36596895 Derivatives Ppt

8/8/2019 36596895 Derivatives Ppt

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DERIVATIVES:

FUTURES & OPTIONS


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Defining Derivatives

A derivative is a financial instrument whose

value depends on is derived from the

value of some other financial instrument,called the underlying asset

Common examples of underlying assets are

stocks, bonds, corn, pork, wheat, rainfall,

etc.


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Basic purpose of derivatives In derivatives transactions, one partys loss is

always another partys gain

The main purpose of derivatives is to transfer

risk from one person or firm to another, that is,to provide insurance

If a farmer before planting can guarantee a

certain price he will receive, he is more likelyto plant

Derivatives improve overall performance of

the economy


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Major categories of derivatives

1. Forwards and futures

2. Options

3. Swaps


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Forwards

A forward contract is customized contract

between two entities, where settlement

takes place on a specific date in the future attodays pre-agreed price.

Example: interest rate forwards

Forwards are highly customized, and are

much less common than thefutures


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Futures

An agreement between two parties to buy or sell anasset at a certain time in the future at a

certain price. Futures contacts are special types of

forward contracts in the contracts in the sense that

the former are standardized exchange-tradedcontracts.

Structure of a futures contract:

Seller (hasshort position) is obligated to deliver

the commodity or a financial instrument to the

buyer (has long position) on a specific date

This date is calledsettlement, or delivery, date


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Part of the reason forwards are not as common is that

it is hard to provide assurances that the parties willhonor the contract

In futures trading, this is done through the clearing

corporation

Basis is defined as the difference between cash andfutures prices:

Basis = Cash prices - Future prices.

Basis can be either positive or negative (in Index

futures, basis generally is negative).


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Basis may change its sign several times during thelife of the contract.

Basis turns to zero at maturity of the futures contract

i.e. both cash and future prices

converge at maturity


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Operators in the derivatives market

Hedgers - Operators, who want to transfer a

risk component of their portfolio.

Speculators - Operators, who intentionally take therisk from hedgers in pursuit of profit.

Arbitragers - Operators who operate in the different

markets simultaneously, in pursuit of profit and

eliminate mis-pricing.


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Often, agents hedge against adverse events in the

market using futures

E.g., a manager wishes to insure the firm against the

rise in interest rates and the resulting decline in the

value of bonds the firm holds

Can sell a futures contract and lock in a price.

Speculators try to use futures to make aprofit by

betting on price movements:

Sellers of futures bet on price decreases

Buyers of futures bet on price increases


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Options

Options are instruments whereby the right is given bythe option seller to the option buyer to buy or sell a

specific asset at a specific price on or before a

specific date.

Call Option - The right to buy a specified amount ofcurrency at a specified rate

Put Option -The right to sell a specified amount of

currency at a specified rate

Premium - The price of an option

Strike - The rate at which the right can be exercised

Expiry Date - The date at which the right can be

exercised


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Option Seller - One who gives/writes the option. He

has an obligation to perform, in case option buyerdesires to exercise his option.

Option Buyer - One who buys the option. He has the

right to exercise the option but no obligation. Call Option - Option to buy.

Put Option - Option to sell.

American Option - An option which can be exercisedanytime on or before the expiry date.


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Expiration Date - Date on which the option expires.

European Option - An option which can be exercised

only on expiry date.

Exercise Date - Date on which the option getsexercised by the option holder/buyer.

Option Premium - The price paid by the option buyer

to the option seller for granting the option.


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Like futures, options are agreements between 2

parties.

Seller is called an option writer - Incurs obligations

Buyer is called an option holder - Obtains rights

2 types of options

Call option

Put option


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Call option a right to buy an asset at a

predetermined price (strike price ) on or before a

specific date

If asset price is higher than the strike price Option is

In The Money

If asset price is exactly at the strike price Option is AtThe Money

If asset price is below the strike price Option is Out

Of The Money

Obviously would not exercise an option that Is out

Of the money


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Put option a right to sell an asset at a predetermined

price on or before a specific date

If asset price is lower than the strike price Option is

In The Money

If asset price is exactly at the strike price Option is At

The Money

If asset price is higher than the strike price Option is

OutOf The Money


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STRATEGIES OF TRADING IN

FUTURE AND OPTIONS

USING STOCK FUTURES

1. Hedging: long security, sell future

2. Speculation: bullish security, buy Futures

3. Speculation : bearish Security, Sell Futures

4. Arbitrage: overpriced Futures: buy spot, sell futures

5. Arbitrage: underpriced Futures: sell spot, buy futures


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USING STOCK OPTIONS

Hedging:Have stock, buy puts

Speculation: bullish stock, buy calls or sell puts

Speculation : bearish Stock, buy put or sell calls


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BULLISH STRATEGIES


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LONGCALL

Market Opinion Bullish Most popular strategy with

investors Used by investors because of better

leveraging compared to buying the underlying stock

insurance against decline in the value of the

underlying.

Risk Reward Scenario

Maximum Loss = Limited (Premium Paid)

Maximum Profit = Unlimited

Profit at expiration = Stock

Price at expiration Strike Price Premium paid

Break even point at Expiration = Strike Price +

Premium paid


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SHORT PUT

Maximum Loss Unlimited

Maximum Profit Limited (to the extent of option

premium)

Makes profit if the Stock price at expiration > Strike

price premium


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BULLCALL SPREAD

For Investors who are bullish but at the same time

conservative

Buy A Call Closer To Spot Price & Write A Call With

A HigherPrice In a market that has bottomed out, when stocks rise,

they rise in small steps for a short duration. Bull Call

Spread can be Used where gains & losses are limited.


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BEARISH STRATEGIES:

LONGPUT

Market Opinion Bearish. For investors who want to

make money from a downward price move in the

underlying stock Offers a leveraged alternative to a

bearish or short sale of the underlying stock


Maximum Loss Limited (Premium Paid)

Maximum Profit - Limited to the extent of price of

stockProfit at expiration - Strike Price StockPrice at

expiration - Premium paid

Break even point at Expiration Strike Price -

Premium paid


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SHORT CALL


Maximum Loss Unlimited

Maximum Profit - Limited (to the extent of option

premium)

Makes profit if the Stock price at expiration < Strikeprice + premium

BEARCALL SPREAD

L

ow RiskL

ow Reward Strategy Sell a Call Option with a Lower Strike Price and

Buying a Call Option with a Higher Strike Price


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BEARPUT SPREAD

Again a LOW RISK, LOW RETURN Strategy

Gains as Well as Losses are Limited

BUY PUT OPTION AT A HIGHER STRIKE

PRICE AND SELLANOTHER WITH A

LOWER STRIKE PRICE

Profit Accrues when the price of underlying stock

goes down.


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NEUTRAL STRATEGIES

LONG STRADDLE

Buy one call option and buy one put option at the

same strike price

Maximum Loss: Limited to the total premium paid

for the call and put options

Maximum Gain: Unlimited as the market moves in

either direction.

A long straddle is like placing an each-way bet onprice action: you make money if the market goes up

or down


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SHORT STRADDLE

Short one call option and short one put option at thesame strike price

Maximum Loss: Unlimited as the market moves in

either direction.

Maximum Gain: Limited to the net premium received

for selling the options

Short straddles are a great way to take advantage of

time decay and also if you think the market price willtrade sideways over the life of the option.


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VOLATILITY STRATEGIES

LONG STRANGLE

Long one put option with a lower strike price and

long one call option at a higher strike price.

Maximum Loss:Limited to the total premium paid forthe call and put options

Maximum Gain:Unlimited as the market moves in

either direction.


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SHORT STRANGLE:

Short one put option with a lower strike price and

short one call option at a higher strike price.

Maximum Loss: Unlimited as the market moves in

either direction.

Maximum Gain: Limited to the net premium receivedfor selling the options.

A short strangle is similar to the Short Straddle except

the strike prices are further apart, which lowers the

premium received but also increases the chance of a

profitable trade.

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36596895 Derivatives Ppt