INTRODUCTION TO

FORWARDS AND OPTIONS

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FORWARD CONTRACT
Forward contract: Agreement that sets today the terms-including price and quantity-at which
you buy or sell and asset or commodity at a specific time in the furute.

Specifies the quantity and exact type f the asset or commodity (underlying asset) the seller
must deliver.
Specifies delivery logistics such as time, date (expiration date) and place.
Specifies the price (forward price) buyer will pay at the time of delivery.
Obligates the seller to sell and the buyer to buy subject to the above specifications.

Forward contract requires no initial premium/payment.

The term long is used to describe the buyer.

The term short is used to describe the seller.
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FORWARD CONTRACT

Payoff to long forward = Spot price at expiration forward price




Payoff to short forward = Forward price Spot price at
expiration
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FORWARD CONTRACT
Example 2.1

Suppose the non-dividend S&R (Special and Rich) 500 index has a current price of $1000
and the 6-months of forward price is $1020.
What does this means?

The holder of the long position in the S&R forward contract is obligated to pay $1020
in 6 months for one unit of the index.
The holder of the short position is obligated to sell one unit of the index for $1020
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FORWARD CONTRACT
S&R index in 6 months S&R forward (Long) S&R forward (Short)
900
950
1000
1020
1050
1100
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FORWARD CONTRACT
Long and short forward positions on the S&R 500 index
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FORWARD CONTRACT
Forward Purchase Investment and Forward Purchase
Payment is deferred (unfunded)
Borrow to buy physical index with initial cost
$0 at time $0.
Pay $1020 after 6 months and own the
index.
E.g. Invest $1000 in a zero-coupon bond
(Treasury bills). Therefore initial cost is
$1000 at time 0.
Suppose that 6 months interest rate is 2%.
After 6 months zero-coupon bond is worth
$1020.
Use the bond to pay forward price of $1020.
Own the index after 6 months.
Investing $1000 at the same time entering
forward contract mimics the effect of buying
the index outright (pay in full-funded)

Simple comparison:
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CASH SETTLEMENT
Cash settlement- Buyer and seller settle financially (make net cash payment). No transfer of
physical asset which will likely have significant costs.

Example 2.2

1) Suppose that S&R index at expiration is $1040.

2) Suppose the S&R index at expiration is $960


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OPTIONS
CALL OPTIONS: is a contract that gives the buyer the right , but not the obligation to
sell the underlying asset at a pre-specified price (strike price).

PUT OPTIONS: is a contract that gives buyer the right , but not the obligation to sell the
underlying asset at a pre-specified price (strike price).

Option Trading gives buyer/seller the right to walk away from the deal.
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OPTIONS
TERMS

Strike price the amount can be exchange for underlying asset
Exercise the exchange of the strike price for the underlying asset at the terms
specified in the option contract
Expiration the date beyond which an unexercised option is worthless
Exercise style the circumstances under which an option holder has the right to
exercise an option.
i. European style option exercise only at expiration
ii. American style option exercise at anytime during the life of the option
iii. Bermudan style option can only exercise during specified period, not the
entire life of the option

Option writer the party with short position in the option 10
PURCHASED CALL
Payoff at expiration Profit at expiration
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CALL OPTIONS
Example 2.3

Suppose that a buyer purchase a call option to pay $1020 for S&R index in 6 months.
What is the payoff if:
i. In 6 months, the S&R price is $1100.


ii. In 6 months, the S&R price is $900.



Thus, at the time buyer and seller agree to the contact, buyer must pay the seller
initial price (premium). It is to compensates seller for being at a disadvantage at
expiration.
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CALL OPTIONS
Example 2.4

Consider a call option on the S&R index with 6 months to expiration and a strike price
of $1000.

i. Suppose the index is $1100 in 6 months.



i. Suppose the index is $900 in 6 months



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CALL OPTIONS
Example 2.5

Consider a call option on the S&R index with 6 months to expiration and a strike price
of $1000. Suppose the risk free rate is 2% over 6 months. Assume that the index spot
price is $1000 and the premium for the call is $93.81. What is the payoff?

i. Suppose the S&R index price is $1100



ii. Suppose the index is $900 in 6 months




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PUT OPTIONS
Example 2.6

Consider a put option n the S&R index with 6 months to expiration and a strike price
of $1000

i. Suppose the S&R index price is $1100


ii. Suppose the index is $900 in 6 months



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PUT OPTIONS
Example 2.6

Consider a put option on the S&R index with 6 months to expiration and a strike
price of $1000. Suppose that the risk-free rate is 2% over 6 months. Assume the
premium is $74.20.

i. Suppose the S&R index price is $1100



ii. Suppose the index is $900 in 6 months




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PROFIT FOR LONG PUT POSITIONS
Profit table
Profit diagram
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MONEYNESS OF AN OPTION
Options are often describe by their degree of moneyness

In-the-money option call with a strike price < asset price, put with strike price > asset
price

Out-of- the-money option call with a strike price > asset price, put with strike price <
asset price

At-the-money option strike price is approx. equal to asset price
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OPTIONS ARE INSURANCE
Call Option is also insurance. By buying a call, you have bought insurance against an
increase in the price
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OPTIONS ARE INSURANCE
Homeowners Insurance is a Put Option

Suppose that you own a house that cost $200,000 (assume that physical damage is the
only thing that will affect the market value.
Buy a $15,000 insurance policy to compensate you for damage
Suppose the deductible is $25,000
If the house suffers $4000 damage from a storm you pay for all repairs
If the house suffers $45000 damage from a storm you pay $25,000 and the insurance
company pay $20,000
The insurance company pay damage occurs beyond deductible up to $175,000 because
the house is $200,000 ($175,000+$25,000)
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EQUITY-LINKED CDS
Example 2.7

A simple
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1
2
&500 :
At maturity, the CD is guaranteed to repay the invested amount, plus 70% of
the simple appreciation in the S&P 500 over that time.

Suppose the S&P index is 1300 initially and investor invest $10,000.



Let say the index is 2200:


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EQUITY-LINKED CDS
CONT

Suppose the effective annual interest rate is 6% if the index fall below 1300 at expiration,

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OPTIONS AND FORWARD POSITIONS: A SUMMARY
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TUTORIAL
Derivatives Market (THIRD EDITION) Robert L . McDonald

Q2.2, Q2.4, Q2.5, Q2.6, Q2.7, Q2.8, Q2.9, Q2.13


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