Ch 01 Hull Fundamentals

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013IntroductionChapter 1*

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013The Nature of DerivativesA derivative is an instrument whose value depends on the values of other more basic underlying variables*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Examples of DerivativesFutures ContractsForward ContractsSwapsOptions*


Why Derivatives Are ImportantDerivatives play a key role in transferring risks in the economyThere are many underlying assets: stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, the weather, etc.Many financial transactions have embedded derivativesThe real options approach to assessing capital investment decisions, which values the options embedded in investments using derivatives theory, has become widely accepted

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Futures ContractsA futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain priceBy contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Exchanges Trading FuturesCME GroupIntercontinental ExchangeNYSE Euronext Eurex BM&FBovespa (Sao Paulo, Brazil)and many more (see list at end of book)*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Futures PriceThe futures prices for a particular contract is the price at which you agree to buy or sell at a future timeIt is determined by supply and demand in the same way as a spot price*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Electronic TradingTraditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchangeThis has now been largely replaced by electronic trading and high frequency algorithmic trading is becoming an increasingly important part of the market*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Examples of Futures ContractsAgreement to:buy 100 oz. of gold @ US$1750/oz. in December sell 62,500 @ 1.5500 US$/ in March sell 1,000 bbl. of oil @ US$85/bbl. in April*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013TerminologyThe party that has agreed to buy has a long positionThe party that has agreed to sell has a short position

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Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Example

January: an investor enters into a long futures contract to buy 100 oz of gold @ $1,750 per oz in AprilApril: the price of gold is $1,825 per oz What is the investors profit or loss?*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Over-the Counter MarketsThe over-the counter market is an important alternative to exchangesTrades are usually between financial institutions, corporate treasurers, and fund managersTransactions are much larger than in the exchange-traded market*


Size of OTC and Exchange-Traded Markets(Figure 1.2, Page 6)Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013*Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market


The Lehman Bankruptcy (Business Snapshot 1.1, page 4)Lehmans filed for bankruptcy on September 15, 2008. This was the biggest bankruptcy in US historyLehman was an active participant in the OTC derivatives markets and got into financial difficulties because it took high risks and found it was unable to roll over its short term fundingIt had hundreds of thousands of transactions outstanding with about 8,000 counterpartiesUnwinding these transactions has been challenging for both the Lehman liquidators and their counterparties Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Ways Derivatives are UsedTo hedge risksTo speculate (take a view on the future direction of the market)To lock in an arbitrage profitTo change the nature of a liabilityTo change the nature of an investment without incurring the costs of selling one portfolio and buying another*


New Regulations for OTC MarketThe OTC market is becoming more like the exchange-traded market. New regulations introduced since the crisis mean thatStandard OTC products must be traded on swap execution facilitiesA central clearing party must be used as an intermediary for standard productsTrades must be reported to a central registryFundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Forward ContractsForward contracts are similar to futures except that they trade in the over-the-counter marketForward contracts are popular on currencies and interest rates*


Forward PriceThe forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)The forward price may be different for contracts of different maturities (as shown by the table)Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Foreign Exchange Quotes for USD/GBP exchange rate on June 22, 2012 (See Table 1.1, page 7)*

BidOfferSpot1.55851.55891-month forward1.55821.55873-month forward1.55791.55856-month forward1.55731.5580


Example (page 5)On June 22, 2012 the treasurer of a corporation might enter into a long forward contract to sell 100 million in six months at an exchange rate of 1.5573This obligates the corporation to pay 1 million and receive $155.73 million on December 22, 2012What are the possible outcomes?Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013OptionsA call option is an option to buy a certain asset by a certain date for a certain price (the strike price)A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

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Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013American vs European OptionsAn American option can be exercised at any time during its lifeA European option can be exercised only at maturity *


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Google Call Option Prices (June 25, 2012 Stock Price: bid 561.32, offer 561.51; See page 8) *

StrikePrice ($)JulyBidJulyOfferSeptBidSeptOfferDecBidDec Offer52046.5047.2055.4056.8067.7070.0054031.7032.3041.6042.5055.3056.2056020.0020.4030.2030.7044.2045.0058011.3011.6020.7021.2034.5035.30600 5.60 5.9013.5013.9026.3027.10


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013*Google Put Option Prices (June 25, 2012 Stock Price: bid 561.32, offer 561.51; See page 8)

StrikePrice ($)JulyBidJulyOfferSeptBidSeptOfferDecBidDec Offer520 5.00 5.3013.6014.0025.3026.1054010.2010.5019.8020.3032.8033.5056018.3018.7028.1028.6041.5042.3058029.6030.0038.4039.1051.8052.6060043.8044.4051.1052.1063.5064.90


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Exchanges Trading OptionsChicago Board Options ExchangeInternational Securities ExchangeNYSE EuronextEurex (Europe)and many more (see list at end of book)*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Options vs Futures/ForwardsA futures/forward contract gives the holder the obligation to buy or sell at a certain priceAn option gives the holder the right to buy or sell at a certain price*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Hedge Funds (see Business Snapshot 1.3, page 12) Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. Mutual funds must disclose investment policies, makes shares redeemable at any time,limit use of leverageHedge funds are not subject to these constraints.*


Three Reasons for Trading Derivatives:Hedging, Speculation, and ArbitrageHedge funds trade derivatives for all three reasons When a trader has a mandate to use derivatives for hedging or arbitrage, but then switches to speculation, large losses can result. (See SocGen, Business Snapshot 1.4, page 19)

Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Hedging Examples (Example 1.1 and 1.2, page 13)A US company will pay 10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contractAn investor owns 1,000 shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts *


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Value of Shares with and without Hedging (Fig 1.4, page 14)*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Speculation Example (pages 15)

An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of $22.50 is $1What are the alternative strategies? *


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013Arbitrage Example (page 17)A stock price is quoted as 100 in London and $152 in New YorkThe current exchange rate is 1.5500What is the arbitrage opportunity?*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 20131. Gold: An Arbitrage Opportunity?Suppose that:The spot price of gold is US$1,700 per ounceThe quoted 1-year futures price of gold is US$1,800The 1-year US$ interest rate is 5% per annumNo income or storage costs for goldIs there an arbitrage opportunity? *


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 20132. Gold: Another Arbitrage Opportunity?Suppose that:The spot price of gold is US$1,700The quoted 1-year futures price of gold is US$1,680The 1-year US$ interest rate is 5% per annumNo income or storage costs for goldIs there an arbitrage opportunity?*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 2013The Futures Price of Gold If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )Twhere r is the 1-year (domestic currency) risk-free rate of interest.In our examples, S=1700, T=1, and r=0.05 so thatF = 1700(1+0.05) = 1,785*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 20131. Oil: An Arbitrage Opportunity?Suppose that:The spot price of oil is US$80The quoted 1-year futures price of oil is US$90The 1-year US$ interest rate is 5% per annumThe storage costs of oil are 2% per annumIs there an arbitrage opportunity?*


Fundamentals of Futures and Options Markets, 8th Ed, Ch 1, Copyright John C. Hull 20132. Oil: Another Arbitrage Opportunity?Suppose that:The spot price of oil is US$80The quoted 1-year futures price of oil is US$75The 1-year US$ interest rate is 5% per annumThe storage costs of oil are 2% per annumIs there an arbitrage opportunity?*


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Ch 01 Hull Fundamentals