Derivatives Fundamentals

What is a Derivative?
• Common Features
• Derivative Markets
• Exchange-Traded versus OTC
Derivatives
Types of Underlying Assets
• Commodities
• Financials
Why Investors Use Derivatives
• Individual Investors,
Corporations and Businesses
• Derivative Dealers
Options
• Option Exchanges
• Option Strategies for Individual and
Institutional Investors
• Option Strategies for Corporations
Forwards and Futures
• Key Terms and Definitions
• Futures Exchanges
• Futures Strategies for Investors

Derivative : Defined
A derivative is a financial contract between two parties whose value is derived
from, or dependent upon, the value of some other asset.
The other asset, known as the derivative’s underlying asset or underlying
interest or security, could be a financial asset, e.g. stock or bond, currency, or
even an interest rate, a futures contract or an equity index. It could also be a
real asset or commodity, such as crude oil, gold or wheat.
i.e. A derivative is an asset whose value is derived from the value of some
other asset, known as the underlying.
Due to this link between a derivative and its underlying asset derivatives can
act as a substitute for, or as an offset to, a position in the underlying asset.

Example:
If you have a legal contract that, with the payment of a premium, gives you the
option to buy a fixed quantity of kola nuts at a fixed price of $100 at any time in
the next three months.
The kola nuts is currently worth $90 in the world market.
The option is a derivative and the underlying is kola nuts.
Should Kola nuts value increase, then the value of your option increases,
because of your right (but not the obligation) to buy the metal at a pre-
determined price.

Example:
Obasanjo
Farms
Contract with Odumegwu to
Buy @ specified price per kilo
within three months
Odumegwu Nut
Processing
Thus, Odumegwu Nut processing has the ‘OPTION’ to purchase specific
amount of nuts within a specified time – i.e an Option
Thus derivatives are:
• used to manage the risk of an existing or anticipated position in the
underlying asset
• Used to speculate on the value of the underlying asset.

Types: Derivatives - Option
Two basic types: Options Or Forwards.
• Options are contracts between two parties: a buyer and a seller.
The buyer of an option has the right, but not the obligation, to buy or sell a
specified quantity of the underlying asset in the future at a price agreed upon
today.
The seller of the option is obligated to complete the transaction if called upon to
do so.
An option that gives its owner the right to buy the underlying asset is known as a
call option; the right to sell the underlying asset is known as a put option.

Forwards are also contracts between a buyer and a seller.
With forwards, both parties obligate themselves to trade the underlying asset in
the future at a price agreed upon today.
Neither party has given the other any right; they are both obligated to
participate in the future trade.
Nature of the contract as a ‘right’ or an ‘obligation’ is the fundamental
difference between an option and a forward
Types: Derivatives - Forwards

Features Common to All Derivatives
• Derivatives are contractual agreements between two parties - known as
counterparties.
• Agreements spell out the rights and/or obligations of each party.
• Derivatives have a price - Buyers try to buy derivatives cheaply, sellers try to
sell them for as much as possible.
• Both parties must fulfill their obligations or exercise their rights under the
contract on or before the expiration date.

• Derivatives contract is drawn up, it includes a price or formula for
determining the price of an asset to be bought and sold in the future, either on
or before the expiration date.
• Derivatives can be considered a zero-sum game i.e. aside from commission
fees and other transaction costs, the gain from an option or forward contract
by one counterparty is exactly offset by the loss to the other counterparty
i.e. gain by one party represents loss by counterparty to contract.
• With forwards, no up-front payment is required. At times one or both parties
make a performance bond or good-faith deposit, giving the party on the
other side of the transaction some assurance that the terms of the forward will
be honored.

With options, the buyer makes a payment to the seller when the contract is
drawn up. - known as a premium, it gives the buyer the right to buy or sell the
underlying asset at a preset price on or before the expiration date.

Derivative Markets
Derivatives can and do trade ‘Over-the –Counter’ or can be traded on ‘The
Stock Exchange’.
Over-the-counter Derivatives - OTC derivatives market is an active and
vibrant market that consists of a loosely connected and lightly regulated network
of brokers and dealers who negotiate transactions directly with one another
primarily over the telephone and/or computer terminals.
Market is dominated by financial institutions, e.g., banks and brokerage houses,
that trade with their large corporate clients and other financial institutions.
OTC market has no trading floor and no regular trading hours - contracts can be
custom designed to meet specific needs and can be more complex than
exchange-traded derivatives - as special features can be added to the basic
properties of options and forwards.

Exchange-traded Derivatives
A derivative exchange: a legal corporate entity organized for the trading of
derivative contracts.
The exchange provides the facilities for trading, either a trading floor or an
electronic trading system or, in some cases, both.
The exchange also stipulates the rules and regulations governing trading in order
to maintain fairness, order and transparency in the marketplace.
Derivative exchanges evolved in response to the OTC issues of standardization,
liquidity and credit risk.
Derivative Markets

Exchange-traded Derivatives cont’d:
Exchange trades include: options on stocks, bonds and indexes, and futures
(forwards that are exchange-traded) on bonds and indexes on bonds and
indexes, futures and future options on agricultural goods such as canola and
western barley
Derivative Markets

Exchange-Traded vs. OTC Derivatives
Co-existence of both the OTC market and the Exchange traded market in
derivatives has proven successful because each market offers advantages to
users depending on their particular needs.
• Standardization And Flexibility:
In the OTC market, the terms and conditions of a contract can be tailored to
the specific needs of their users i.e users may choose the most appropriate
terms to meet their particular needs.
With exchange-traded derivatives, the exchange specifies the contracts
that are available to be traded on the exchange; each contract has standardized
terms and other specifications, which may or may not meet the needs of
certain derivative users.

• Privacy : With OTC derivative transactions, neither the general public nor
others (including competitors) know about the transaction.
On exchanges, transactions are recorded and known to the general public,
although the exchanges do not announce, nor do they necessarily know, the
identities of the ultimate counterparties to every transaction.
Liquidity and Offsetting: Due to the private and custom design, OTC
derivatives cannot be easily terminated or transferred to other parties in a
secondary market-usually they contracts can only be terminated through
negotiations between the two parties.
But the standardized and public nature of exchange-traded derivatives can be
terminated easily by taking an offsetting position in the contract.

Liquidity and Offsetting cont’d
Default Risk: With OTC transactions default risk is a major concern.
Default risk is the risk that one of the parties to a derivative contract cannot
meet its obligations to the other party.
Thus, the need by OTC dealers to establish a level of credit worthiness amongst
parties to a transaction.
Also size of most contracts in the OTC market may be greater than most
investors can manage. Thus, the OTC market is restricted to large institutional
and corporate customers.

With exchange-traded derivatives. Clearinghouses, are set up by exchanges to
ensure that markets operate efficiently, guarantee the financial obligations of
every party and contract – market participants need not be concerned with the
honesty or reliability of other trading parties -the integrity of the clearinghouse
is the only concern.
The clearing corporation is in effect, the buyer for every seller and the seller for
every buyer.
By being on the opposite side of all trades, the clearing corporation minimizes
the risk of default. Though individual trades are negotiated between the two
parties through the exchange, once the contract has been made, the clearing
corporation is the counterparty.

Regulation: OTC contracts are private and exchange-traded contracts are
public i.e. derivative transactions on exchanges are extensively regulated by the
exchanges themselves and government agencies, OTC derivative transactions
are generally unregulated.
The largely unregulated environment in the OTC markets permits unrestricted
and explosive growth in financial innovation and engineering but the regulated
environment of exchange-traded derivatives brings about fairness, transparency
and an efficient secondary market.

Difference b/W OTC and Exchange traded Derivatives
Exchange-Traded
• Traded on an exchange
• Standardized contract
• Transparent (public)
• Easy termination prior to contract
expiry
• Clearinghouse acts as third-party
guarantor ensuring contract’s
performance to both trading
partners
• Performance bond required,
depending on the type of
derivative
Over-the-Counter
• Traded largely through computer
and/or phone lines
• Terms of the contract agreed to
between buyer and seller
• Private
• Early termination more difficult
• No third-party guarantor
• Performance bond not required in
most cases

Exchange-Traded
• losses accrue on a day-to-day
• Heavily regulated
• Delivery rarely takes place
• Commission visible
• Used by retail investors,
corporations and institutional
investors
Over-the-Counter
• Contracts are generally not marked-
to market; basis (marking-to-
market) gains and losses are
generally settled at the end of the
Contract
• Much less regulated
• Delivery or final cash settlement
usually takes place
• Fee usually built into price
• Used by corporations and financial
institutions
Difference b/W OTC and Exchange traded Derivatives

Types Of Underlying Assets
Generally 2 major categories of underlying assets for derivative contracts –
commodities and financial assets.
• Commodities: futures and options are commonly used by producers,
merchandisers and processors of commodities to protect themselves against
fluctuating commodity prices. Types of commodities that underlie derivative
contracts include:
 Grains and Oilseeds e.g., wheat, corn, soybeans and canola
 Livestock and Meat e.g., pork bellies, hogs, live cattle and feeder
cattle
 Forest, Fiber and Food e.g., lumber, cotton, orange juice, sugar,
cocoa and coffee

 Precious and Industrial
metals e.g., gold, silver,
platinum, copper and
aluminum
 Energy Products e.g.,
crude oil, heating oil,
gasoline, natural gas and
propane
Other than the energy category,
most commodity derivatives are
exchange-traded contracts.

• Financial Derivatives. – these include:
Equity Indexes: Equity is the underlying
asset of a large category of financial
derivatives.
The predominant equity derivatives are
equity options i.e., options on individual
stocks. -
Traded mainly on organized exchanges
e.g., the Bourse de Montréal in Canada,
Chicago Board Options Exchange (CBOE),
International Securities Exchange (ISE) etc

Interest Rates: generally based on interest rate-sensitive securities rather
than on interest rates directly - underlying assets include bankers’
acceptances and Government bonds.
In the OTC market, interest rate derivatives are generally based on well-
defined floating interest rates, which are not easily manipulated by market
participants.
Examples of underlying assets include LIBOR or the London Interbank
Offer Rate (the interest earned on Eurodollar deposits in London) and the
yields on Treasury bills and Treasury bonds.
* These contracts are cash settled.

Currencies: commonly
used underlying assets in
currency derivatives are the
U.S. dollar, British pound,
Japanese yen, Swiss franc
and Euro.
Types of contracts traded
include currency futures and
options on organized
exchanges and currency
forwards and currency
swaps in the OTC market.

Users can be divided into four groups:
• Individual Investors
• Institutional Investors
• Businesses And Corporations
• Derivative Dealers.
Individual and institutional investors, including businesses and
corporations, are end users - use derivatives either to speculate on price or value
of an underlying asset, or to protect the value of an anticipated or existing
position in the underlying asset – i.e. hedging
Derivative dealers - these are intermediaries in the markets that buy and sell to
meet the demands of the end users. - balancing their risks and earning profits
from the volume of deals done with customers.

• Individual Investors: Normally individual investors are able to trade
exchange-traded derivatives only – being active investors in exchange-traded
options markets and, to a lesser extent, futures markets.
Adequate understanding of all of their potential risks and rewards is required
due to their highly speculative nature – i.e. potential for extreme losses.
Though risk management strategies, can be beneficial to all investors, from
the most conservative to the most aggressive.

• Institutional Investors:
These include mutual fund managers, hedge fund managers, pension fund
managers, insurance companies and more.
Institutional investors use derivatives for both speculation and risk management
and are able to trade OTC derivatives in addition to exchange-traded
derivatives.
Institutional investors may use derivatives to quickly carry out changes to their
portfolio’s asset allocation—the mix of stocks, bonds, and cash held in a
portfolio avoiding excessive hidden transaction costs.
i.e., portfolio managers frequently need to shift funds from one market segment
to another market segment, from one type of market to another type of market,
and from one country to another country.

• Corporations and Businesses:
Tend to be larger companies that make use of borrowed money, have
multinational operations that generate or require foreign currency, or produce or
consume significant amounts of one or more commodities.
Use of derivatives primarily for hedging purposes – they tend to focus on
derivatives that help them hedge interest rate, currency and commodity price
risk.
Hedging is the attempt to eliminate or reduce the risk of either holding an asset
for future sale or anticipating a future purchase of an asset.
With derivatives this involves taking a position in a derivative with a payoff that
is opposite to that of the asset to be hedged.

Corporations and Businesses: (cont’d)
E.g., a hedger who owns an asset, and is concerned that the price of the asset
could fall in the future, a short position in a forward contract based on the asset
would be appropriate.
A decline in the price of the asset will result in a loss on the asset being held, but
would be offset by a profit on the short forward contract. Another solution
would be to buy a put option on the underlying asset.
- Corporations hedge with derivatives in order to focus their efforts
on running their primary business instead of trying to guess where interest rates,
currencies or commodity prices are going.

On the other hand, if a hedger anticipates buying an asset in the future, and is
concerned that the price could rise by the time the purchase is made, buying a
forward contract or a call option would be appropriate.
A price increase will result in the higher price being paid by the hedger, but
this would be offset by a profit on he forward or call option.
A hedger starts with a pre-existing risk that is generated from a normal course of
business.
E.g., a farmer growing wheat has a pre-existing risk that the price of wheat will
decline by the time it is harvested and ready to be sold. Also, an oil refiner that
holds storage tanks of crude oil waiting to be refined has a pre-existing risk that
the price of the refined product may decline in the interim.

To reduce or eliminate these price risks, the farmer and the refiner could take
derivative positions that will profit if the price of their assets declined.
Any losses in the underlying assets would be offset by gains in the derivative
instruments.
Thus, any gains in these assets might be offset by derivative losses of roughly
the same size, depending on the type of derivative chosen and the overall
effectiveness of the hedge.
Effectively companies use derivatives in an appropriate fashion as a risk
management tool.
**But Hedging does not always result in the complete elimination of all risks.

• Derivative Dealers: This group; Derivative dealers, play a crucial role
within OTC markets by taking the other side of the positions entered into by
end users. Dealers in exchange traded markets take the form of market
makers that stand ready to buy or sell contracts at any time.
Exchange-traded market makers include banks and investment dealers as
well as professional individuals.

Options
- A contract between two parties, a buyer (also known as the long position or
holder) and a seller (also known as the short position or the writer).
-Contract gives certain rights or obligations to buy or sell a specified amount of
an underlying asset, at a specified price (known as the strike price or exercise
price), within a specified period of time.
- Buyer has the right but is not obligated to exercise her contract, whilst seller is
obligated to fulfill his part of the contract, if called upon to do so.
For the right to buy or sell the underlying asset, option buyers must pay sellers
a fee, known as the ‘option price or option premium’.
Upon payment, the option buyer has no further obligation to the writer, unless
the buyer decides to exercise the option. Thus, the most that the buyer of an
option can lose is the premium paid.

Options Writers must always be ready to fulfill their obligation to buy or sell the
underlying asset.
As evidence of constant ability to fulfill their obligations, writers
of exchange-traded options are required to provide and maintain sufficient
margin in their option accounts.
Writers of OTC options typically do not have this requirement.
An option that gives its holder the right to buy and its writer the obligation to
sell the underlying asset is known as a call option.
An option that gives its holder the right to sell and its writer the obligation to
buy the underlying asset is referred to as a put option.
Options

Rights And Obligations Associated With Option Positions
Call
Pays premium to the writer for the right to BUY the
underlying asset.
Receives premium from the buyer and has the obligation to
SELL the underlying asset, if called upon to do so.
Put
Pays premium to the writer for the right to SELL the
underlying asset.
Receives premium from the buyer and has the obligation to
BUY the underlying asset, if called upon to do so.
Buyer or Holder
Writer or Seller
Buyer or Holder
Writer or Seller

Syntax to Describe an Option
- summarizing the option’s most salient features into a phrase:
“{Underlying Asset} + {Expiration Month} + {Strike Price} + {Option Type}”
i.e. investor wants to buy 10 exchange-traded call options on XYZ stock with an
expiration date in December and a strike price of $50, would say that he wanted
to “buy 10 XYZ December 50 calls.”
Same as buying a stock, the investor would also indicate the price at which he is
willing to pay.
He could purchase “at market,” in which case he agrees to accept the best price
currently available, or he could enter a limit order by specifying the highest price
at which he is willing to pay.

An option’s trading unit describes the size or amount of the underlying asset
represented by one option contract.
E.g, all exchange-traded stock options in North America have a trading unit of
100 shares. Thus, a holder of one call option has the right to buy 100 shares of
the underlying stock, while the holder of one put option has the right to sell 100
shares.
Premium of an option is always quoted on a “per unit” basis, i.e. the premium
quote for a stock option is the premium for each share of the underlying stock
calculated by multiplying the premium quote by the option’s trading unit.
E.g., if a stock option is quoted with a premium of $1, it will cost the buyer $100
for each contract.
Options

Options : American and European Style
Options that can be exercised at any time up to and including the expiration date
are referred to as American-style options.
Options that can only be exercised on the expiration date are referred to as
European-style options.
Traditionally, options have been listed with relatively short terms of nine
months or less to expiration but there are exchanges that have listed options
with much longer expirations (2-3yrs) called Long-Term Equity Anticipation
Securities (LEAPS).
LEAPS are long term option contracts and offer the same risks and rewards as
regular options.

Option Transactions
Establishment of a new position in an option contract by an investor is referred
to as an Opening Transaction.
An opening buy transaction results in a long position in the option.
An opening sell transaction results in a short position in the option.
On or before an option’s expiration date, one of three things will happen to long
and short option positions.
• For exchange traded options, positions may be liquidated prior to expiration
by way of an offsetting transaction, which, in effect, cancels the position.
Offsetting a long position involves selling the same type and number of
contracts, while offsetting a short position involves buying the same type and
number of contracts. OTC Contracts can be offset by negotiation

• The party holding the long position can exercise the option. i.e, the party
holding the short position is said to be assigned on the option.
For the owners of call options, the act of exercising involves buying the
underlying asset from the assigned writer at a price equal to the strike price.
For the owners of put options, exercising involves selling the underlying asset
to the assigned put writer at a price equal to the strike price.
• Parties holding a long position can let the option expire. Buyers of options
have rights, not obligations. If they do not want to exercise their options
before they expire, they don’t have to; it’s a right not an obligation.
Owners of options will exercise only if it is in their best financial interest, which
can only occur when an option is in-the-money.
Option Transactions

• A call option is in-the-money when the price of the underlying asset is higher
than the strike price.
If this be the case, the call option holder can exercise the right to buy the
underlying asset at the strike price and then turn around and sell it at the
higher market price.
• A put option is in-the-money when the price of the underlying asset is lower
than the strike price.
If this be the case, the put option holder can exercise the right to sell the
underlying asset at the higher strike price, which would create a short
position, and then cover the short position at the lower market price.
Option Transactions

The in-the-money portion of a call or put option is referred to as the option’s
intrinsic value.
E.g., if XYZ stock is trading at $60, a call option on XYZ stock with a strike
price of $55 has $5 of intrinsic value. Similarly, a put option on XYZ with a
strike price of $65 has $5 of intrinsic value. Thus,
Intrinsic Value of an In-the-Money Call Option = Price of Underlying –
Strike Price; $5 = $60 – $55
Intrinsic Value of an In-the-Money Put Option = Strike Price–Price of
Underlying; $5 = $65 – $60
Option Transactions

If an option is not in-the-money, it has zero intrinsic value.
For example, a call option on XYZ with a $65 strike price has no intrinsic
value, as does a put option with a strike price of $55.
Option Transactions

Prior to the expiration date, most options trade for more than their intrinsic
value.
The amount by which an option is trading above its intrinsic value is known as
the option’s time value.
E.g., if a call option on XYZ with a strike price of $55 is trading for $6 when
XYZ stock is trading at $60, the option has $1 of time value.
Time Value of an Option = Option Price – Option’s Intrinsic Value
$1 = $6 – $5
Rearranging the equation: Option Price = Intrinsic Value + Time Value
Option Transactions: Time Value

Intrinsic Value is the amount that the owner of an in-the- money option would
earn by immediately exercising the option and offsetting any resulting position
in the underlying asset.
Time Value represents the value of uncertainty.
Option buyers want options to be in-the-money at expiration; option writers
want the reverse.
The greater the uncertainty about where the option will be at expiration, either
in-the-money or out-of-the-money, the greater the option’s time value.
Option Transactions: Intrinsic Value & Time Value

‘Out of’ or ‘At the Money’ Options
Owners of options will definitely not exercise if they are out-of-the-money or
at-the-money.
• A call option is out-of-the-money when the price of the underlying asset is
lower than the strike price.
• A put option is out-of-the-money when the price of the underlying asset is
higher than the strike price.
• Call and put options are at-the-money when the price of the underlying asset
equals the strike price.
If a call option is out-of-the-money, it does not make financial sense for the call
option holder to buy the underlying asset at the strike price (by exercising the
call) when it can be purchased at a lower price in the market.

if a put option is out-of-the-money, it does not make financial sense for the put
option holder to sell the underlying asset at the strike price (by exercising the
put) when it can be sold at a higher price in the market.
There is generally no advantage to exercising an at-the-money option (for which
the strike price equals the market price of the underlying asset), at-the-money
options are normally left to expire worthless.
‘Out of’ or ‘At the Money’ Options

Equity Option Quotation
XYZ Inc. 17 3/4 Bid Ask Last Opt Vol Opt Int
Mar $17.50 3.80 4.05 3.95 50 1595
$17.50P 2.35 2.60 2.40 5 3301
Sept $17.50 1.10 1.35 1.25 41 3403
$17.50P 0.95 1.05 1.00 30 1058
Dec. $20.00P 1.85 2.00 1.90 193 1047
Total 319 10404
Explanation:
XYZ Inc. The underlying equity for the option.,
17 ¾ - The closing market price of the underlying equity.,
Mar. The options’ expiration month (March, September, December).,

Explanation: Equity Option Quotes
XYZ Inc. The underlying equity for the option.,
17 ¾ - The closing market price of the underlying equity.,
Mar. The options’ expiration month (March, September, December).,
$17.50 - The exercise price of each series.,
$17.50P - The option is a put.,
3.80 - closing bid price for each XYZ option expressed as a per share price.,
4.05 - closing asked price for each XYZ option expressed as a per share price.,
3.95 - The last sale price (last premium traded) of an option contract for the
day expressed as a per share price.
E.g., the 3.95 figure for the XYZ March 17.50 calls is the last sale price for this
series on the trading day in question.

Op Int – i.e. open interest – the total
number of option contracts in the series
that are currently outstanding and have
not been closed out or exercised.
E.g., the figure 1595 refers to the open
interest for the XYZ March 17.50 calls.
The figure 10,404 refers to the open
interest of all series of XYZ options,
including the series that did trade as
well as the series that did not trade.
Explanation: Equity Option Quotes

Option Strategies For Individual And Institutional Investors
Range and complexity of trading strategies are practically limitless.
Eight option strategies used by individual and institutional investors will be
discussed involving either a long or short position in an XYZ call or put option.
Strategies will either be a speculative or risk management based on exchange-
traded options.
At times, the option position will be the only part of the strategy, but in other
cases the option position will be combined with a position or expected position
in XYZ stock.
There are other, more complex strategies that are commonly employed.

The strategies assume that it is currently June and that XYZ Inc. stock is
trading at $52.50 per share.
If XYZ Inc. was a real company and it had options listed on its stock, there
would typically be a variety of expiration dates and strike prices to choose
from. –see four options listed in Table.
General assumption: it is currently June and XYZ Inc. stock is trading at $52.50
per share.
Option Strategies For Individual And Institutional Investors

Four Options on XYZ Inc. Stock Trading At $52.50
Option Type Expiration Strike Price Premium
Call September $50 4.55
Call December $55 2.00
Put September $50 1.5
Put December $55 4.85
For simplicity, commissions, margin requirements and dividends are ignored in
all of the examples
XYZ Inc. has options listed on its stock, with a variety of expiration dates and
strike prices to choose from. –see Table.

Buying Call Options
Reasons: to profit from an expected increase in the price of the underlying stock
– a speculative strategy that relies on the fact that call option prices tend to rise
as the price of the stock rises.
Challenge: selecting the appropriate expiration date and strike price to generate
maximum profit given the expected increase in the price of the stock.
Two ways to realize profit on call options when the underlying increases in
price:
• Investors can exercise the option and buy the stock at the lower exercise price
• They can sell the option directly into the market at a profit.

Calls may be bought to establish a maximum purchase price for the stock, or to
limit the potential losses on a short position in the stock. - buying options act
much like insurance, protecting the investor when the stock price moves higher.
Buying Call Options

Strategy #1: Buying Calls to Speculate
An investor buys 5 XYZ December 55 call options at the current price of $2.
Pays a premium of $1,000 ($2 × 100 shares × 5 contracts) to obtain the right to
buy 500 shares of XYZ Inc. at $55 a share on or before the expiration date in
December.
The options are out-of-the-money (the strike price is greater than the stock price
of $52.50), the $2 premium consists entirely of time value.
The options have no intrinsic value.

For the speculative investor - intent of the call purchase is to profit from an
expectation of a higher XYZ stock price.
The call buyer will want to sell the 5 XYZ December 55 calls before they
expire, preferably at a higher price than what was paid for them.
But if the price of XYZ shares rise, the price of the calls will likely rise, and the
call buyer will be able to sell them at a profit.
Of course, the call buyer faces the risk that if the stock price does not rise or,
worse, it falls.

E.g., if by September the price of XYZ stock is $60, the XYZ December 55 calls
will be trading for at least their intrinsic value, which in this case is $5. Since
there are still three months remaining before the options expire, the premium
will also include some time value.
Assuming the calls have $1.70 of time value, they will be trading at $6.70.
Therefore, the investor could choose to sell the options at $6.70 and realize a
profit of $4.70 a share, equal to the difference between the current premium
minus the premium paid, or $2,350 total ($4.70 × 100 shares × 5 contracts).

However, XYZ shares are trading at $45 a share in September, the XYZ
December 55 calls might be worth only $0.25.
At this time, and indeed, at all other times before expiration, the investor will
have to decide whether to sell the options or hold on in the hope that the stock
price (and the options’ price) recovers.
If the investor sells at this time, a loss equal to $1.75 a share, or $875 total
($1.75 × 100 shares × 5 contracts) will result.
Selling before expiration allows the call buyer to earn any time value that
remains built into the option premium.
Also, the option buyer gives up any chance of reaping any further increases in
the option’s intrinsic value. The call buyer’s outlook for the stock price plays a
crucial role in the decision.

Strategy #2: Buying Calls to Manage Risk
Investors buy call options is to manage risk.
E.g., a fund manager intends to buy 50,000 shares of XYZ stock, but will not
receive the funds until December.
Buying 500 XYZ December 55 call options will protect the fund manager from
any sharp increase in the price of XYZ above the $55 strike price, because they
will establish a maximum price at which the shares can be purchased.
E.g., if XYZ shares increase to $60 just prior to the expiration date in December,
the options will be trading for their intrinsic value only, in this case $5
= ($60 – $55).

Since the call buyer now has the money to buy the shares, the calls can be
exercised, at which point the call buyer will purchase 50,000 shares of XYZ at
the strike price of $55.
Thus, the call buyer’s net purchase price is actually $57 a share, considering the
$2 paid for the option.
But If, XYZ shares are trading at $45 just prior to the expiration date, the call
buyer will let the options expire and will buy the shares at the going price of $45
each.
The investor’s effective cost is $47, which includes the $2 paid for the calls.
Strategy #2: Buying Calls to Manage Risk

Writing Call Options
Investors write call options primarily for the income they provide. i.e. the
premium, which is the writer’s to keep no matter what happens to the price of
the underlying asset or what the buyer eventually does.
Call-writing strategies are primarily speculative in nature, but it can also be
used to manage risk.
Two classifications of call option writers:
• Covered call writers own the underlying stock, and will use this position to
meet their obligations if they are assigned.
• Naked call writers do not own the underlying stock and if assigned, the
underlying stock must first be purchased in the market before it can be sold
to the call option buyer.

Call option buyers will only exercise if the price of the stock is above the strike
price, assigned naked call writers must buy the stock at one price (the market
price) and sell at a lower price (the strike price).
Naked call writers hope, that this loss is less than the premium they originally
received, so that the overall result for the strategy is a profit.
Since all exchange-traded stock options have an American-style exercise
feature, call writers (and put option writers) face the risk of being assigned at
any time prior to expiration.
Prior to expiration, it is more advantageous for call buyers to sell their options
rather than exercise them - because by selling they receive the option’s time
value as well as its intrinsic value.

Only the intrinsic value is captured when an option is exercised.
So the chance of being assigned before expiration is not as great as one might
think.
Though this happens, particularly when the time value is small, and option
writers must be aware of this.

Strategy #1: Covered Call Writing
Assume an investor writes 10 XYZ September 50 call options at the current
price of $4.55.
The investor receives a premium of $4,550 ($4.55 × 100 shares × 10 contracts)
to take on the obligation of selling 1,000 shares of XYZ Inc. at $50 a share on
or before the expiration date in September.
Because the options are in-the-money (the strike price is less than the stock
price), the $4.55 premium consists of both intrinsic and time value. Intrinsic
value is equal to $2.50 and time value is equal to $2.05.
If the investor already owned (or purchased at the same time as the options
were written) 1,000 shares of XYZ, the overall position is known as a covered
call. i.e. covered call writer.

At expiration in September, the price of XYZ stock is greater than $50 (i.e., the
options are in-the-money), the covered call writer will be assigned and thus
have to sell the stock to the call buyer at $50 a share.
From the covered call writer’s perspective, however, the effective sale price is
$54.55, because of the initial premium of $4.55.

But If, the price of the stock at expiration in September is less than $50, the
covered call writer will not be assigned and the options will expire worthless.
Call buyers will not elect to buy stock at $50 when it can be purchased for less
in the market.
The covered call writer will retain the shares and the initial premium. Thus, the
premium reduces the covered call writer’s effective stock purchase price by
$4.55 a share.
i.e., if the covered call writer bought the XYZ stock at, $50, and the options
expired worthless, the covered call writer’s effective purchase price is now
$45.45 ($50 – $4.55).
In this sense, writing the call slightly reduces the risk of owning the stock.

Strategy # 2: Naked Call Writing
Assume an investor writes 10 XYZ September 50 call options at the current
price of $4.55. if call is not already owned - a naked call writer.
The best the naked call writer could hope for is, that the price of XYZ stock will
be lower than $50 at expiration.
In this instance, the calls will expire worthless and the naked call writer will
earn a profit equal to $4.55 a share, the initial premium received.
This is the most that this call writer can expect to earn from this strategy.

But if the price of the shares increases, the naked call writer will realize a loss if
the stock price is higher than the strike price plus the premium received, in this
case $54.55.
In this instance, the naked call writer will be forced to buy the stock at the
higher market price and then turn around and sell them to the call buyer at the
$50 strike price.
When the stock price is greater than $54.55, the cost of buying the stock is
greater than the combined proceeds from selling the stock and the premium
initially received.
Strategy # 2: Naked Call Writing

For example, if the price of the XYZ rose to $60 at expiration, the naked call
writer will suffer a $10 loss on the purchase and sale of the shares (buy at $60,
sell at $50).
This loss is offset somewhat by the initial premium of $4.55, so that the actual
loss is $5.45 a share, or $5,450 in total ($5.45 × 100 shares × 10 contracts).
Strategy # 2: Naked Call Writing; Example

Buying Put Options
Investors buy put options for:
• To profit from an expected decline in the price of the stock. - speculative
strategy relies on the fact that put option prices tend to rise as the price of the
stock falls. Just like buying calls, the selection of an expiration date and strike
price is crucial to the success (or lack thereof ) of the strategy.
• For risk management purposes. - puts can be used to lock in a minimum
selling price for a stock, they are very popular with investors who own stock.
Buying puts can protect investors from a decline in the price of a stock below
the strike price.

Strategy #1: Buying Puts to Speculate
Assume an investor buys 10 XYZ September 50 put options at the current
price of $1.50. The put buyer pays a premium of $1,500 ($1.50 × 100 shares ×
10 contracts) to obtain the right to sell 1,000 shares of XYZ Inc. at $50 a share
on or before the expiration date in September.
Because the options are out-of-the-money (the strike price is less than the stock
price), the $1.50 premium consists entirely of time value. The option has no
intrinsic value.
Opinion of put buyer might be the exact opposite of the opinion of put seller. If
the stock price falls, the XYZ September 50 put options will likely rise in
value. This will allow the put buyer to sell his options for a profit. Of course, if
the stock price rises, the put options will most likely lose value and the put
buyer may be forced to sell the options at a loss.

E.g., if XYZ stock is trading at $45 one month before the September expiration
date, the XYZ September 50 puts will be trading for at least their intrinsic value,
or $5.
Since there is still one month before the expiration date, the options will have
some time value as well.
Assuming they have time value of $0.25, the options will be trading at $5.25.
Therefore, the put buyer could choose to sell the puts for $5.25 and realize a
profit of $3.75 a share, which is equal to the difference between the current put
price and the put buyer’s original purchase price.
Based on 10 contracts, the put buyer’s total profit is $3,750
i.e. ($3.75 × 100 shares × 10 contracts).

But if, XYZ were trading at $60 a share, the XYZ September 50 puts might be
worth only $0.05.
Because the options are so far out-of-the-money, and because there is only one
month left until the options expire, the options will not have a lot of time value.
The low option price tells us the market does not believe there is much of a
chance for XYZ shares to fall below $50 anytime over the next month.
Put buyer has to decide whether to sell the options at this price, or hold on in
hope that the price of XYZ does fall to below $50. If the stock does fall, the
price of puts will rise. If the stock doesn’t fall below $50, the puts will be
worthless when they expire. If the put buyer decides to sell the options at $0.05,
a loss equal to $1.45 a share ($0.05 – $1.50) or $1,450 i.e.
($1.45 × 100 shares × 10 contracts) would result.

Strategy #2: Buying Puts to Manage Risk
Assume an investor buys 10 XYZ September 50 put options at the current price
of $1.50, but in this case the put buyer actually owns 1,000 shares of XYZ. –
thus the put purchase acts as insurance against a drop in the price of the stock. -
Recall that put buyers have the right to sell the stock at the strike price.
Buying a put in conjunction with owning the stock, a strategy known as a
married put or a put hedge, gives the put buyer the right to sell the stock at the
strike price.
If the price of the stock is below the strike price of the put when the puts expire,
the put buyer will most likely exercise the puts and sell the stock to the put
writer.
The strike price acts as a floor price for the sale of the stock.

E.g., if XYZ shares are trading at $45 just prior to the expiration date in
September, the puts will be trading very close to their intrinsic value of $5,
because the puts are in-the-money and there is very little time left until the
expiration date.
The put buyer may choose to exercise the puts and sell the stock at the $50
strike price. The put buyer has been protected from the drop in the stock price
below $50.
The protection was not free, because the put buyer had to pay $1.50 for the
puts. The put buyer’s effective sale price is actually only $48.50, after
deducting the cost of the puts. But this sale price is still better than the stock’s
$45 market price.
Example: Strategy #2: Buying Puts to Manage Risk

The put buyer, may not want or even be able to sell the stock. If so, the puts
should be sold.
Any profit on the sale of the puts reduces the put buyer’s effective stock
purchase price.
If the put buyer originally bought the stock at a price of, $40, and then sold the
puts at $5, for a net profit of $3.50, the effective stock purchase price becomes
$36.50.
Eventually, when the shares are sold, the put buyer will measure the total profit
on the stock purchase as the difference between the sale price and the effective
purchase price of $36.50.
Example: Strategy #2: Buying Puts to Manage Risk

Writing Put Options
Primarily done for the income they provide - in the form of premium, - the
writer’s to keep no matter what happens to the price of the underlying asset or
what the buyer eventually does.
Like call-writing, put-writing strategies are primarily speculative in nature, but
they can also be used to manage risk.
• Put option writers can be classified as either covered or naked. Covered put
writing, is not nearly as common as covered call writing because, technically,
a covered put write combines
a short put with a short position in the stock. More common is a “nearly”
covered put writing strategy is known as a cash-secured put write.
A cash-secured put write involves writing a put and setting aside an amount of
cash equal to the strike price.

• Naked put writers have no position in the stock and have not specifically
earmarked an amount of cash to buy the stock. They must be prepared to buy
the stock, so they should always have the financial resources to do so.
They hope to profit from a stock price that stays the same or goes up.
If this happens, the price of the puts will likely decline as well, and the chance
of being assigned will also be less.
The naked put writer may then choose to buy back the options at the lower
price to realize a profit. If the stock price does not rise, the put writer may be
assigned, and may suffer a loss.
Based on how low the stock price is and the amount of premium received,
naked put writers may still profit even if they are assigned.
Writing Put Options

Strategy # 1: Cash-Secured Put Writing
Assume investor writes 5 XYZ December 55 put options at the current price of
$4.85. The put writer receives a premium of $2,425 ($4.85 × 100 shares × 5
contracts) to take on the obligation of buying 500 shares of XYZ Inc. at $55 a
share on or before the expiration date in December.
Because the options are in-the-money (the strike price is greater than the stock
price), the $4.85 premium consists of both intrinsic value and time value.
Intrinsic value is equal to $2.50 and time value is equal to $2.35.
If the put writer set aside cash equal to the purchase value of the stock, the
strategy is known as a cash-secured put write. The put writer in this case would
have to set aside $27,500 ($55 strike price × 100 shares × 5 contracts).

Some investors actually use cash-secured put writes as a way to buy the stock at
an effective price that is lower than the current market price.
The effective price is equal to the strike price minus the premium received.
Strategy # 1: Cash-Secured Put Writing

Example: Strategy # 1: Cash-Secured Put Writing
E.g., if at expiration in December the price of XYZ stock is less than $55, the
put writer will be assigned and will have to buy 500 shares of XYZ at the strike
price of $55 a share.
The effective purchase price is actually $50.15, because the put writer received
a premium of $4.85 when the options were written.
This effective purchase price is less than the $52.50 price of the stock when the
cash-secured put write was established.

If at expiration in December the price of XYZ stock is greater than $55, the
cash-secured put writer will not be assigned because the options are out-of-the-
money.
The cash-secured put writer, however, gets to keep the premium of $4.85, and
will have to decide whether to use the cash to buy the stock at the market price.
Example: Strategy # 1: Cash-Secured Put Writing (b)

Strategy #2: Naked Put Writing
Suppose a different investor writes 5 XYZ December 55 put options at the
current price of $4.85.
If the put writer does not set aside a specific amount of cash to cover the
potential purchase of the stock, the put writer is considered a naked put writer.
The naked put writer desires the price of XYZ to be higher than $55 at
expiration.
If this happens, the puts will expire worthless and the put writer will earn a
profit equal to $4.85 a share, the initial premium received.

Strategy #2: Naked Put Writing (b)
If the price of XYZ stock falls, the naked put writer will most likely realize a
loss, as put buyers will exercise their options to sell the stock at the higher
strike price.
(The naked put writer in this case will suffer a loss only if XYZ stock is trading
for less than $50.15 at option expiration.)
The naked put writer will have to buy stock at a price that is higher than the
market price.
If the put writer does not want to hold the shares in anticipation of a higher
price, they could be sold.

Example: Strategy #2: Naked Put Writing
E.g., if the price of XYZ fell to $45 at expiration, the naked put writer will
suffer a $10 loss on the purchase and sale of the shares (buy at the strike price
of $55, sell at the market price of $45).
This loss is offset somewhat by the initial premium of $4.85, so that the actual
loss is $5.15 a share, or $2,575 in total ($5.15 × 100 shares × 5 contracts).

Option Strategies for Corporations
Normally, corporations do not speculate with derivatives.
They are interested in managing risk, and often use options to do it.
These risks are often related to interest rates, exchange rates or commodity
prices.
E.g., corporations take on debt to help finance their operations and attimes the
interest rate on the debt is a floating rate that rises and falls with market interest
rates.
Just like the investor who buys a call to establish a maximum purchase price for
a stock, corporations can buy a call to establish a maximum interest rate on
floating-rate debt.

Call Option Strategies: Corporations
Suppose a Canadian company knows it will buy US$1 million worth of goods
from a U.S. supplier in three months’ time.
If the exchange rate is C$1.12 per U.S. dollar, the U.S. dollar purchase will
cost the company C$1.12 million.
The company can either buy the US$1 million now and pay C$1.12 million, or
wait three months and pay whatever the exchange rate is at that time.
If company chooses to do the latter and wait, by doing this, it faces the risk that
the value of the U.S. dollar will strengthen relative to the Canadian dollar.
Thus, the Canadian dollar cost of the purchase would be higher than C$1.12
million.
To protect itself against this risk, the corporation can buy a call option on the
U.S. dollar.

Suppose the corporation buys a three-month U.S. dollar call option with a strike
price of C$1.15.
This option is an OTC option and would most likely be written by the
corporation’s bank.
If at the end of three months the exchange turns out to be C$1.20, the
corporation will exercise the call and buy the U.S. dollars from its bank for
C$1.15 million.
If, however, the U.S. dollar weakens so that in three months the exchange rate is
C$1.10, the corporation will let the option expire and will buy the U.S. dollars
at the lower exchange rate.
The purchase of the call option has capped the exchange rate at C$1.15 plus the
cost of the option.
Call Option Strategies: Corporations

Put Option Strategies - Corporations
Assume a Canadian oil company will have 1 million barrels of crude oil to sell
in six months’ time and present price of crude oil is US$70 a barrel but unsure
of what the price will be in six months.
To lock in a minimum sale price, the company buys a put option on one million
barrels of crude oil with a strike price of US$68 a barrel.
This will protect the company from an oil price lower than US$68 a barrel.
in six months, if price of crude oil is less than US$68, the company will exercise
its put option and sell the oil to the put option writer at the strike price.
But if the price is greater than US$68, the company will let the option expire
and will sell the oil at the going market price.

This is a contract between two parties: a buyer and a seller.
The buyer of a forward agrees to buy the underlying asset from the seller on a
future date at a price agreed upon today.
**Both parties are obligated to participate in the future trade.
Forwards can trade on an exchange or over the counter.
• When traded on an exchange, they are referred to as futures contract.
Futures contracts can further be classified into 2 groups:
 Contracts that have a financial asset – a stock, bond, currency, interest
rate or index – as the underlying asset are referred to as financial
futures.
 Contracts with physical assets (e.g. gold, crude oil, soybeans etc) as
the underlying asset are known as Commodity futures.

A forward contract traded over the counter, it is generally referred to as a
forward agreement.
Predominant types of forward agreements are based on interest rates and
currencies.
Forward agreements on commodities exist, but the size of trading in these
contracts is small compared to trading in interest rate and currency forwards.
The market is dominated by institutional traders and large corporations.
But Futures, are accessible to a much broader segment of the market,
including investment advisors and individual investors.
Thus, we focus on the key features of futures and some basic futures strategies.

Futures – Key Terms
Futures are simply exchange-traded forward contracts.
They are agreements between two parties to buy or sell an underlying asset at
some future point in time at a predetermined price.
They are standardized with respect to the amount of the asset underlying each
contract, expiration dates and delivery locations.
The expiration date on a futures contract is set by the exchange on which the
contract is listed.
Many commodity futures require additional standardization; such as the quality
of the underlying asset and the delivery location. Standardization allows users
to offset their contracts prior to expiration and provides the backing of a
clearinghouse.

The party that agrees to buy the underlying asset holds a long position in the
futures contract.
This party is also said to have bought the futures contract.
The party that agrees to sell the underlying asset holds a short position in the
futures contract, and is said to have sold the futures contract.
The buyer of a futures contract does not pay anything to the seller when the two
enter into the contract and the seller does not deliver the underlying asset right
away.
The futures contract simply establishes the price at which a trade will take place
in the future. Most parties end up offsetting their positions prior to expiration,
so that few deliveries actually take place.

If a contract is not offset and is held to the expiration date, delivery will occur.
Longs will have to accept delivery of the underlying asset and make payments
to the shorts.
Shorts have to make delivery of the underlying asset and accept payments from
the longs.

Cash-Settled Futures
Financial futures are based on underlying assets that are difficult or even
impossible to deliver.
For these futures, delivery involves an exchange of cash from one party to the
other based on the performance of the underlying asset from the time the future
was entered into until the time that it expires.
These futures are known as cash-settled futures contracts e.g., equity index
futures contract.
Those who are long a stock index futures contract are not obligated to accept
delivery of the stocks that make up the index, nor are those who are short
required to make delivery of the stocks.

Instead, if the position is held to the expiration date, either the long or the short
will make a cash payment - based on the difference between the price agreed to
in the futures contract and the price of the underlying asset on the expiration
date.
• If the price agreed to in the futures contract is greater than the price of the
underlying asset at expiration, prices have fallen, and the long must pay the
short.
• If the price agreed to in the futures contract is less than the price of the
underlying asset at expiration, prices have risen, and the short must pay the
long.
**Cash-settled futures can be offset prior to expiration
Cash-Settled Futures

Margin Requirements And Marking-to-market
Buyers and sellers of futures contracts must deposit and maintain adequate
margin in their
futures accounts. futures margins are meant to provide a level of assurance that
the financial obligations of the contract will be met i.e. a good-faith deposit or
performance bond.
Two levels of margin used in futures trading:
• Initial or original margin is required when the contract is entered into.
• Maintenance margin is the minimum account balance that must be
maintained while the contract is still open.
Minimum initial and maintenance margin rates for a particular futures contract
are set by the exchange on which it trades,

Chief feature of futures trading is the daily settlement of gains and losses a
process known as marking-to-market.
At the end of each trading day, those who are long a contract make a payment to
those who are short, or vice versa, depending on the change in the price of the
contract from the previous day.
If either party accumulates losses that cause their account balance to fall below
the maintenance margin level, they must deposit addition margin to their futures
accounts.
Margin Requirements And ‘Marking-to-market’

Futures Quotation
Contract
High
Contract
Low
Month Open High Low Settled Change
(I)
Open
Interest
(I)
3 month Bankers Acceptance
97.38 97.23 Mar 97.29 97.33 97.28 97.29 -0.04 98,446
97.27 97.05 Sep 97.21 97.26 97.19 97.19 -0.05 56,749
96.75 96.55 Dec 96.71 96.75 96.70 96.70 -0.03 7,759
Est Sales Previous sales Open Interest
(2)
Change (2)
24,522 64,264 278,061 +23,558

Explanation
3-Month Bankers’Acceptances, $1M The underlying interest
Contract High
The highest price the contract has reached since it
started trading.
Contract Low
The lowest price the contract has reached since it
started trading.
Month
Delivery month. E.g., the first contract listed has
a delivery month of March 2007.
Open
The price the contract opened at that day. E.g.,
the March contract opened at 97.29
High The highest the contract traded that day.
Low The lowest the contract traded that day.

Settled The price the contract closed at that day.
Change (1)
The difference between the closing price that day and the closing
price previous trading day. E.g., the March future closed down 0.04
per cent from the previous day
Open Interest (1) The open interest in that specific futures contract.
Est Sales Estimated volumes for that trading day.
Previous Sales Volumes for the previous trading day.
Open Interest (2) The total number of futures contracts open on the underlying interest.
Change (2)
The change in the number of futures contracts open on the underlying
interest. In this case, there are 23,558 more contracts open than at the
end of the previous trading day.
Explanation!

Futures Strategies for Investors
.
.
Only two basic positions with futures contracts – long and short.
number of strategies that can be designed with futures is limited because there
are only two basic positions for each expiration date.
Buying Futures:
• To profit from an expected increase in the price of the underlying asset,
• To lock in a purchase price for the asset on some future date i.e. speculation

Strategy #1: Buying Futures to Speculate
Done by Investors either to profit from an expected increase in price of the
underlying asset, or to lock in a purchase price for the asset on some future
date.
The former being speculation and the latter is risk management.

Strategy #1: Buying Futures to Speculate
E.g., investor buys 10 December gold futures at a price of US$575 an ounce.
Each gold futures contract has an underlying asset of 100 ounces of gold, the
investor has agreed to buy 1,000 ounces of gold from the futures seller on a
specific date in December for a total cost of US$575,000 ($575 × 100 ounces ×
10 contracts).
If investor bought in order to profit from future higher price, he/she would
prefer to sell the 10 December gold futures, preferably at a higher price than
what was paid for them – i.e., no intention of actual delivery.
This is dependent on the spot price of gold in the spot/ cash market.

Example: Strategy #1; Buying Futures to Speculate
E.g., if in early November the price of December gold futures have risen to
$600 in response to a rising gold spot price, the investor could choose to sell the
futures at $600 and realize a profit of $25 an ounce, or $25,000 total ($25 × 100
ounces × 10 contracts).
If, however, December gold futures were trading at $550, the investor would
have to decide whether to sell the futures or hold on in the hope that the price
recovers before the expiration date.
If the investor decided to sell at this price, a loss equal to $25 an ounce, or
$25,000 total – ($25 X 100 ounces X 10 contracts)

Strategy #2: Buying Futures to Manage Risk
If an a different investor buys 10 December gold futures at a price of US$575 an
ounce with the intention of actually buying 1,000 ounces of gold in December.
The gold purchase may actually be a speculative decision, but the purchase of
futures to lock in a purchase price is considered a risk management decision.
In this case, all the investor needs to do is not offset the contract.
At expiration, the investor will be required to take delivery of 1,000 ounces of
gold for a payment of US$575,000.
The purchase of the futures contracts locks the investor in to a purchase price of
US$575 an ounce regardless of what happens to the price of gold in the spot
market.

Selling Futures
Investors sell futures either to profit from an expected
decline in the price of the underlying asset or to lock
in a sale price for the asset on some future date.

Strategy #1: Selling Futures to Speculate
If an investor sells 5 December Government of Canada ten-year bond
futures at a price of 105. (- like prices in the bond market, prices of
bond futures contracts are quoted on a “per $100 of face value”
basis.)
Each bond futures contract has a $100,000 face value bond as its
underlying asset, thus the investor has agreed to sell a $500,000 face
value bond to the buyer on a specific date in December for total
proceeds of $525,000
([105 ÷ 100] × $100,000 bond × 5 contracts).

In the earlier described the investor scenario could have sold the futures
simply to profit from an expectation of a lower bond futures price.
The investor probably has no intention of actually selling $500,000 of bonds.
Rather, the investor might buy back the 5 December bond futures in the
market, preferably at a lower price than what they were sold for. The chances
of this happening depend primarily on the price of ten-year Government bonds
in the spot or cash market. If bond prices fall in the cash market, then the price
of bond futures will fall, too.
Of course, the investor faces the risk that bond prices will rise - If this so, price
of bond futures will rise as well, and the investor may be forced to buy back
the contracts at a loss.
Strategy #1: Selling Futures to Speculate (b)

Example: Strategy #1; Selling Futures to Speculate
if in early November the price of December bond futures have declined from
105 to 100, the investor could choose to buy back the futures at 100 and realize
a profit of 5 points, or $25,000 total
([5 ÷ 100] × $100,000 face value × 5 contracts).
If, however, December bond futures were trading at 107.50, the investor would
have to decide whether to buy the futures or hold on in the hope that the price
falls before the expiration date. If the investor decided to buy them back, a loss
equal to 2.5 points, or $12,500 total would be the result.
([2.5 ÷ 100] × $100,000 face value × 5 contracts)

Strategy #2: Selling Futures to Manage Risk
If an investor decides to sell 5 December Government of Canada ten-year bond
futures at a price of 105 and that, for whatever reason, the investor actually
wanted to sell $500,000 of bonds in December.
Thus, all the investor needs to do is not offset the contracts.
At expiration, the investor will be required to make delivery of $500,000 of
bonds and in return will receive $525,000.
The sale of the futures contracts locks the investor in to a sale price of 105
regardless of what happens to bond prices.

Futures Strategies For Corporations
Corporations use futures to manage risk in the same way that investors do.
If a company needs to lock in the purchase price of an asset, it may decide to
buy futures on the asset. Also, when a company needs to lock in the sale price
of an asset, it may decide selling futures on the asset.
Though companies take futures positions consistent with risk management
needs, many offset their positions prior to expiration rather than actually
making or taking delivery of the underlying assets.
Also, futures can satisfy a company’s risk management needs by providing
price protection.

Forwards Contract Futures Contract
Private contract b/w two parties
bilateral contracts
Traded on exchanges
Not Standardized (customized) Standardized contracts
Normally one specified delivery date Range of delivery dates
Settled at end of maturity. No cash
exchange prior to delivery date
Daily Settled. Profit/Loss is/are paid in
cash
More than 90% of forwards contracts
are settled by actual delivery of assets
Not ,more than 5% of futures contracts
are settled by delivery
Delivery or final cash settlement
usually takes place
Contract normally closed out prior to
delivery
Difference b/w Futures & Forwards Contract

Rights & Warrants
Rights and Warrants are securities that give their owners the right, but not the
obligation, to buy or sell a specific amount of stock at a specified price on or
before the expiration date.
They are usually issued by a company as a method of raising capital - though
they may dilute the positions of existing shareholders if they are exercised, but
they allow the company raise capital quickly and cost-effectively.
Major Difference: Rights are usually very short term, with an expiration date
often as little as four to six weeks after they are issued, while warrants tend to be
issued with three to five years to expiration.

Rights
This is a privilege granted to an existing shareholder to acquire additional shares
directly from the issuing company.
To raise capital by issuing additional common shares, a company/s may give
shareholders rights that allow them to buy additional shares in direct proportion
to the number of shares they already own.
E.g., shareholders may be given one right for each share they own, and the offer
may be based on the right to buy one additional share for each ten shares held.
Thus, the company wants to increase its outstanding shares by 10%, and each
shareholder is given the opportunity to increase their own holdings by 10%.

The exercise price of a right; known as the subscription or offering price, is
almost always lower than the market price of the shares at the time the rights are
issued. making them valuable and giving shareholders an incentive to exercise
such rights.
A record date is announced when the decision to do a rights offering is taken –
used to determine the list of shareholders to receive the rights, similar to
issuance of a dividend i.e. common shareholders who are in the record books on
the record date receive rights.
Two business days before the record date, the shares trade ex rights i.e. anyone
buying shares on or after the ex rights date is not entitled to receive the rights
from the company.
Rights (b)

Anyone who buys the stock is entitled to receive the rights if they hold the stock
until at least the record date - between the day of the announcement that rights
will be issued and the ex rights date, the stock is said to be trading cum rights.
Investors need the correct number of rights required to purchase shares, the
subscriber must pay the subscription price to the company to acquire these
additional shares. No commission is levied when a rights holder exercises the
rights and acquires shares – fractional shares are at the discretion of the
company.
A secondary market might develop for the rights as holders who do not want to
subscribe can sell - price of the rights tend to rise and fall in the secondary
market as the price of the common stock fluctuates, though not necessarily to
the same degree.
Rights (c)

Course Of Action for the Rights Holder
4 Options:
• Exercise some or all of the rights and acquire the shares
• Sell some or all of the rights
• Buy additional rights to trade or exercise later
• Do nothing and let the rights expire worthless - provides no benefit. Rights
are not automatically exercised on behalf of their Holders. Holders must
select a course of action appropriate for his or her circumstances.
More in-depth treatment of topic in our more advanced module!

Warrants
A security that gives its holder/s the right to buy shares in a company from the
issuer at a set price for a set period of time.
Similar to call options, but warrants are issued by the company itself, whilst
call options are issued – that is, written – by other investors.
They are often issued as part of a package that also contains a new debt or
preferred share issue - warrants help make issues more attractive to buyers by
giving them the opportunity to participate in any appreciation of the issuer’s
common shares i.e., they function as a sweetener.
Once issued, they can be sold immediately or after a certain holding period.
The expiration date of warrants; which can extend to several years from the
date of issue, is longer than that of a right.

warrants may have both intrinsic value and time value.
Intrinsic Value is the amount by which the market price of the underlying
common stock exceeds the exercise price of the warrant - no intrinsic value if
the market price of the common stock is less than the exercise price.
Time Value is the amount by which the market price of the warrant exceeds the
intrinsic value. If the market price of the underlying common stock is less than
the exercise price of the warrant, the warrant has no intrinsic value.
This does not mean the warrant has no value; it may still have time value
because of the potential for the stock price to increase before the warrants
expire.
Ceteris paribus, the further away the expiration date, the greater the time value.
Warrants (b)

Main Attraction of Warrants is their leverage potential.
Market price of a warrants are usually much lower than the price of the
underlying securities, and generally move in the same direction at the same
time as the price of the underlying.
Thus, capital appreciation of a warrant on a percentage basis can greatly exceed
that of the underlying security.
Warrants (c)

Example: Warrants
Example: A warrant has a market value of $4, exercisable at $12 on an
underlying common stock that has a market price of $15.
If the common stock rises to $23 a share before the warrants expire, the
warrants would rise to at least their intrinsic value of $11, generating a 175%
return from the original market value.
The common stock buyer’s profit would be $8 ($23 – $15), or 53%.
The reverse is also true!.
A decline in the price of the common stock from $23 to $15 would result in a
35% loss for the shareholder, whereas if the warrants fall from $11 to $4, the
buyer will face a 64% loss.
In-depth treatment of topic in more advanced module!

Fortuna Favi et Fortus Ltd.,
:118 Old Ewu Road, Aviation Estate, Lagos,
:07032530965 www.ffavifortus.com info@ffavifortus.com

Derivatives Fundamentals

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