Ec1723 Section Notes: Derivatives (Lectures 19-22)

December 1, 2011
A derivative security (or simply derivative) is a nancial instrument whose payo depends explicitly on the price of some other asset (the so-called underlying asset).

Forwards, Futures and Swaps

Forwards A forward contract is a binding agreement to trade an asset at a given date in the future for a xed price decided upon today Although the forward price is agreed upon today by the parties who enter into the forward contract, no money changes hands until the future date Notation Assume that the agreement is made at time 0, and the specied future date is time 1 Let F0 denote the forward price agreed upon at time 0 Let S0 (the spot price) denote the price of the underlying asset at time 0, and S1 the price of the underlying at time 1 Forward-spot parity Assume that the underlying asset pays no dividends, and that it can be stored without cost To obtain the asset at date 1, you can either buy it today at the spot price S0 and hold it until date 1, or you can enter a forward contract today to buy the asset on date 1 at the forward price F0 . F0 You could obtain F0 at date 1 with certainty by investing 1+Rf at the riskless rate Rf today, so you can obtain the asset with certainty at date 1 either by paying S0 , or by F0 paying 1+Rf . Thus there is an arbitrage opportunity unless S0 or F0 = F0 1 + Rf = (1 + Rf ) S0

Similar relationships hold if we relax the no dividend assumption and/or the costless storage assumption The forward price F0 can be greater than, less than, or equal to the expected future spot rate E0 [S1 ] 1

 F0 = E0 [S1 ] : (pure) expectations hypothesis (underlying asset earns no risk premium) F0 < E0 [S1 ] : normal backwardation (underlying asset earns a positive risk premium) F0 > E0 [S1 ] : contango (underlying asset earns a negative risk premium) Futures Forward contracts are written directly between two parties, say A and B. Futures are essentially a special type of forward contract that is intermediated by a centralized clearinghouse. Rather than A contracting directly with B, A contracts with the clearinghouse, and B contracts with the clearinghouse The ultimate outcome is basically equivalent to A and B contracting directly with one another (as they would in a forward contract), except that the intermediation by the clearinghouse largely eliminates counterparty risk There are some small technical dierences that we ignore in this course The practical relevance of centralized intermediation is that futures contracts are fungible in a way that forward contracts are not Unlike forwards, futures are typically very liquid nancial instruments Futures (with standardized terms) are traded on exchanges like stocks Swaps A swap is a (binding) agreement to exchange one stream of cashows for another stream of cashows at one or more dates in the future Common examples: an interest-rate swap exchanges xed-rate payments for oating-rate payments; a currency swap exchanges payments in one currency (e.g., dollars) for payments in another currency (e.g., Yen); and so on. Swaps are typically structured so that no money changes hands at the initial date Interest rate swaps Consider an interest-rate swap with a maturity of m years, and a notional amount N At the end of each year for the next m years, the xed-rate payer pays N Y f ixed and the oating-rate payer pays N Y1,t , where Y1,t denotes the 1-year rate that prevailed at the start of that year and Y f ixed denotes the xed rate Since the notional amount, N, is the same for both parties who are engaged in the swap, it is irrelevant whether each party gives the other one N, or whether (as happens in practice) the notional amount is never actually exchanged. If we imagine that the notional amount actually is exchanged at the end of the swap, then we can analyze the stream of oating-rate payments like a oating-rate coupon bond, and the stream of xed-rate payments like a xed-rate coupon bond Determining the xed rate The present value of the oating-rate coupon bond is exactly N: If I invest N dollars in 1-year bonds at the beginning of 2012, then I will have (1 + Y1,2012 ) N = N + N Y1,2012 at the end of 2012 At the end of 2012, I can make a payment of N Y1,2012 , and reinvest N dollars in a new batch of 1-year bonds at the beginning of 2013. By repeating this strategy each year for m years, I will replicate the payos of the oating-rate coupon bond 2

 Assuming that no money is exchanged at the initial date of the swap, the present value of the xed-coupon bond must equal the present value of the oating-rate coupon bond; thus the present value of the xed-coupon bond is also exactly N, so the xed-coupon bond is trading at par Recall that a xed-coupon bond trades at par if and only if its yield-to-maturity (YTM) equals its coupon rate (Ycmt ) Hence Y f ixed = Ycmt = Y T M We can therefore nd Y f ixed if we know the yield-to-maturity of a xed-coupon bond of maturity m that is trading at par. Credit default swaps (CDSs) A CDS is basically an insurance contract against the default of a particular bond If I own a corporate bond that might default, I can enter into a CDS with some third party to protect against default I pay the third party some yearly premium until the bond matures, and in exchange, the third party promises to buy the bond from me at face value in the event that the bond-issuer defaults. If we know the expected recovery rate on a given bond in the event of default, we can use CDS rates to back out estimates of the implied probability that default will occur.

Options
Terminology An option is a nancial instrument that grants the right to trade an asset at a specied xed price (the strike price) A call option grants the right to buy at the strike price A put option grants the right to sell at the strike price The rights granted by a European option must be exercised on a specied future expiration date, while the rights granted by an American option may be exercised at any time on or before the specied expiration date. As a notational convention, we will denote the strike price by X, the underlying asset price by S, and the expiration date by T. Provided that options are exercised optimally, their payos are never negative, and are sometimes positive The payo of an optimally exercised option at expiration is max {ST X, 0} for a call option, and max {X ST , 0} for a put option

By no-arbitrage considerations, it follows that the price of an option must be strictly positive An option is said to be in the money if it would be protable to exercise it today; an option is said to be out of the money if if would be unprotable to exercise it today.

Relevance and Prevalence Because options oer payo proles that are non-linear functions of the price of the underlying asset, they can be combined in numerous ways to create a variety of novel and potentially useful payo proles. In addition to explicit option securities (puts, calls, etc.), option-like payo structures or implicit options also arise naturally in many settings Risky debt (because of limited-liability laws, the issuer of the debt pays min {net worth, f ace value of debt} at maturity) Callable debt and mortgages (e.g., homeowners who take out a xed-rate mortgage retain an American option to repay their remaining debt in full at any time. When homeowners renance their mortgages in response to a drop in interest rates, they are essentially calling their original debt). Implications of No-Arbitrage for Option Prices Ignoring some minor frictions (trading costs, tax-code peculiarities, borrowing vs. lending spreads), simply imposing no-arbitrage leads to a variety of easy but useful results about option prices. See Lecture 20, slides 22-23 for examples. Put-Call Parity Put-call parity is a less trivial and extremely useful consequence of no-arbitrage Consider a European call and a European put with the same expiration date, and the same strike price, on an asset that pays no dividends during the life of the options. Then: C0 + where C0 is the call price, P0 is the put price
X (1+Rf )T

X (1 + Rf )
T

= S 0 + P0

is the discounted strike price, S0 is the asset price, and

Proof is a routine application of replicating-portfolio arguments... Lower bound on the price of a European call option on a non-dividend paying stock The payo of the call is always weakly greater than the payo of a portfolio of equity plus borrowing cash (levered equity) Thus the price of the call must be weakly greater than that of the levered equity portfolio: C0 S0 X (1 + Rf )
T

No early exercise of an American call option on a non-dividend-paying stock The price of a European call is always greater than its value if exercised immediately The price of an American call is always (weakly) greater than the price of an equivalent European call Hence the price of an American call always (weakly) exceeds its immediate exercise value.

Inuences on Option Value

C0 +

(1+Rf ) S (spot price) X (strike price) Rf D (dividend) Volatility T (maturity)

T

=S0 +P0

Call + + + +

Put + + + ?

Pricing Options
Binomial Option Pricing Two-period setting Consider a stock that is worth S0 today, and will be worth either uS0 or dS0 tomorrow (where u > 1 > d > 0). Let S1 denote the price of the stock tomorrow. Let the risk-free rate be Rf . Consider a 1-period call option on the stock with a strike price of X. This call option pays o max {S1 X, 0}. How much is the call option worth today? This is identical to problems that we saw in the context of the discrete-state assetpricing model in the second week of the course Find the price of the Arrow-Debreu securities for each state, and use these to nd the price of a portfolio of A-D securities that delivers the same payo prole as the option... Multiple-period setting Consider the same stock from the last bullet point, and suppose that at each date t = 2, ..., T , the price of the stock evolves so that either St = uSt1 or St = dSt1 . The possible price evolution of the stock can be represented in a binomial tree, and we can nd the Arrow-Debreu prices along each branch of this tree in the usual manner We can compute the price of a European option with exercise date T in exactly the same way as in the two-period setting: add up the prices of the A-D securities in the portfolio that delivers the same payo prole as the option. Provided that the stock doesnt pay any dividends, it follows from the no early exercise result that an American call option has the same value as a European call option in this case By contrast, to compute the price of an American (put) option, we must use backward induction First, calculate the option payo in each state at date T Next, use the payos at date T and the associated one-period A-D prices to compute the value of holding the option in each state at date T 1. Similarly, at each state of date T 1, compute the payo from exercising the option. The value of the option at a given state of date T 1 is the maximum of the value from holding the option and the payo from exercising the option. Repeat the above steps... Aside: risk-neutral pricing 5

 Recall that if we divide the one-period Arrow-Debreu prices by the one-period risk-free rate (1 + Rf ), the resulting normalized state prices satisfy the the requirements of probabilities (non-negative, between 0 and 1, sum to 1). These pseudo-probabilities are also known as risk-neutral probabilities. Computing the price of an asset by adding up the prices of the A-D securities in a replicating portfolio is equivalent to taking the expectation (with respect to the risk-neutral probabilities) of the assets future payos. The arbitrage/replication approach that we have been using to price options is isomorphic to the risk-neutral pricing approach Black-Scholes Model The Black-Scholes model is essentially a limiting case of a multi-period binomial model in which the number of periods tends to innity, while the length of each period tends concomitantly to zero. The Black-Scholes model assumes: Continuous trading, with no jumps in the price of the underlying asset Constant volatility Constant riskless interest rate r The underlying asset pays no dividends

Under the above assumptions, the distribution of the underlying assets price at a given date in the future is log-normal, and this leads to a closed-form expression for the price of a European call option with strike price X and maturity T : 2 2 log (S0 /X) + r + T log (S0 /X) + r T 2 2 XerT C0 = S0 T T where () denotes the standard normal CDF The qualitative behavior of the Black-Scholes model is directly analogous to that of the simple binomial model. Implied Volatility The Black-Scholes formula provides a mapping between option prices and volatility Given an estimate of volatility, we can use the formula to determine the price of certain options Alternatively, given an option price, we can invert the B-S formula to obtain an estimate of volatility Such an estimate is called implied volatility Implied volatility: empirical results If the B-S model held perfectly in the real world, then implied volatility would be constant over time, constant across dierent option maturities and strike prices, and equal to realized volatility In practice, implied volatility (and realized volatility) varies over time, implied volatility is lower for options that are closer to being at-the-money, and implied volatility is almost always higher than realized volatility.