Chapter 1 FD

Financial Derivatives

Harsh Vardhan

Objectiveh ? What is Derivative?

Why Derivatives are worth studying? Derivative Markets, Future Products in India, Ways Derivatives are used Indian Derivatives market‐an Overview Th t f t d H d S l t A bit Three types of traders‐ Hedger, Speculator, Arbitrageurs OTC & Exchange Traded Markets Spot and Future Contracts, Long and Short Positions Future Contract & Forward Contract Option Contracts Put & Call Long & Short Futures Short Selling Long & Short Futures, Short Selling Hedging using Forward and Options Role of Derivative Market Numerical Problems

2Chapter 1 /Harsh/2013

The Nature of Derivatives A derivative is an instrument whose value dependson the values of other more basic underlyingy gvariables.

It is an instrument that derives value from anunderlyingunderlying.

Derivative instruments are also known as contracts. Underlying is an instrument which lends value to the Underlying is an instrument which lends value to thederivative instrument.Crude (underlying) Petrol(derivative)y gMilk (underlying) Curd(derivative)

Derivatives have been very successful in briningi i i h C i l M kinnovation in the Capital Market.

Chapter 1 /Harsh/2013 3

Examples of Derivatives Futures Contracts Forward ContractsForward Contracts Options Swaps The underlying instruments could be The underlying instruments could be stocks, indices, commodities, metal Very often the variables underlying derivatives are the prices of traded assets Example stock option is a derivative its valueof traded assets. Example stock option is a derivative, its value depends on the price of the stock. Other derivative products relates to interest rate, foreign exchange and equity derivativesexchange and equity derivatives.

Underlying Cash Market Reliance EQ NIFTY

RelianceDerivative F&O Market

Reliance Future & Reliance Option

NIFTY Future & NIFTY Option

NIFTY can not be

4

Stock Derivative

Index Derivative

NIFTY can not be traded in the cash market on its own

Why Derivatives are worth studying? The Bank of International Settlement of Basel, Switzerland,estimated that at the end of 2010,the notional amount ofover‐the counter derivative contracts outstanding worldwide is over $ 601 trillion. In comparison ,GDP in the US atthe end of 2010 was about $15 trillion.the end of 2010 was about $15 trillion.

According to Futures Industry magazine, the global listedderivative trading volume in 2010 was 22.3 billion contracts

d h f h h b llover 78 derivative exchanges. Of which 11.2 billion arefutures and 11.1 billion are options.

The top five volume categories 2010 for equity indices (7 4The top five volume categories 2010 for equity indices (7.4billion), individual equities (6.3 billion),interest rate (3.2billion),foreign currency (2.4 billion) and agriculture

di i (1 3 billi )commodities (1.3 billion).Chapter 1 /Harsh/2013 5

The notional amount is a measure of thesize of a derivative contract stated in units ofcurrency on which payment is calculated. While the notional amount reflects the sizeof the market on which derivatives areof the market on which derivatives arebased, market value indicates amount oft l dactual money under exposure.

Market value of contracts totals $ 21 trillion,making the derivative market a sizeableforce in the global marketforce in the global market.


Notional amount of over the counter derivative 1998 2010contracts 1998‐2010

Notional amount increasedmonotonically , but financial crisishas significant impact in 2008


Exchange ‐Traded Marketsd h k h d d l A derivative exchange is a market where individuals

trade standardized contracts that have been defined bythe exchange.g

Some of the oldest exchanges are: The Chicago Board of Trade (CBOT ,www.cbot.com)

established in 1884; started with grain trading and,established in 1884; started with grain trading andmoved to dealing with futures in grain. The Chicago Mercantile Exchangeg g(CME, www.cme.com) established in 1919. The Chicago Board Options Exchange(CBOE www cboe com) 1973 started trading in Call(CBOE, www.cboe.com) ,1973, started trading in Calloption contracts on 16 stocks. Put option contractsstarted trading on exchange in 1997.Now around1 000 stocks and many stock indices are traded1,000 stocks and many stock indices are traded.


Top Ten Derivatives Exchanges world wide trading volume in 2010 in billionvolume in 2010 in billion


Derivative Markets Derivative markets are markets for contractualinstruments whose performance is determined byh i hi h h h ithe way in which the another instrument or assetperform.

Instrument term is used to describe asset or liabilityInstrument term is used to describe asset or liability. A contract is an enforceable legal agreement. A security is a tradable instrument representing aA security is a tradable instrument representing aclaim on a group of asset.

Like all contracts derivatives are agreementsb i b d ll i hi h hbetween two parties buyer and seller in which eachparty does something for other. These contractshave a price and buyer try to buy as cheaply asp y y y p ypossible while seller try to sell as dearly as possible.


Indian Derivative Market‐Time line Derivative market in India started in 2000 on bothNSE & BSE with trading in Equity derivatives.NSE & BSE with trading in Equity derivatives. June 2000 ‐Index futureJ 2001 I d ti June 2001‐Index option July 2001‐Options in individual stocks November 2001 ‐ Futures in single stockderivatives 2008 ‐Currency Future


Indian experience with derivative market hasb i ibeen positive. The derivative turn over on NSE surpassed equitymarket turn over. The turn over of derivatives on NSE increasedfrom ` 23,654 million in 2000‐2001 to` 292,482,211 million in 2010‐2011. Average daily turn over increased from ` 723,921million in 2009‐2010 to ` 1,151,505 million in, ,2010‐11 ,an increase of around 59%.


Futures Products in IndiaFutures Products in India

1 Equity Index Futures1. Equity Index Futures2. Single Stock Futures33. Interest Rate Futures4. Commodity Futures5. Currency Futures


Futures Indian Market Perspectiveh h h h ff d NSE & BSE are the exchanges which offers trading in

Futures. Contracts are available for different tenures(expiry)( p y) Typically contracts are available for 1,2 or 3 months Last working Thursday is the date of expiry for that month.

If Thursday is holiday then last Wednesday is consideredIf Thursday is holiday ,then last Wednesday is considered. Buyers and sellers will not take or give delivery of the

underlying.fi & l d i h Profit & Loss are settled in cash.

Since there is no delivery of the underlying ,we couldtrade in broad indices like NIFTY.NIFTY is most traded bothfor Futures & Options

One can start trade in Futures by paying small % ofcontract value known as margin.co t act a ue o as a g

Contract size and margin are set by exchange.Chapter 1 /Harsh/2013 14

Turnover of Indian Derivatives MarketsTurnover of Indian Derivatives Markets

TURNOVER of INDIAN DERIVATIVES MARKET

`(` Crore)

Year Equity Derivatives Currency Derivatives Interest Rate

Derivatives

Index Futures

Index Options

Stock Futures

Stock Options

Forward Swap Exchange Traded

Currency O ti d

Interest Rate Swap

Options and Futures

1 2 3 4 5 6 7 8 9

2008-09 35 81 870 37 31 512 34 79 657 2 29 227 25 54 994 40 65 695 3 11 389 49 04 7522008-09 35,81,870 37,31,512 34,79,657 2,29,227 25,54,994 40,65,695 3,11,389 49,04,752

2009-10 39,34,485 80,28,103 51,95,247 5,06,065 20,35,879 31,45,402 37,27,262 25,69,488

2010-11 43,56,909 1,72,69,366 54,95,757 10,30,343 28,90,222 41,12,539 84,06,307 47,46,390


Source RBI

F&O Segment Turn over in Crore `

Index Future 4,356,909The index option is the leader with 61% of total turnover of, ,

Index Option 17,269,366

Stock Future 5,495,757

Stock Option 1,030,343

NSE 2010 11

with 61% of total turnover of F&O segment of NSE followed by stock future(20%) and index future(15%).

NSE 2010-11

15%20%

4%

Turn over in % of F&O segment of NSE for 2010‐11

20%

Index Future

Index Option

Stock Future

61%

Stock Future

Stock Option


Number of Derivative Stocks traded on NSENumber of Derivative Stocks traded on NSEYear Index Stock Index Stock Interest Currency

futures futures options options rate futuresfutures

2000 01 90 5802000–01 90,580 – – – – –

2001–02 10,25,588 19,57,856 1,75,900 10,37,529 – –

2002–03 21,26,763 10,67,683 4,42,241 35,23,062 – –

2003–04 1,71,91,688 3,23,68,842 17,32,414 55,83,071 10,781 –

2004–05 2,16,35,449 4,70,43,066 32,93,538 50,45,112 0 –

2005–06 5,85,37,886 8,09,05,493 1,29,35,116 52,40,776 0 –

2006–07 8,14,87,424 10,49,55,401 2,51,57,438 52,83,310 0 –

2007–08 15,65,98,579 20,35,87,952 5,53,66,038 94,60,631 0 –

2008–09 15,64,84,642 17,14,22,782 13,79,49,487 91,90,538 0 1,60,68,559

17Chapter 2 /Harsh/2013


Nifty Future on 17/6/13 at 1:05 pm for 27thJ iJune expiry




Spot and Future ContractSpot and Future Contract Spot ContractAn agreement to buy or sell an asset immediatelyAn agreement to buy or sell an asset immediately(or within a very short period of time) for a certainprice.

Futures ContractA futures contract is an agreement to buy or sell anasset at a certain time in the future for a certainprice agreed upon today.Futures are traded in organized exchanges. Theyare standardized contracts, margin is required &th i ttl t i d b htheir settlement is done by cash.


Futures PriceFutures Price

The futures prices for a particular contract isThe futures prices for a particular contract isthe price at which you agree to buy or sell inthe future. It is determined by supply and demand in thesame way as a spot price.


Examples of Futures ContractsExamples of Futures ContractsAgreement to: buy 100 oz. of gold @ US$600/oz. inDecember (NYMEX) sell £62,500 @ 1.9800 US$/£ in March(CME)( ) sell 1,000 bbl. of oil @ US$65/bbl. in April(NYMEX),(bbl =oil barrel =158.987 L)(NYMEX),(bbl oil barrel 158.987 L)


Forward Contractsd l f h Forward contracts are similar to futures except that

they trade in the over‐the‐counter market usuallybetween two financial institutions.between two financial institutions.

A forward contract is a contract between two partiesa buyer and a seller‐to purchase or sell something atl tt d t t i d t da latter date at a price agreed upon today.

One of the parties in Forward contract assumes along position and other short positionlong position and other short position.

Forward contracts are popular on currencies andinterest rates.

Forwards are traded over thecounter, customized, margin is not required, stocks orgoods are settledgoods are settled.


Long & Short Position The party that has agreed to buy the underlying asseton a certain specified future date for a specified pricehas a long position

The party that has agreed to sell the underlying asseton a certain specified future date for a specified pricehas a short position

Bid ‐ the price that a dealer is prepared to pay for anasset.

Ask or Offer‐ the price that a dealer is offering to sell anasset.

Bid‐Ask Spread ‐ the amount by which the ask priceexceeds the bid price. 26

Option ContractOption Contract An agreement that gives the right but not theobligation to buy or sell an asset at a certain timeobligation to buy or sell an asset at a certain timein the future for a certain price agreed upontoday.today. The option buyer pays the seller a sum of moneycalled the price or premiumcalled the price or premium. The option seller stands ready to sell or buy

di t th t t t if d h thaccording to the contract term if and when thebuyer so desires.


An option to buy something is referred to asAn option to buy something is referred to as call ,an option to sell something is known as putput. The price in the contract is known as the exercise price or strike priceexercise price or strike price.


Options vs Forward/FuturesOptions vs Forward/Futures A forward/futures contract gives the holderthe obligation to buy or sell at a certain pricethe obligation to buy or sell at a certain priceat a future date

h h ld h h b An option gives the holder the right but notthe obligation to buy or sell at a certain price

f dat a future date


American vs European OptionsAmerican vs European Options

An American option can be exercised at anytime during its lifetime during its life. A European option can be exercised only atmaturity.


Electronic TradingElectronic Trading

Traditionally futures contracts have beenTraditionally futures contracts have beentraded using the open outcry system wheretraders physically meet on the floor of thetraders physically meet on the floor of theexchange. Increasingly this is being replaced by Increasingly this is being replaced byelectronic trading where a computer matchesbuyers and sellersbuyers and sellers.


Over‐the Counter MarketsOver the Counter Markets

The Over‐the Counter Market is an importantThe Over the Counter Market is an importantalternative to exchanges It is a telephone and computer‐linked networkIt is a telephone and computer linked networkof dealers who do not physically meet Trades are usually between financialTrades are usually between financialinstitutions, corporate treasurers, and fundmanagers


Size of OTC and Exchange Markets$516.4 trillion OTC

$ 96.7 trillion Exchange t d d k ttraded market

Source: Bank for International Settlements. Chart shows totalprincipal amounts for OTC market and value of underlyingassets for exchange market

By June 2007, the OTC market had grown to $516.4 trillion andexchange traded market to $96.7 trillion


Role of Derivative Market Derivative markets provide a means of adjustingthe risk of spot market investments to a morepacceptable level. They make trading easier andless costly and spot markets more efficient.Th k t l id fThese markets also provide a means ofspeculating.

Operational Advantages First derivative markets Operational Advantages First, derivative marketsentail lower transaction costs. Second, derivativemarkets often have greater liquidity than spotg q y pmarkets. And third, derivative markets allowinvestors to sell short in an easier manner.


RiskRisk Risk results from exposure to uncertainty. Uncertainty is the doubt about our ability topredict future outcomes.predict future outcomes. When uncertainty exists outcomes cannot beforecasted with precisionforecasted with precision. Uncertainty is a function of circumstances in

hi h th t i iblwhich more than one outcome is possible.


Two Types of Riskyp Risk in decision making relating to underlying nature ofbusiness which deals with matters such as uncertaintyof future sales or the cost of inputs is known asof future sales or the cost of inputs is known asbusiness risk.

Another class of risk deals with uncertainty such asAnother class of risk deals with uncertainty such asinterest rates, stock prices and commodity prices .Theseare known as financial risks.D i ti l bl i i Derivatives serve a valuable purpose in managingfinancial risk.

By using derivatives companies and individuals canBy using derivatives companies and individuals cantransfer for a price any undesired risk to other partieswho either have risks that offset or want to assumethat riskthat risk.


Ways Derivatives are UsedWays Derivatives are Used To Hedge risks.

l ( k h f To Speculate (take a view on the futuredirection of the market) To lock in an Arbitrage profit. To change the nature of an investmentgwithout incurring the costs of selling oneportfolio and buying another.p y g


Categories of TradersCategories of Traders Three broad category of traders are:H d S l d A biHedger, Speculator and Arbitrageurs. Hedgers use derivatives to reduce the risk dueto potential future movements in the marketvariables. Speculators use them to bet on the futuredirection of market variables. Arbitrageurs take offsetting positions in two ormore instruments to lock in profit.more instruments to lock in profit.


HedgingHedging

Eliminating or reducing exposure to uncertaintyEliminating or reducing exposure to uncertainty Eliminating or reducing risk Hedger is risk averse Hedger is risk averse This is not the same as eliminating or reducing

t i tuncertainty A description of a risk averse investor who, whenf d ith t i t t ith i ilfaced with two investments with a similarexpected return (but different risks), will preferthe one with the lower riskthe one with the lower risk.


SpeculationSpeculation Take a view on the future direction of an

t i k tuncertain market If the view turns out to be right in the future

kyou make money If the view turns out to be wrong in the future

lyou lose money Speculator consciously takes on risk by taking

t t i texposure to uncertainty Speculator is a risk seeker


ArbitrageArbitrage

Risk‐free profitRisk free profit Assured profit with zero uncertainty

l Buy low Sell high Buy and sell prices known with zero uncertaintyy


Difference between d l d bHedging, Speculation and Arbitrage

A trader is hedging when he has an exposure toA trader is hedging when he has an exposure tothe price of an asset and takes a position in aderivative to offset the exposurederivative to offset the exposure. In speculation the trader has no exposure tooffset He is betting on the future movementsoffset. He is betting on the future movementsin the price of the asset.A bi i l ki i i i Arbitrage involves taking a position in two ormore different markets to lock in a profit.


ExampleExampleExample Example

On July 20 2007 the treasurer of aOn July 20, 2007 the treasurer of acorporation enters into a long forwardcontract to buy £1 million in six months at ancontract to buy £1 million in six months at anexchange rate of 2.0489 This obligates the corporation to pay This obligates the corporation to pay$2,048,900 for £1 million on January 20, 2008Wh h ibl ? What are the possible outcomes?

43

Foreign Exchange Quotes for USD/GBP on July 20 2007 Q i b f USD GBP20, 2007,Quote in number of USD per GBP

Foreign Contracts are used toBid Offer

Spot 2.0558 2.0562

ghedge foreign currency risk.On July 20,2007 the treasurer ofUS corporation knows that theyhave to pay £ 1 million in 6

1-month forward

2.0547 2.0552have to pay £ 1 million in 6months. The treasurer buy £ 1forward from bank at exchangerate 2.0489. The corporation has

3-month forward

2.0526 2.0531long forward contract on GBP ,itwill buy £ 1 million from bankfor $ 2.0489 million .The bankhas short forward contract on

6-month forward

2.0483 2.0489has short forward contract onGBP and will sell £ 1 million for $2.0489 million on Jan 2008.

44

Spot‐ the Bank is prepared to buy sterling (£) in the spot market for immediate delivery.

Payoffs from Forward Contracts The forward contract help the corporation to buy £ 1million for $2,048,900.

h h d Incase spot exchange rate rose to 2.100,at the endof 6 months ,the forward contract will be worth$51,100(=$2,100,000‐$2,048,900) to the$51,100( $2,100,000 $2,048,900) to thecorporation.

Thus it had enabled 1 million £ to be purchased ath t f 2 0489 i t d f 2 100an exchange rate of 2.0489 instead of 2.100.

On the other hand if the exchange rate falls to1 9000 at the end of 6 months the forward contract1.9000 at the end of 6 months ,the forward contractwill have negative value of $ 148,900 andcorporation will pay $ 148,900 more than themarket price of the £market price of the £.


Profit from aLong Forward Positiong

Profit

P i f U d l iPrice of Underlyingat Maturity, ST

KPay off for a long position in a forward contract on one unit of an asset is ST - K, where K is the delivery price and ST is the spot price .Let K=2.0489,ST=2.1000,pay off =2.100-2 0489 $0 0511/£

46

2.0489=$0.0511/£,when ST =1.9000,payoff = - 0.1489/£

Profit from a Short Forward PositionShort Forward Position

Profit

Price of UnderlyingPrice of Underlyingat Maturity, ST

K

Pay off for a short position in a forward contract onPay off for a short position in a forward contract on one unit of an asset is K‐ST , where K is the delivery price and ST is the spot price .Let K=2.0489,ST=2.1000,pay off =2.0489-2.1000=

47

Let K 2.0489,ST 2.1000,pay off 2.0489 2.1000-$0.0511/£,when ST =1.9000,payoff = 0.1489/£

Relationship between Forward and Spot Prices

Consider a stock which is not paying anydividend and is worth $ 60 today. You maydividend and is worth $ 60 today. You mayborrow or lend at 5%.What should be the priceof 1 year forward. If $60 invested for a year, it will be$60*1.05=$63. Let the forward price is more that $ 63 say $67.Borrow $60 ,buy a share of stock; sell it forward$ , y ;for $ 67.Pay loan interest =$3,Net gain =$(67‐60)‐$3=$4


If the forward price is less than $63 say $58 Investor owning the stock sell it for $60 andInvestor owning the stock sell it for $60 andenters into a forward to buy at $58. Proceeds of the sales of $60 are invested for a Proceeds of the sales of $60 are invested for ayear at 5%,interest earned =$3.N t i $2 $3 $5 Net gain = $2+$3=$5.

Thus the investor would end up $5 more thanif the stock is kept in the portfolio.


Difference between a long forward d h f dposition and a short forward position

When the trader enters into a long forwardWhen the trader enters into a long forwardcontract ,he is agreeing to buy the underlyingasset for a certain price at a certain time in theasset for a certain price at a certain time in thefuture. Where as when the trader enters into a short Where as when the trader enters into a shortforward contract ,he is agreeing to sell theunderlying asset for a certain price at a certainunderlying asset for a certain price at a certaintime in the future.


US $ ‐` cCCurrency Futures Quote 27/6/13 y

511$ =`59.8538,on 27/6/2013 F0=S0erT


Exchanges Trading OptionsExchanges Trading Options

Chicago Board Options Exchange ( largest forChicago Board Options Exchange ( largest for trading stock options) American Stock Exchange American Stock Exchange Philadelphia Stock Exchange International Securities Exchange Eurex (Europe)( p )


Example Call & Put Option: Intel Option Prices (S 12 2006 S k P i 19 56)(Sept 12, 2006; Stock Price=19.56)

Calls PutsCalls PutsStrike Price Oct Jan Apr Oct Jan Apr

($) 2006 2007 2007 2006 2007 2007$15.00 4.650 4.950 5.150 0.025 0.150 0.275$17.50 2.300 2.775 3.150 0.125 0.475 0.725$20.00 0.575 1.175 1.650 0.875 1.375 1.700$22.50 0.075 0.375 0.725 2.950 3.100 3.300$2500 0025 0125 0275 5450 5450 5450$25.00 0.025 0.125 0.275 5.450 5.450 5.450

The price of call option decreases as the strike priceSource www.cobe.com

increases.The price of put option increases as the strike priceincreases


increases.Both option become more valuable as time ofmaturity increases.

Call Option Exercise Investor instructs broker to buy one April call option onIntel at strike price $ 20.

Price of the April call option at strike price $20 is $1.650 Option contract size is of 100 shares. Investor buys one contract of 100 Intel share at a strikeprice $20 for $165.

The seller has received $ 165 and has agreed to sell 100Intel shares for $20/share; incase investor chooses to

i iexercise option. Expiration date is 21 April,2007. If the price before 21st April does not rise above $ 20 , theoption is not exercised and investor looses $ 165 55

If the Intel share price is well above $ 20 ,say $ 30.The investor is able to buy share $ 20 which is for $ 30. Thus gain =100*(30‐20) = $ 1000. The initial cost of option $165 The initial cost of option $165 Thus net gain=$ (1000‐165)=$835


1500 Profit ($)Pay Off‐profit as a function of final

1000

500

a function of final stock price

500

010 20

30

stock price ($)

‐50030

Purchasing a contract consisting of 100 April call option with strike price $ 20


Put Option Exercise Investor instructs broker to buy one April put option onIntel at strike price $ 17.50.

Price of the April put option at strike price $17.50 is $0.725 Option contract size is of 100 shares. Investor buys one contract of 100 Intel share @$0.725/share for $72.50.

The seller has received $ 72.50 and has agreed to sell 100Intel shares for $17.50/share; incase investor chooses to

i iexercise option. Expiration date is 21 April,2007. If the price before 21st April increase above $ 17.50 , theoption is not exercised and investor looses $ 72.50

If the Intel share price is well below $ 17.50,say $ 15.The investor is able to sell share $, y17.50 while it is for $ 15. Thus gain =100*$(17.50‐15) = $ 250.Thus gain 100 $(17.50 15) $ 250. The initial cost of put option is $72.50Th t fit $ (250 72 50) $177 50 Thus net profit=$ (250‐72.50)=$177.50


1500 Profit ($)Pay Off

1000

500500

010 20 30 stock price ($)

‐500Purchasing a contract consisting of 100 April put option with strike price $ 17.50


There are four types of participants in the option market:1. Buyer of Calls2. Sellers of Calls3. Buyers of Puts4. Sellers of Puts


Long FutureLong Future If a trader buys a NIFTY future at 4625 whatcould be the profit or loss at various level ofNIFTY closure. If NIFTY closes at 4500,trader loses (4625‐4500)*50=125*50=` 6250[lot size =50]

Similarly ,if NIFTY closes at 4700 , trader gains(4700‐4625)*50=75*50=` 3750( )


Pay off graph ‐ Long FuturesSpot closing at expiry

Instrument ActionStrike Price

Number of Lots* 4500 4600 4625 4700 4800 4900Instrument Action Price Lots 4500 4600 4625 4700 4800 4900

Future Buy 4625 1 ‐125 ‐25 0 75 175 275Total

Profit/Loss ‐6250 ‐1250 0 3750 8750 13750Profit/Loss 6250 1250 0 3750 8750 13750

275300

Long Futures*( 1 lot of 50)

75

175

275

100

150

200

250

or Loss

125

‐250

75

‐100

‐50

0

50

4500 4600 4625 4700 4800 4900

Profit o


‐125‐150

Spot Price

Short FuturesShort Futures

If a trader sells a NIFTY future at 4625 whatIf a trader sells a NIFTY future at 4625 whatcould be the profit or loss at various level ofNIFTY closureNIFTY closure. If NIFTY closes at 4400,trader gains (4625‐4000)*50=225*50=` 11 250[lot size =50]4000) 50=225 50= 11,250[lot size =50]

Similarly ,if NIFTY closes at 4700 , trader loses(4700 4625)*50 75*50 ` 3 750(4700‐4625)*50=75*50=` 3,750


Short FuturesShort FuturesSpot closing at expiry

Instrument ActionStrike Price

Number of Lots 4400 4500 4600 4625 4700 4800Instrument Action Price Lots 4400 4500 4600 4625 4700 4800

Future Buy 4625 1 225 125 25 0 ‐75 ‐175Total

Profit/Loss 11250 6250 1250 0 ‐3750 ‐8750

225200

250

Short Futures

125

2500

50

100

150

200

it & Loss

0

‐75

‐175200

‐150

‐100

‐50

0

4350 4400 4450 4500 4550 4600 4650 4700 4750 4800 4850Prof


‐200Spot Price

Short Selling If an individual anticipates the price of a stockfalling, he can attempt to capture a profit by sellingshort.

He would first borrow the stock from a broker andll h k i h k l If h i f hsell that stock in the marketplace. If the price of the

stock then indeed fell, he would buy back the stock ata lower price This would allow him to capture aa lower price. This would allow him to capture aprofit and repay the shares to the broker.

Short selling creates a liability in the sense that theShort selling creates a liability in the sense that theshort seller is obligated to someday buy back thestock and return it to the broker; however, the shortll d k h h h ll hseller does not know how much he will have to pay to

buy back the shares. 66

Hedging Using Forward Contracts Foreign Exchange Q t f USD GBP J l 20th 2007Quotes of USD per GBP on July 20th 2007


Hedging Using Forward Contractsg g g The purpose of hedging is to reduce risk. But it is uncertainthat the outcome with hedging may be better with hedgingor without hedging.

On July 20,2007 an Import company based in US knew thati h £10 illi O b 2007 f h iit has to pay £10 million on October 2007 for the importsfrom a British supplier.$ £ h t t d b th fi i l i tit ti $‐£ exchange rate quoted by the financial institution aregiven in the Table(slide 67).

Import Co can hedge by buying £ in 3 month forward Import Co can hedge by buying £ in 3 month forwardmarket at 1£=$2.0531

This will help in freezing the price and payment of $ This will help in freezing the price and payment of $20,531,000 to the British exporter

68

For the Import Co.For the Import Co. If the exchange rate is 1.9 on Oct 20th ( $appreciates, earlier it was 2.0531)and theappreciates, earlier it was 2.0531)and thecompany has not hedged ,the £10 million thatit has to pay will cost $ 19,000,000 instead of$20,531,000. On the other hand incase the exchange rate is2.1000($ depreciates, import company willneed more $s for sterling pound),it will cost$21 000 000 d th ld h$21,000,000 and the company would havethought if they have hedged.


US export company Export Co, exports goods to the UK. It will receive £ 30 million in 3 months.the UK. It will receive £ 30 million in 3 months. The company may hedge its foreign exchange risk by selling £ 30 million in 3 months forwardrisk by selling £ 30 million in 3 months forward market at exchange rate £ 1 =$2.0526.Thi ill h ff t i l ki i th US $ t b This will have effect in locking in the US $ to be realized for the pound sterling at $ 61,578,000 Hedge may make company better or worse??


For the Export company If the exchange rate in October is less than2.0526(£ has depreciated) say 1.9,the exportcompany will get less USDs, the company willthink had it hedged. If the exchange rate is more that 2.0526 ,thecompany would be better without hedging.p y g g


Hedging Using Hedging Using Options Options g g gg g g pp An investor who is in May owns 1,000Microsoft shares currently worth $28 per shareMicrosoft shares currently worth $28 per share.There are chances that stock price may go downin the next two months. Investor wants protection. Investor could buy atwo‐month put with a strike price of $27.50costs $1 The investor decides to hedge bycosts $1. The investor decides to hedge bybuying 10 contracts each of 100 shares. Quoted option price= $1Quoted option price $1 Cost of each option contract =$1*100=$100 Total cost of hedging =$100*10=$1 000

72

Total cost of hedging $100 10 $1,000

The strategy costs $ 1,000 but ensures at least $27 50 d i th lif f th ti27.50 during the life of the option. If the market price of Microsoft share is lessth 27 50 th ti i i d Th $than 27.50,the option is exercised. Thus $27,500 is realized irrespective of declined shareprice Less cost of option $ 1 000; it will giveprice. Less cost of option $ 1,000; it will give$26,500. If the market price is above $27 50 the option is If the market price is above $27.50,the option isnot exercised and it expires worthless.Thus the value of holding is always aboveThus the value of holding is always above$26,500 The dotted line in the figure indicates value of The dotted line in the figure indicates value ofportfolio without hedging.

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Value of Microsoft Shares with and without Value of Microsoft Shares with and without d id iHedging Hedging

40,000 Value of Holding ($)

35,000

30,000

No Hedging

Hedging

25,000

Stock Price ($)

20,00020 25 30 35 40

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SpeculatorsSpeculators Speculation using FuturesUS speculator in February thinks that £ willp ystrengthen in comparison to $ in 2 months.

Two possibilities‐1.To buy £ 250,000 in spot.or 2. To take long position on 4

April future contract, each contract of £ 62,500 Margin per contract $5000 There are 4 future Margin per contract $5000.There are 4 futurecontracts. Margin amount $20,000.

Assume current exchange rate is 2.0470$/ £ andg /April futures price is 2.0410$/ £

Profits for both buying in spot and buying future for April spot price =2 100 and 2 000 are calculatedApril spot price =2.100 and 2.000 are calculated


The first alternative needs upfront of$511,750(=250000*2.0470 ); where as initialsmall margin required by the speculator forfutures =4* $ 5000=$ 20,000.


Speculation using Spot and Future contractsOne Future contract is of £62,500 .Initial margin for 4 contract =$4*5000=$20000

Possible TradesBuy £250,000 Buy 4 Futures contractsSpot Price =2 0470 Futures Price =2 0410Spot Price =2.0470 Futures Price =2.0410

Investment $511,750 $20,000Profit if April spot is 2 1000 $13 250 $14 750Profit if April spot is =2.1000 $13,250 $14,750

‐$11,750 ‐$10,250Profit if April spot is =2.0000

It is seen from the table that futures market provides leverage, with relatively small amount investor may take a


large speculative position.

Speculation Using Options It is October and speculator thinks that stock will rise in the next 2It is October and speculator thinks that stock will rise in the next 2

months . Current Price of stock =$20. 2 months call option with $ 22 50 strike price is currently selling for 2 months call option with $ 22.50 strike price is currently selling for

$1 Let the stock price touches $27 by December. Speculator wishes to invest $2000 Speculator wishes to invest $2000 Two options ‐Either purchase 100 stocks or 2000 call options. Buying stock yield profit = 100*($27‐$20)=$700 Buying option yields profit = 2000*$(27‐22.50)‐$2000 =$7000, where

$2000 is cost of option .Thus Option buying is 10 times more profitable.

However if stock price declines to $ 15,Loss for buying stocks =100*($15‐$20)=$500.The call option is not exercised ,the original amount paid for option is p , g p p$2000 ,which is the loss.

78

Comparison of profit (losses) from two alternative

$15 $27

stategies for using $ 2000 to speculate on stock worth $20 in OctoberDecember stock price

$15 $27

Investor's strategyBuy 100 shares ‐$500 $700

‐$2,000 $7,000Profit/loss by option loss 4 time 10 times profitableBuy 2000 call optionsProfit/loss by option loss 4 time 10 times profitableOption cost $2,000

Thus option like future provides a leverage. Good p p goutcomes become very good , but the investment is lost in bad out comes


Wh t i th diff b t t i i t What is the difference between entering into along forward contract when the forward price is$50 d t ki l iti i ll ti$50 and taking a long position in a call optionwith strike price of $50? In the first case the trader is obliged to buy theasset for $50.(He has no choice) Whereas in the 2nd case the trader has an optionto buy the asset for $50(The trader does nothave to exercise the option)


Swap Contracth h A swap is a contract in which two parties agree to

exchange cash flows. An agreement that can be modeled as a series of An agreement that can be modeled as a series offorward contracts.

The agreement specifies a number of exchanges ofg p gcash flows between two counterparties at differentpoints in time in the future

The quantum of cash flow exchanged at each point The quantum of cash flow exchanged at each pointin time is determined by a formula specified in theagreement

Interest rate swaps make up more than 60% of the$ 601 trillion notional principle over the counterderivative market in 2010derivative market in 2010.


Payoffs from OptionsWhat is the Option Position in Each Case?

K = Strike price, ST = Price of asset at maturity

Payoff Payoff

KST STK

K

Payoff Payoff

KST STK

K

8.82

TermsTerms Volume‐Weighted Average Price (VWAP) is theratio of the value traded to volume tradedratio of the value traded to volume tradedover a particular time horizon (usually oneday). It is a measure of the average pricea stock traded at over the trading horizon. The aim of using a VWAP trading target is toensure that the trader executing the orderdoes so in‐line with volume on the market. Open Interest The total number of long/shortpositions outstanding in a futures contract


Tick Size ‐ a tick size is the smallest increment(tick) by which the price of stocks futures(tick) by which the price of stocks, futurescontracts or other exchange‐traded instrument can move.traded instrument can move.

Tick sizes can be fixed (e.g., USD 0.01) or varyaccording to the current price (common ing p (European markets) with larger increments athigher prices. Heavily‐traded stocks are given

ll ti k ismaller tick sizes. An instrument price is always a rationalnumber and the tick sizes determine whichnumber and the tick sizes determine whichnumbers are permissible for a given instrumentand exchange.g


Open Outcry ‐ is the name of a method ofi ti b t f i l t kcommunication between professionals on a stock

exchange or futures exchange. It involves shouting andthe use of hand signals to transfer informationprimarily about buy and sell orders. The part of thetrading floor where this takes place is called a pit.

Market Maker a trader who is willing to quote both Market Maker ‐ a trader who is willing to quote bothbid and offer prices for an asset.

Speculator & Gambler‐The word Speculator comesp pfrom the Latin word specula or to see. This is theforemost difference between a gambler & a speculator.A Gambler is one who goes in blind taking a chance & aA Gambler is one who goes in blind taking a chance & aSpeculator goes in to trade after 'seeing' the odds.


Documents

Chapter 1 FD