Comprehensive Study Notes: Options, Futures, and Other Derivatives (John C.
Hull)
Chapter 1: Introduction to Derivatives
Definition and Importance
- Derivatives are financial instruments whose value is derived from an underlying asset (e.g., stocks, bonds, commodities, interest
rates, currencies).
- They are widely used in risk management, speculation, and arbitrage.
Types of Derivatives
1. Futures Contracts: Agreements to buy/sell an asset at a future date for a fixed price, standardized and traded on exchanges.
2. Forward Contracts: Similar to futures but privately negotiated and customized, traded over-the-counter (OTC).
3. Options:
- Call Option: Right (not obligation) to buy an asset at a predetermined price (strike price).
- Put Option: Right (not obligation) to sell an asset at a predetermined price.
4. Swaps: Agreements to exchange future cash flows based on predetermined conditions (e.g., interest rate swaps, currency
swaps).
Key Market Participants
- Hedgers: Use derivatives to reduce risk (e.g., farmers using futures to secure prices for crops).
- Speculators: Trade derivatives to make a profit from price fluctuations.
- Arbitrageurs: Exploit price differences between markets to earn risk-free profits.
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Chapter 2: Mechanics of Futures Markets
Futures Market Structure
- Futures contracts are traded on organized exchanges such as the Chicago Mercantile Exchange (CME).
- Standardized in terms of contract size, expiration date, and settlement procedures.
- Clearinghouse acts as an intermediary to mitigate counterparty risk.
Margin and Daily Settlement
- Initial Margin: A deposit required to enter a futures contract.
- Maintenance Margin: The minimum account balance required to keep the position open.
- Marking to Market: Daily settlement of gains/losses to prevent default.
Delivery vs. Cash Settlement
- Some contracts result in physical delivery of the asset (e.g., gold, oil, wheat).
- Others are settled in cash based on the asset's price at expiration (e.g., stock index futures).
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Chapter 3: Hedging Strategies Using Futures
Hedging Concepts
- A hedge reduces risk by taking an offsetting position in a related derivative.
- Long Hedge: Used when anticipating an increase in price (e.g., farmers buying wheat futures).
- Short Hedge: Used when anticipating a price drop (e.g., oil producers selling crude oil futures).
Basis and Basis Risk
- Basis = Spot Price - Futures Price.
- Basis Risk: The risk that the spot price and futures price do not move in perfect correlation.
- Cross Hedging: Hedging using a related but different asset (e.g., airline hedging fuel costs using crude oil futures).
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Chapter 4: Interest Rates and Bond Pricing
Interest Rate Types
- Zero Rates: Interest rate for zero-coupon bonds.
- Spot Rates: Interest rate for immediate transactions.
- Forward Rates: Expected future interest rates derived from bond prices.
Bond Pricing Concepts
- Bonds are priced by discounting future cash flows.
- Duration & Convexity measure bond price sensitivity to interest rate changes.
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Chapter 5: Forward and Futures Pricing
Cost of Carry Model
- Futures Price = Spot Price + Carrying Costs (storage, financing, insurance) - Income (dividends, yields).
- Used for pricing commodities, stocks, and financial instruments.
Investment vs. Consumption Assets
- Investment Assets: Stocks, bonds, gold (held for value appreciation).
- Consumption Assets: Oil, wheat (used for consumption, not typically held for investment).
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Chapter 6: Interest Rate Futures
- Treasury Bond Futures: Used to hedge long-term interest rate exposure.
- Eurodollar Futures: Represent expectations of future short-term interest rates.
- Duration-Based Hedging: Used to manage bond portfolio risk.
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Chapter 7: Swaps
- Interest Rate Swaps: Exchange of fixed and floating interest rate payments.
- Currency Swaps: Exchange of principal and interest payments in different currencies.
- Commodity Swaps: Fixed-for-floating commodity price exchange.
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Chapter 8: Securitization and the Credit Crisis
- Securitization: Pooling illiquid assets (e.g., mortgages) into tradable securities.
- 2007-2008 Crisis: Triggered by excessive risk-taking in mortgage-backed securities.
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Chapter 10: Mechanics of Options Markets
- Call Option: Right to buy at a fixed price.
- Put Option: Right to sell at a fixed price.
- Option Premium: Cost of purchasing the option.
- American vs. European Options: American can be exercised anytime, European only at expiration.
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Chapter 11: Properties of Stock Options
- Put-Call Parity: Mathematical relationship between put and call prices.
- Factors Affecting Option Prices: Stock price, strike price, time to expiration, volatility, interest rates.
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Chapter 12: Option Trading Strategies
- Spreads: Combining different options to limit risk/reward (bull, bear, calendar spreads).
- Combinations: Using multiple options (straddles, strangles, butterflies).
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Chapter 13: Binomial Trees
- Risk-Neutral Valuation: Used to price options by modeling potential price movements.
- Binomial Model: Step-by-step approach for valuing options.
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Chapter 15: Black-Scholes-Merton Model
- Formula Components:
- Delta: Measures price sensitivity.
- Gamma: Measures delta’s rate of change.
- Theta: Measures time decay.
- Vega: Measures sensitivity to volatility.
- Rho: Measures interest rate sensitivity.
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Chapter 19: The Greeks
- Delta: Option price change per unit change in stock price.
- Gamma: Rate of change of delta.
- Theta: Time decay effect on option price.
- Vega: Sensitivity to volatility.
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Chapter 22: Value at Risk (VaR)
- Methods:
- Historical Simulation
- Variance-Covariance Approach
- Monte Carlo Simulation
- Used to measure portfolio risk exposure.
