Derivatives - Session 01

7/28/2019 Derivatives - Session 01

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DERIVATIVES

PROF KAUSHIK DESARKAR

FULLTIME PGDM PROGRAM

GOA INSTITUTE OF MANAGEMENT



DERIVATIVES

•What are derivatives

•Taxonomy & Terminologies

•Basic Introduction



FINANCIAL DERIVATIVES•Last 35 years have seen Derivatives move to the forefront of finance.

•Most Exchanges today have active trading units in Futures & Options

•Derivatives are found in Bond Issues (Convertibles) and Executive

Compensation (ESOPS)

•They are also found in Capital Investment Opportunities – can you

guess what

they

are

called

?

•Answer : REAL OPTIONS – Options embedded in CapEx Decisions



DERIVATIVES

•A Derivative can be defined as a financial instrument whose valuedepends on (or derives from) the values of other, more basic,underlying variables.

•Very often the variables underlying the derivatives are prices of traded assets.

•There are however exceptions to the above – like WeatherDerivatives.

•Nevertheless, whatever the underlying, there must be an agreementto its measure for writing derivative contracts on it.





DERIVATIVES

•Derivatives can be classified in various ways but 2 basic classifications are based on

•Exchange Traded (ET) Vs. Over The Counter (OTC).

•Linear Payoffs

Vs.

Non

‐Linear

Payoffs.



DERIVATIVES

•Exchange Traded (ET) Vs. Over The Counter (OTC)

•Derivatives traded

on

the

exchange

have

the

following

features

•Standardized Contracts

•Standardized Dates

•The Exchange stands as the counterparty (negligible counterpartycredit risk)

•Price transparency and discovery



DERIVATIVES•Exchange Traded (ET) Vs. Over The Counter (OTC)

• However the

OTC

market

is

larger

is

terms

of

volume.

• OTC market allows non‐standardization of contracts to suit client needs.

• Buyers and sellers can create mutually attractive and acceptable deals.

• Let us strike a deal whereby based on tomorrow’s price of Tata Steel > Rs.270/‐, the loserwill compensate the winner Re.1/‐. (There is a name for such a product – guess?)

• However issue of counterparty credit risk (Lehman Brothers 2008).



DERIVATIVES

•Payoffs

• Let us take a simple example.

•You bought 1 share of Tata Motors on 1st May 2012 @ Rs.232 per share. On 18th

July 2012, Rs.4/‐ dividend per share was paid to you. On 1st May 2013 you soldthe share for Rs.313.45.

•What is the Payoff ?

•Answer : Payoff is the amount you received = 313.45 + 4 = Rs.317.45

•What is the Profit ?

•Answer : Profit = Payoff – Investment = 317.45 – 232 = Rs.85.45



DERIVATIVES

•Payoffs

•Certain Derivatives’

payoffs

mimic

the

underlying

price

movements

–

thus they have linear payoffs – Forwards and Futures

•Others have a discontinuity in their payoffs, hence termed as non‐

linear payoffs ‐ Options



DERIVATIVES•Use

•Risk Management

– allows

transfer

of

risk

•Speculation – Highly leveraged bets

•Reduced Transaction Costs – managing a large portfolio and hedgingusing derivatives

•Arbitrage – bypassing rules while participating in deals like InterestSwaps



DERIVATIVES• FORWARD CONTRACTS

• Relatively simple Derivative

• Agreement to buy or sell an asset at a certain future time for a certain price. Theagreement is binding and both parties are obliged to complete the deal.

•Forward

contracts

are

traded

in

the

OTC

Market.

• 2 parties involved – one assumes a Long Position and agrees to buy the underlying asseton a certain specified future date for a certain agreed specified price. The other partyassumes a Short Position and agrees to sell the asset for the same terms and conditions.

• Very popular in the Foreign Exchange market and in short term Interest rate hedging.Also prevalent in commodities and used by corporates to secure long‐term agreements.



DERIVATIVES•FORWARD CONTRACTS

• As the treasurer of your company, you know that on July 1st 20XX you will be paying outUS$ 5 million to settle an imported item bill. Since your business is based in India,unsettled forex rates may force you to pay more Indian Rupees than originally plannedfor.

• One strategy you may pursue to hedge against the forex risk is by entering into a ForwardContract to buy on July 1st 20XX, US$ 5 Million at a agreed exchange rate of Rs.62 perUS$1.

• You have entered into a Long Forward to buy and the bank/counterparty has enteredinto a Short Forward to sell. Both parties are obliged to complete the deal.

• Entering into Forwards usually cost nothing !!! All you require is a good relationship withthe counterparty and a good credit rating.

• The cost comes up when the contract is completed – if the USDINR rate is 64, you got agood deal but if the USDINR rate is 60, you lost Rs2 per USD.



DERIVATIVES

•FUTURES

• Close relative

of

the

Forward

Contract.

• Exchange based and marked to market.

• They are standardized – in terms of size, quality of underlying (commodities and FIS

products), maturity dates.

• Popular underlying includes Financial assets, commodities.

• One can reverse a trade by entering into an offsetting trade thus allowing loss mitigation.

• Zero cost to enter.

•But

Exchanges

impose

margin

requirements

– initial

and

maintenance

margins.

• Risk : LIQUIDITY (remember 2008).





DERIVATIVES•OPTIONS

• Traded on

both

the

Exchange

as

well

as

the

OTC

market.

• Comes in 2 flavors : Vanilla and Exotics

• Basically 2 types of Vanilla Options

• Call

•Put

• A Call Option is the right to buy a particular asset for an agreed amount at a specifiedtime in the future.

•

A Put Option is the right to sell a particular asset for an agreed amount at a specifiedtime in the future.

• The keyword is Right to Buy/Sell – not an obligation from the holder’s perspective.



DERIVATIVES

•OPTIONS

• The Call

Option

focusses

on

the

upside

with

a capped

loss

risk.

• The Put Option focusses on the downside with a capped loss risk.

•

3

important

players

• Buyer (Long) – the person who buys the right of the option

• Seller (Short) – the person who sells the right of the option

• Writer (Short) – the person who is responsible to fulfill (obliged) if the option rights are

exercised.• Hence Options involve a right‐and‐obligation relationship.



DERIVATIVES

•OPTIONS

• Important terminologies

related

to

Options

• Options are not Costless : Unlike Forwards and Futures, you have to pay a Premium tobuy the contract – hence the capped loss risk. Option Pricing and valuation is all aboutestablishing the ‘true’ Premium.

• Exercise Price : the agreed amount/price the holder of the option will pay to the writerof the option if she/he chooses to exercise the right. Also called the Strike Price.

• Exercise Dates : Can be at the end of the Option’s life (European Option). Can at any timeof the Option’s life (American Option). Can be at selective (agreed) dates (Bermudan

Option).• Payoffs/Profits : Can have a binary outcome (Binary Options), can be based on a singular

value of the underlying or the average price during a selected interval (Asian Options).





DERIVATIVES•What does the payoff profiles of Forwards and Options look like ???

•Returning back

to

the

treasury

example

we

have

the

following

2 choices

to

hedge

the US$5 Million purchase price on July 1st 20XX :

1. Using Forward – quoted rate Rs.62.00

2. Using a European Call Option – Strike (Exercise Price) Rs. 62.00 – premium

Rs.1.50

•

Outcomes – next

slide



DERIVATIVES•The profiles of your choice:



DERIVATIVES•Another example – this time with Short Forward & Put Option.

•You will

be

receiving

US$

5 Million

on

1st July

2013

– you

are

not

sure

of

the

exchange rates and have the following quotes from your bank:

1. Using Forward – quoted rate Rs.62/‐

2. Using a European Put Option – Strike (Exercise Price) Rs. 62.00 – premium Rs.

1.25. ( We will see later that usually Puts are cheaper than Calls – BUT NOTALWAYS)

•Outcomes – next slide



DERIVATIVES•Profit Profile of your choice



DERIVATIVES•To round up

•If S(T)

is

the

Spot

Price

on

date

T and

K is

the

agreed/Strike

Price

•Profit from Long Forward = S(T) – K

•Profit from Short Forward = K – S(T)

•Profit from Long Call = Max(S(T) – K, 0) – Premium

•Profit from Long Put = Max(K – S(T),0) ‐ Premium



DERIVATIVES

•Next Session

– The

world

of

Forwards

•Please read Chapter 1 of JC Hull (6th/7th/8th edition)

Documents

Derivatives - Session 01