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LecturePresentationSoftwaretoaccompanyInvestmentAnalysisandPortfolioManagementSeventhEditionbyFrankK.Reilly&KeithC.BrownChapter21Chapter21-AnIntroductiontoDerivativeMarketsandSecuritiesQuestionstobeanswered:•Whatdistinguishesaderivativesecuritysuchasaforward,futures,oroptioncontract,frommorefundamentalsecurities,suchasstocksandbonds?•Whataretheimportantcharacteristicsofforward,futures,andoptioncontracts,andinwhatsensecanthebeinterpretedasinsurancepolicies?Chapter21-AnIntroductiontoDerivativeMarketsandSecurities•Howarethemarketsforderivativesecuritiesorganizedandhowdotheydifferfromothersecuritymarkets?•Whatterminologyisusedtodescribetransactionsthatinvolveforward,futures,andoptioncontracts?•Howarepricesforderivativesecuritiesquotedandhowshouldthisinformationbeinterpreted?Chapter21-AnIntroductiontoDerivativeMarketsandSecurities•Whataresimilaritiesanddifferencesbetweenforwardandfuturescontracts?•Whatdothepayoffdiagramslooklikeforinvestmentsinforwardandfuturescontracts?•Whatdothepayoffdiagramslooklikeforinvestmentsinputandcalloptioncontracts?•Howareforwardcontracts,putoptions,andcalloptionsrelatedtooneanother?Chapter21-AnIntroductiontoDerivativeMarketsandSecurities•HowcanderivativesbeusedinconjunctionwithstockandTreasurybillstoreplicatethepayoffstoothersecuritiesandcreatearbitrageopportunitiesforaninvestor?•Howcanderivativecontractsbeusedtorestructurecashflowpatternsandmodifytheriskinexistinginvestmentportfolios?DerivativeInstruments•Valueisdependsdirectlyon,orisderivedfrom,thevalueofanothersecurityorcommodity,calledtheunderlyingasset•ForwardandFuturescontractsareagreementsbetweentwoparties-thebuyeragreestopurchaseanassetfromthesellerataspecificdateatapriceagreedtonow•OptionsofferthebuyertherightwithoutobligationtobuyorsellatafixedpriceuptooronaspecificdateWhyDoDerivativesExist?•Assetsaretradedinthecashorspotmarket•Itissometimesadvantageousenterintoatransactionnowwiththeexchangeofassetandpaymentatafuturetime•Riskshifting•Priceformation•InvestmentcostreductionDerivativeInstruments•Forwardcontractsaretherightandfullobligationtoconductatransactioninvolvinganothersecurityorcommodity-theunderlyingasset-atapredetermineddate(maturitydate)andatapredeterminedprice(contractprice)–Thisisatradeagreement•Futurescontractsaresimilar,butsubjecttoadailysettling-upprocessForwardContracts•Buyerislong,sellerisshort•ContractsareOTC,havenegotiableterms,andarenotliquid•Subjecttocreditriskordefaultrisk•Nopaymentsuntilexpiration•AgreementmaybeilliquidFuturesContracts•Standardizedterms•Centralmarket(futuresexchange)•Moreliquidity•Lessliquidityrisk-initialmargin•Settlementprice-daily“markingtomarket”Options•TheLanguageandStructureofOptionsMarkets–Anoptioncontractgivestheholdertheright-butnottheobligation-toconductatransactioninvolvinganunderlyingsecurityorcommodityatapredeterminedfuturedateandatapredeterminedpriceOptions•Buyerhasthelongpositioninthecontract•Seller(writer)hastheshortpositioninthecontract•BuyerandsellerarecounterpartiesinthetransactionOptions•OptionContractTerms–Theexercisepriceisthepricethecallbuyerwillpayto-ortheputbuyerwillreceivefrom-theoptionselleriftheoptionisexercised•OptionValuationBasics–Intrinsicvaluerepresentsthevaluethatthebuyercouldextractfromtheoptionifheorshesheexerciseditimmediately–Thetimepremiumcomponentissimplythedifferencebetweenthewholeoptionpremiumandtheintrinsiccomponent•OptionTradingMarkets-optionstradebothinover-the-countermarketsandonexchangesOptions•Optiontobuyisacalloption•Optiontosellisaputoption•Optionpremium-paidfortheoption•Exercisepriceorstrikeprice-priceagreedforpurchaseorsale•Expirationdate–Europeanoptions–AmericanoptionsOptions•Atthemoney:–stockpriceequalsexerciseprice•In-the-money–optionhasintrinsicvalue•Out-of-the-money–optionhasnointrinsicvalueInvestingWithDerivativeSecurities•Calloption–requiresupfrontpayment–allowsbutdoesnotrequirefuturesettlementpayment•Forwardcontract–doesnotrequirefront-endpayment–requiresfuturesettlementpaymentOptionsPricingRelationshipsFactorCallOptionPutOptionStockprice+-Exerciseprice-+Timetoexpiration++Interestrate+-Volatilityofunderlyingstockprice++ProfitstoBuyerofCallOption4050607080901001,00050001,5002,0002,5003,000(500)(1,000)ExercisePrice=$70OptionPrice=$6.125ProfitfromStrategyStockPriceatExpirationProfitstoSellerofCallOption405060708090100(1,000)(1,500)(2,000)(500)05001,000(2,500)(3,000)ExercisePrice=$70OptionPrice=$6.125StockPriceatExpirationProfitfromStrategyProfitstoBuyerofPutOption4050607080901001,00050001,5002,0002,5003,000(500)(1,000)ExercisePrice=$70OptionPrice=$2.25ProfitfromStrategyStockPriceatExpirationProfitstoSellerofPutOption405060708090100(1,000)(1,500)(2,000)(500)05001,000(2,500)(3,000)ExercisePrice=$70OptionPrice=$2.25StockPriceatExpirationProfitfromStrategyTheRelationshipBetweenForwardandOptionContractsPut-callparity–LonginWYZcommonatpriceofS0–LonginputoptiontodeliverWYZatXonT•PurchaseforP0–ShortincalloptiontopurchaseWYZatXonT•SellforC0•Netpositionisguaranteedcontract(risk-free)•Sincetherisk-freerateequalstheT-billrate:(longstock)+(long