settlement Price.
10

In the event of the third Friday not being a business day, the Last Trading Day shall normally

be the last business day preceding the third Friday.