# 1. Options, Futures and Other Derivatives Ch1: Introduction Part 1

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00:10
well here we are right at the very beginning this is a long road this is probably one of the best textbooks underlying this course which is the whole book it's the standard for options futures and other derivatives in any course at either the upper upper level undergraduate courses in finance or at the MBA level so it is at times challenging however here's a here's a
00:42
promise to you that if you can get through this it elevates you above all others who can't in this field it is the standard so I'm going to try to get you through each chapter in a little bit not such a hard academic way but with a huge amount of real-world experience with futures options and derivatives that I can bring a perhaps a better insight into some of the topics so here we go
01:15
we're just gonna jump right into the first chapter and start as if you'd never seen these before so derivatives what are they well they are at the very heart financial instruments whose value depends on or I put in brackets here is derived from and you'll notice derived is the root of derivatives and that's how we get the word derivative because its value is derived from the value of
01:45
some other and this is a critical word a lot of other definitions sort of skip this but this is critical some other more basic underlying variables so let's deal with the more basic this means that whatever the financial instrument is deriving its value from that particular asset has a price that's closer to the value of it itself so for instance if you have an option on
02:17
a stock the option derives its value from the price of the stock but the price of the stock derives its value from the value of of the company itself it's next in line in other words so it's not that it derives its value off of something more complex or more higher-order like it like a second-order derivative you can't go the other way and it says it derives the value of some other more basic underlying variable now I didn't I put underlying asset why am I
02:47
putting underlying variable there well it's because it doesn't necessarily have to be an asset it could be a real asset like property it could be a financial asset and a financial asset could be a share of stock it could be an index whether it be a stock index a housing price index the rate of inflation the index the tract rate of light could be an index it could even be just an event
03:20
it could be just an event for instance the the amount of snowfall in a given region perhaps a ski resort wants to hedge against a bad winter and maybe there's an option for the bet that they can make a derivative available that bets on the amount of snowfall that pays off if it's under a certain amount and doesn't if it's over a certain amount we can all think of catastrophe bonds or what are called cat bonds that cat bonds will pay off except in the event of a
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catastrophe so if a cat catastrophe happens then obviously it doesn't so that's why it's called an underlying variable as opposed to an underlying asset because the underlying doesn't necessarily need to be an asset an event is not an asset so let's very be very clear about the definition of a derivative to be inclusive it is derived from the value of some other more basic underlying variable now derivatives can be exchange-traded or over-the-counter
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exchange-traded are standardized contracts Oh TC can be standardized but they allow for a lot of customization that can't be found on exchanges on exchange traded a buyer and a seller come together to form a contract we'll see later on that all derivatives require a buyer and a seller and they they enter their contract through a clearinghouse so that the Clearinghouse is the counterparty to all contracts the buyer enters into a contract with the Clearinghouse and the
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seller enters into a contract with the Clearinghouse it eliminates counterparty risk if the buyer wins and the seller can't pay well that's a big problem but the Clearinghouse is counterparty to all and there's never been a default on an exchange-traded derivative never highly regulated highly regulated because they're exchange-traded which means they're available to people anybody can can make a transaction in a futures contract or an options contract so a lot of regulation there to protect
05:24
the investors on OTC they could the transaction is between a buyer and a seller this is called bilateral clearing but as we can see here if the buyer wins big and the seller loses if the seller is unable to pay the buyer hasn't really won anything have they in other words they're in a position as if they had never entered into the contract to begin with which what was the point of that or and this is really becoming more and more popular now ever since 2008-2009 that really changed a lot of opinions
05:57
about about this wild wild west over-the-counter derivative trading now the buyer and seller can opt to clear through a central party a central counterparty which means that they can eliminate counterparty risk by opting to choose a central counterparty not only that a lot of regulation is pushing this marketplace to say look if it can be cleared by a central counterparty do it the more standardized that are less customized the OTC contract is the more
06:29
this becomes necessary and not just optional but slowly and slowly it's moving towards more more of these of these OTC derivatives being being cleared through a central counterparty so that it reduces this kind of counterparty risk the OTC market is less regulated I'm not going to say there's no regulation this is highly regulated Shange trade is highly regulated OTC is just less regulated not as highly regulated it's less regulated
06:59
but this regulation is increasing will it ever get to the level of the exchange traded probably not because you don't want to constrain the ability for customization here and these are these are intelligent people these are institutions that are trading they're not they're not retail traders they're institutions so they know what they're doing they don't need that kind of protection they need flexibility they have the responsibility to deal with
07:30
that flexibility so let them go right so it's less regulated regulation is increasing but it'll never get to the point where it's as regulated as an exchange dollar value wise the over-the-counter market is roughly about twelve times larger than the exchange traded market in terms of the principal dollars underlying the assets that's all it is in terms of the principal dollars underlying the assets if we look at the value of the contracts itself the
08:03
exchange traded actually is larger if we look at just the value the market value of the financial remember these are financial instruments so if we had to settle up everything just the dollar value of them the exchange traded is larger but the dollars underlying the assets in the over-the-counter market are about twelve times larger but keep in mind these are institutional traders they may in one contract may represent 100 million dollars whereas on an exchange-traded marketplace a I think
08:36
the largest Forex contract I've seen is for if you get into the Swedish and the Norwegian quona they can amount to depending on the exchange rate up to 200 250 300 thousand u.s. that's considered a large contract the standard contract and most of the foreign currency on the futures market is about a hundred thousand dollars the British Pound is sixty two five so they vary but they're nowhere near a hundred million well one contract here could represent 100 million so when we say
09:06
that it's much much much larger it's in terms of the the principal value of the underlying assets not the value of the derivative contract itself in in this introduction I'm just going to introduce some of the terminology that we'll be looking at in more detail later on but we'll start with forwards or forward agreements and it is an agreement to buy or sell to buy or sell a specific asset often referred to as the underlying
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asset at a specific price and since we're talking about forwards we're talking about a delivery price when we talk about options we talk about an exercise price but this would be a delivery price at a specific price at a certain future date 10 then we tend to call this the delivery date when we look at options we'll call that the exercise date or the expiration date but this will be the delivery date so it's an agreement to buy or sell a specific asset at a specific price agreed on today agreed on at the time that we
10:10
enter into the contract but to be delivered at some future date so we'll agree on the asset and the future data which will we'll trade it but we'll agree on a price today it's called a forward contract there OTC traded over-the-counter traded if the forward is exchange traded it is simply called a future that's just the difference between forwards and futures when you hear the term forward that means its OTC traded when you hear the term futures it's a forward agreement that just
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happens to be exchange-traded that's all a buyer has a long position a seller has a short position you need a buyer and a seller to every derivative contract there has to be a long and a short simple as that both parties are obligated to perform this is key both are all blaa gated obligated both have enough Legation when we look at options we'll see that that's not true in options but for forwards and futures both parties to the contract buyer and seller are
11:12
obligated to do something there is no cost to enter a forward or future agreement other than paying the commission on the exchange or paying any kind of Commission on a futures exchange however there will be margin but the margin doesn't leave your account the key point here is that no money trades hands when the contract is entered I don't have to if I'm the buyer I don't have to pay the seller anything today I may have to segregate a certain amount of my money as margin but I don't have to part with it so that's important
11:44
let's look at some payoff graphs you're going to have to get used to these if you don't like payoff graphs stop now stop now because there's a lot of these throughout the throat all of the textbook well here's what we need some terminology S sub T is the spot price at time T a spot price means a spot market the price in the spot market in a spot market is what you can buy and sell it for right then and there at that point in time right now that's called a spot market so you can think of a stock market as a spot market at any point
12:16
what's the what's a hundred shares of IBM trading and I want to buy it right now go ahead well that's the spot price that's the spot market and K is the delivery price K will be the specific price that that the parties agree to the certain future date will be at time T sometime in the future so let's look at an example an agreement to buy or sell an asset for \$100 in three months so T is three months K is is 100 so we can
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put K down here representing the buyer and the seller both are obligated to perform something at that hundred dollar mark so there is K in terms of the buyer and here is K in terms of the seller we'll put buyer up here and we'll put seller down here to show their payoff charts well let's look at two examples here let's say that an example one if the spot price equals a hundred and
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fifty dollars at time T the buyer makes fifty dollars how do I arrive at that because they've agreed to trade it in three months at a hundred so the seller must sell to the buyer for a hundred in three months time the spot price is 150 it doesn't matter there's an agreement to trade at the price of a hundred dollars so they trade at a hundred dollars the buyer can immediately sell
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in the spot market at 150 thereby making fifty dollars so we can see that the buyer would make fifty dollars at time T however the seller would have to has to deliver the asset to the buyer so the seller would have to go into the spot market pay a hundred and fifty dollars for it and then sell it for a hundred dollars the seller would lose fifty dollars well if the spot market the spot
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price at time T is 75 dollars the buyer loses twenty-five dollars don't think because they still must perform they're obligated to buy it for a hundred dollars they sell it they're going to lose twenty-five dollars whereas the seller will make the twenty-five dollars so we can see very very quickly here that this is a zero-sum zero-sum because
14:54
for the buyer to make a dollar the seller must lose a dollar no wealth is created in a derivatives contract let's be clear about that now no wealth is created only transferred so for the buyer to win the seller must lose but for the seller to win the buyer must lose and if we draw our charts we can see that they are asymmetrical in terms
15:27
of payoff dollar-for-dollar so that if you add these two together you will get a straight line so we have a gain here with a loss here it nets to zero and if you draw them out together you will get a straight line showing no wealth creation only wealth transfer this is an important point to remember for a buyer to win the seller must lose for a seller to win the buyer must lose the sum of their gains and
15:58
losses always sum to zero it is a zero-sum and that's what a payoff graph looks like so we can see where the payoff is each time when we get into options combined here there was no cost to enter so basically the payoff is a linear relationship with the price of the underlying asset with the spot price once we have options there is a cost to enter these payoff graphs change theirs forwards futures nice introduction we're going to get into an a lot more this is
16:28
just something to introduce you to it you