 Hello, and welcome to the session in which we would look at the derivatives markets specifically as an asset class. This topic is covered in essentials of investments or principles of investment course, whether it's a graduate or undergraduate. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorials. If you like my lectures, please like them, share them, put them in playlist. If they benefit you, it means they might benefit other people, connect with me on Instagram. On my website, farhatlectures.com, you will find additional resources to supplement your finance or accounting education, especially if you are studying for your CPA or CFA exam. So the first thing I would like to talk about is the different asset classes because the derivatives were going to be considered as a different asset class. In the prior session, we looked at the fixed income as an asset class, the equity, and today we'll look at derivatives. And under fixed income, we broke it down into money market and capital market. And we talked about this topic, this topic, and today we're going to talk about this derivatives. So if you'd like to learn about equity or fixed income, whether it's money market short term or capital market, please look at the prior sessions. Let's look at the derivatives market. What is a derivative? A derivative is a security with a payoff that depends on the price of another security. Now this all sounds complicated. Let me give you a simple example. Maybe you could relate to. Let's assume next semester, you need to take a course called Intermediate Accounting. Don't take this course unless you have to. If you're a finance student, you don't need it, okay? Because it's a tough course. But let's assume you are accounting and finance major and you need to take this course next semester. Pay the book. You can purchase this book for $150. So the price of the book today is $150. But you don't need the book now. If you buy the book today, you don't need it until three months from now. But here's the thing. You're going to be waiting until three months later where you're going to have to buy the book. But you don't know what's going to happen to the price. The price could go up of this tax book. The price could go down. Since you want to buy it, what is your risk? Your risk is the price could go up. Okay? That's your risk. If the price goes down, that's another risk to you. So what can you do to hedge that risk or to deal with that risk? Here's what you do. Let's assume you find another student. Let's assume you find another student or some counterpart, another person. And that other person tell you, look, you pay me $20 today, pay today. And I will sell you this book. I will guarantee it for $140. But you have to pay me $20 today. Now let's think about it. You pay $20 today, then you can buy the book for $140. So simply you end up paying for the book in total $160, but you know this is how much you are paying. So what happened is $20 that you pay to the other student or to the counterparty, that's basically your premium. There is a cost because this individual, the other individual, the other individuals, what they did is they gave you the right to buy it at $140, but simply put, you're going to end up paying $160 in total. But that's it. You have that option. Now you can sleep well that you know you can buy this book for $160. Okay? Now let's assume this tax book, there is a shortage of this tax book when next semester came and the book went up to $180 or went up to $200. Here's what happened. For one thing, you can buy the book, you can buy the book for $160, turn around and sell it for $180 or turn around and sell it for $200. But here's what happened too. This option here, your $20 is an option. Your $20, if the tax book goes up in value, this option goes up in value. So let's assume you changed your major. You know what? I don't want this option anymore because I'm going to go finance and econ. Don't do that. But yes, let's assume you want to go finance and econ, not finance and accounting. What you do is you will sell this option. So if the price of the book goes up, your option is worth more. So if the price of the book a month later is $180, you may ask $30 for your option. So your option is worth more. And conversely, if the price of the tax book drops to $100 because there's a new addition, guess what? Your option becomes worthless. If you try to sell it to someone, tell them, I'll give you the option to buy it for $140. They would say, are you crazy? I can buy it for $100. Why would I buy it for $140 and pay $20 to date to buy it for $140? So the option value, this $20 depends on the value of the price of your intermediate accounting. So I hope you kind of get an idea about what is security that pay off, a derivative security. So in the real world, we're not dealing with textbook. We're dealing, we're going to be dealing with stocks, bonds, interest rate, commodities. So what we have is we have derivatives that are called futures and options and related derivatives contract provide a payoff that depend on the value of other variables. But rather than using the textbook, now we're looking at commodities. You want to buy wheat, corn, coffee. You want to buy bonds and stocks. You have derivatives. You want to buy, you want to hedge your interest. You might have interest, you might have payment to the bank or you might want to borrow a loan. You want to hedge your interest rate or you want to buy indexes. We talked about the indices in the prior session. You want to buy the Dow. You want to buy the S&P 500. You want to buy the NASDAQ. So you want to hedge that position. So let's first take a look at options. We have two type of options. We have call options and we have put options. But we're going to take one at a time then we'll look at an example. What is a call option? The call option gives its holder the right. Now it's very important to understand the right, not obligation. And you're going to see why I am emphasizing this. The right means I have the right to do something, but I don't have to do it. If I want to do it, I can do it. Simply put, sometime when a student skip so many classes, I have the right to drop them. I don't have to drop them, but if I want to drop them, I can. So this is what the right is. To purchase an asset for a specified price called the exercise or strike price on or before a specified expiration date. So simply put, I have the right to buy Apple. I have the right to buy Microsoft at a certain price within a specific time period. Okay, that gives me the right to buy. So call option, I have the right to buy and we'll work an example in a minute. Put option on the other hand, it's the exact opposite. Now let's go back to the call option. The call, who would buy the call option? Remember the textbook, the intermediate accounting textbook? The person that thinks the price is going to go up will buy the call option because this person, they want to buy the textbook. Okay, and because they are going to take that course in the future, they need the textbook. Therefore, they want to buy a call option to make sure the price that they buy is fixed at a certain amount. Now put option is the exact opposite. It gives the other party the right to sell an asset at a specified price. So let's assume you are taking intermediate accounting now. So you are taking intermediate accounting now and you have the textbook. But you need the textbook until the semester ends. Once the semester ends, you want to sell it. Now today, if you want to sell the textbook is for 150. If you want to sell it today, but you cannot sell it today because you need it for your class. You're going to have to sell it three months from now. You don't know what's going to happen three months from now. What's your risk? Your risk, if you're selling it, that the price could go down to 100 and you would lose $50. That's your risk. If the price goes up to 200, you're happy. You would sell it for 200. That's not your risk. You risk that the price will drop. Here's what you do. You'll try to find another student that's going to be taking this course and you'll tell them, look, would you like to buy my book? I will give you the right to buy my book at a certain price. So what happens is you will tell them, for example, you would agree with them for 140. Now what's going to happen is whatever happened in the future, you can sell your book for 140. This is what the option, the right to sell an asset. You have the asset, which is the textbook, and you have the right to sell it for 140. Now you don't care that the other person is thinking the price could go up. That's why they want to buy it for 140. So you're both happy. Not both happy. You both protected yourself. So back to the textbook example. But let's take a look at an actual example for an actual stock. So we are dealing now with Apple stock. And this is April 18, 2017. The price of Apple on that day was 140, 120. Forget it. Now it's 350 or 360 trading at this moment. So here's what happened. Here are how we read options. So it's very important to know how to read options. Options are sold in 100 option increments. So when you buy an option, you buy 100 options, right to buy 100. So we're going to be specifically looking for, to illustrate this example, the June 17 expiration with a strike price of 170. I'm sorry, 140, not 170. So this is the option we're going to be looking at. What does that mean? We are standing today is April 18, 2017. And here's what happened. We have an option on June 16 with a strike price of 140. What does it mean a strike price? Well, if you want to buy Apple for 140 on June 16, which is two months from now, you can buy it for 140, two months from now, two months from now. Well, hold on a second. Why would I want to buy it for less than what it is today, which is 141? The reason why, because you might think the price is going to go up. That's why. You just, you know what? I want to buy Apple, but I'm not ready. So what I would do, I will buy the option, the call option. So this is the call option. Remember the call option, the right to buy. The call option is priced at $4.80. Remember, each option is 100 shares. Therefore, if you pay today, here's what we're talking about here. You pay today $480. This is what you have to pay to the other party. If you pay $480, what's going to happen is they will guarantee Apple stock for 140, okay? Why would you do so? Because you think Apple stock is going to go up to 160. Therefore you can buy it for 140, but you have to pay a premium. That's you. The other person that's selling you the option thinks the Apple stock is going to go down to 120. You will buy it for 120 and give it to you for 140 and sell it to you for 140. So there's always two parts to it. But you have to pay. So simply put, if I ask you, what is your total cost? If you do exercise this option, your total cost for Apple is $144.80. This is how much you are buying Apple stock for. Because you're paying $480 now of the price, and if you decide to buy it, you have to pay $140. Now you don't have to buy it. So the maximum you would lose really is $480. So you pay $480 now, and this is the maximum you would lose for the right to buy it for $140. If the price goes up to $2,000 per share, you did great. If the price goes down to zero to Apple, then you lost $480, because you don't have the obligation. You only have the right. Now, so this is the call price. So the price of the call option, notice decreases as the price increases. So if we look at the same date, June 16, 2017, and June 16, 2017, notice this option, if you want to buy it for $145, you only have to pay $250. And this makes sense, because the price is higher, but your cost is higher. Therefore, you're going to pay less of a premium. So notice as the strike price goes up, it's worth less for me. Therefore, I have to pay less of a premium. So if you want to, you can pay $250 to buy Apple stock for $145 on the same date, but simply put $145, it means you are paying in total $165.50. I'm sorry, $2.147.50. So your price goes up. If your price goes up, you pay less premium, because you are willing to pay more. So because you're paying more, because you are paying more per stock, your premium will go down. Hopefully, you can see this. Also, what you need to know, let's talk about the put price now. So we talked about the call price. Now always there's a put, and here's the put price for the same option. The put price is $3.90. What does that mean? It means if you pay today, someone, $390, you have to pay $390. You pay the premium $390. You pay $390, because each contract is $3.90 times $100, because all options comes in $100. You have to pay $390. You have the right to sell Apple stock at $140. Now assuming you have $100 shares of Apple, we're going to assume it's a covered put, which we'll talk about that later on. But simply put, you have $100 shares, and you think now what you're thinking, you're thinking Apple's going to drop to $100. And guess what? I think it's going to drop to $100 in June. What you do, you pay today $390, and you will give another sucker, in your opinion, another sucker, another sucker, the obligation to buy it from you. Simply put, because you have the right, you know, they have to deliver. So simply put, you're thinking it's going to go down to $100. So you can sell it for $140, and you're thinking, well, that's excellent for me. The other person thinking Apple stock's going to go up. The other person thinking Apple stock's going to go up to $200, and therefore you're going to pay me $390 now, and you're never going to come back to me, ask me to buy your shares for $140, because they'll be crazy. Why? Because the price is $200. So notice, if you buy a put option, you think the price is going to go down. That's why you buy a put option. The person that sells you the put option doesn't think so. The person thinks the price is going to go up, therefore they're never going to see you. You're never going to pay them $390, and you're never going to come back. And they're hoping they'll never hear from you. But the put option, and notice, the put price is increased for the exercise price. So if you want to sell your stock, the same stock, the same 100 shares at $145, if you want to sell it for a higher price, you have to pay a higher premium, because you are guaranteeing your stock rather than $140, you're guaranteeing your stock at $145. But remember, you have to pay a premium. You have to pay a premium. So simply put, let's go back to this example, you have to pay $390, so simply put, you can sell it at $1,140 for this option here, but you have to pay upfront $3.09 per share. So really, let's see, your cost is $140.10, so this is how much you're really selling it for. You're not selling it. I'm sorry, $140 minus $390, $140 minus $390, simply put, you're selling it for $137.1. This is what you're doing, $136, not $137. So basically, you're selling it for $136, if you bought that put, you're selling it net $136.10, because you had to pay $3.90 per share, then you sell it for $40, therefore you're selling it for $136.10. So this is your net sale, your net sale. But notice, if you want a higher price, if you want to sell your stock at $145, you have to pay $6.65, and hopefully this makes sense, because if you want to sell it for more, you have to pay a higher premium. Now also, what I want you to notice is option prices also increase with the time until expiration, and hopefully this will make more sense to you. Let me show you what I mean. So today is April, today is April, if we're looking at the May options, May options are a month from now. Month from now, you can buy Apple stock for $140, paying only $3.80. Notice that, if you want to buy Apple stock June 16th, which is two months from now, at $140, you pay more. Why? Because the more time you are buying, just think of common sense, the more time you have. If somebody has given you more time, you have to pay premium for that time, because many things could happen. Therefore, you have to pay premium, you have more option. More time is more option. More option. Think about it. If I give you a month to finish your paper versus two months, you prefer two months. But if it's two months and I'm charging you for two months, I'm going to charge you more because I'm giving you more time. So as time goes by, as time increases, the value of the option increases, and as time goes down, the opposite is true. If somebody has given you less time or as time expires, the option is worth less. So every day, the option loses value. And we'll see that later on when we'll talk about options. The option has a time value factor. The option goes down in value as time goes by. So let's see if we can try to look at this. What would be the profit or loss per share to an investor who bought the June expiration Apple call option with an exercise price of $140. So we're looking at this here. We're looking at this one here. If the stock price at the expiration was $150, what would the purchaser of a put option with the same exercise price and expiration? So simply put that asking us, what would happen to the expiration on the expiration date? Okay. Assuming the price is $150. Well, let's assume you were, you bought the option to buy it at $140. To buy it at $140. Remember, you bought it at $140, but you paid an extra $4.80. Okay, let's do this. Let's get a calculator here. So you bought it. So your price per share is $140 plus $4.80. You could multiply it by $100. So it's $144.80. So your cost is $144.80. If the option is $150, at the expiration, the Apple stock is $150, well, you made a profit $150 minus $144.80 minus $150 to find the profit. The profit, you made a profit of $5.20 per share, per share, which is times $100, is $520. That's your profit per share. What happened if you bought the put option and you paid $3.90 per stock times $100. So you paid $390. What will be your loss or your gain? Guess what? This is what you lost. That's what your loss is. If you bought the right to sell it for $140 and it's at $150, you're not going to sell it for $140, right? Because you can sell it for $150. So what happened is you purchased this option for $390 and now you're just going to let it go. You would lose $390. So your loss, the person that purchased the put loses $390. The person that bought the call made $520. Hopefully this makes sense. Now let's turn from options to future contract. They're kind of a little bit in concept the same, but they're different, really. A future contract calls for a delivery of an asset. You have to deliver the asset or in some cases, it's cash value at specified delivery or maturity date for an agreed upon price called the future price to be paid at the contract maturity. Kind of the same thing. You promise, but here what happened is you promise and if you have that promise, it's an obligation not right. You promise and you have to deliver. Here the future contracts deal with commodity, coffee, oil. For example, last month when the oil prices went down substantially and inventory went up, there was no room. There was no room for people holding the contract. So for example, if you had a contract to buy the product, to buy the oil, you had the contract to buy the oil and what happened is they're going to deliver the oil to you because you have that contract, but there was not enough capacity to store that oil. So what people were doing, they were paying people. So rather than selling the contract, I will give you money if you take the contract off my hands. It was very unusual time because when they delivered that oil to you, you have no place to store it. Companies, traders were trying to give you money rather. It's like I'm selling you something and I'm going to give you money just to take it off my hand, right? It has value, but I can't, I can't have it because I don't have enough capacity. It wasn't unusual time because of the coronavirus, but that's what actually happened. So that's what that's what the future contract is. The long position is held by the trader who commit to purchase. If you are holding that, if you have a long position, if you were, if you're saying, I'm going, I want to buy the oil and you have that contract on, you have to buy it. On the delivery date, you have to buy the oil and there was no room. There was no inventory, no capacity because people were not driving to store the oil. This is the long position. The trader who takes the short position commit to delivering. Now the person that, that sells you, who takes the short position, they will deliver it to you. They will give you the oil. They don't want it. They're selling it, but you have to accept the oil. Okay. So let's take a look at an actual example to see how the, how the future market work and how different is it from the, from the, from the, from the option market. So we're looking here at the corn future prices on the Chicago mercantile exchange April 18, 2017. So we have the maturity, May, July, September, December, March. This is when the delivery will have to take place. Okay. So here's what's going to happen. Each contract calls for 5,000 bushels of corn. So we're dealing with 5,000 bushels of corn. The long side of the contract profit from prices increases. Here's what's going to happen. Here's what happened. Today is April. Here's what they're telling you. May 17th, May 17th, a month from now, you can buy, you can buy the 5,000 bushel for $3.61. Pay a premium now. Forget about the premium now. We don't have to worry about it. But if you pay me a price now, pay me $200 now and I will deliver 5,000 of bushels of corn for $3.61. Now, suppose at the expiration, the price is 381. What do you think happened if I bought this option? What do you think happened if I purchased this option? Well, if I purchase this option, I have a profit. I have a profit. If I purchase this option, I have a profit. The long trader who entered the contract at the future price of $3.61 on April 18th would pay the previously agreed-upon price for each bushel of corn, which is $3.61. That's worth $381.15. Now, why would I do that? Why would I pay that? Why would I, if I am the long position, why would I pay a premium to buy it at $3.61? Because my fear is the price will go up. And indeed, the price goes up. The price went up. As a result, I made a profit. Let's ignore all fees and everything. How much is my profit? Well, my profit is $1,000. If I did not buy it, I'll have to pay 381. Now, I only have to pay $361.25 times $5,000 bushel. I made a profit of $1,000 because I purchased this option. Now, obviously, again, there must be a cost. And you subtract your cost. And your cost may be like $200. So your net profit is $800. But we're ignoring the fees for now to illustrate the point. We'll talk a little bit more in advance about these topics later on. Now, on the other hand, the short position must deliver 5,000 bushels for $361. Now, the person that promised to deliver the bushels at $361 made a mistake because if they did not sell you that future contract, they could have sold it in May for $381. But look, they made a commitment. They have to deliver. Therefore, their loss, obviously, is $1,000 because they lost $1,000. They could have sold it for $381. But their loss is a little bit less than $1,000. Why? Because you have to pay them a premium. So it's $1,000 minus if you pay them $200. So their loss is $800. Simply put, they mirror your gain. So it's very important to understand this. The purchase price of an option or future is a premium. So when we talk about a premium, it means you have to pay something. Here, there is no premium. I told you the premium is $200. So the long position, the person who wants to buy the corn, the person that wants to buy the corn will have to pay $200 to the person who wants to deliver the corn. And obviously, they have two different mindsets. The person that's buying the corn thinks the corn is going to go up to $4. The person that's selling the corn thinks it's going to go down to $3. So the buyer, because he thinks it's going to go up to $4, he wants to lock it at $361. The seller, because he thinks it's going to go down to $3, he wants to lock it at $361. So they're both, in a sense, happy because they hedge the risk. That's the purpose of the derivatives, which we'll talk about that later, is to hedge your risk. Now remember, a future contract is an obligation. A plug obliges the long position to purchase. Very important and big difference between the call option. It conveys the right to purchase. You don't have to buy. If you buy a call option, you don't have to buy. You have the right. If you want to buy it, if it's in your best interest, you do. If it's not, you let it go. The future contract you have to buy. And this is why the people that bought the future oil contract, they were trying to get rid of it because they have to get, they have to receive the oil. They have, the oil has to be delivered to them. Therefore, they let it go, okay? So the purchase will be made only if the asset ultimately worth more than the exercise price. Simply put, it's only if you make a profit. As always, I would like to remind you to like this recording, share it. Don't forget to visit my website, farhatlectures.com for additional resources for your finance, as well as your accounting need. If you're a finance major, I strongly suggest you supplement with an accounting minor. Hedge your position, right? Hedge your position. In the next session, we'll start to look at the securities market. Study hard, stay safe, and always, always.