Derivatives(2)

8/6/2019 Derivatives(2)

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DerivativesDerivativesA financial contract of pre-determinedA financial contract of pre-determined

duration, whose value is derived from theduration, whose value is derived from thevalue of an underlying assetvalue of an underlying assetSecuritiesSecurities

commoditiescommodities

bullionbullion

currencycurrency


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What do derivatives do?What do derivatives do?

Derivatives attempt either toDerivatives attempt either to minimizeminimize

the lossthe loss arising from adverse pricearising from adverse price

movements of the underlying assetmovements of the underlying asset

OrOr maximize the profitsmaximize the profits arising out ofarising out of

favorable price fluctuation. Sincefavorable price fluctuation. Since

derivatives derive their value from thederivatives derive their value from the

underlying asset they are called asunderlying asset they are called asderivatives.derivatives.


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Types of DerivativesTypes of Derivatives

((UA: Underlying Asset)UA: Underlying Asset)

Based on theBased on the underlying assetsunderlying assetsderivatives are classified into.derivatives are classified into.

Financial Derivatives (UA: Fin asset)Financial Derivatives (UA: Fin asset)

Commodity Derivatives (UA: gold etc)Commodity Derivatives (UA: gold etc)


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How are derivatives used?How are derivatives used?Derivatives are basicallyDerivatives are basically risk shiftingrisk shifting

instruments. Hedging is the mostinstruments. Hedging is the mostimportant aspect of derivatives and alsoimportant aspect of derivatives and alsotheir basic economic purposetheir basic economic purpose

Derivatives can be compared to anDerivatives can be compared to aninsurance policy. As one pays premium ininsurance policy. As one pays premium inadvance to an insurance company inadvance to an insurance company inprotection against a specific event, theprotection against a specific event, the

derivative products have a payoffderivative products have a payoffcontingent upon the occurrence of somecontingent upon the occurrence of someevent for which he pays premium inevent for which he pays premium inadvance.advance.


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What is Risk?What is Risk?

The concept of risk is simple. It isThe concept of risk is simple. It is

the potential for change in the pricethe potential for change in the price

or value of some asset oror value of some asset or

commodity. The meaning of risk iscommodity. The meaning of risk is

not restricted just to the potential fornot restricted just to the potential for

loss. There is upside risk and there isloss. There is upside risk and there is

downside risk as well.downside risk as well.


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What is aWhat is a HedgeHedge

To Be cautious or to protect against loss.To Be cautious or to protect against loss.

In financial parlance, hedging is the actIn financial parlance, hedging is the act

of reducing uncertainty about future priceof reducing uncertainty about future price

movements in a commodity, financialmovements in a commodity, financial

security or foreign currencysecurity or foreign currency ..

Thus a hedge is a way of insuring anThus a hedge is a way of insuring an

investment against risk.investment against risk.


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Derivative Instruments.Derivative Instruments.Forward contractsForward contracts

FuturesFutures CommodityCommodity

Financial (Stock index, interest rate &Financial (Stock index, interest rate &

currency )currency )OptionsOptions

PutPut

CallCallSwaps.Swaps.

Interest RateInterest Rate

CurrencyCurrency


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Forward Contracts.Forward Contracts.A one to one bipartite contract, which is to beA one to one bipartite contract, which is to be

performed in future at the terms decided today.performed in future at the terms decided today.

Eg: Jay and Viru enter into a contract to tradeEg: Jay and Viru enter into a contract to trade

in one stock on Infosys 3 months from todayin one stock on Infosys 3 months from today

the date of the contract @ a price of Rs4675/-the date of the contract @ a price of Rs4675/-

Note: Product ,Price ,Quantity & Time haveNote: Product ,Price ,Quantity & Time havebeen determined in advance by both thebeen determined in advance by both the

parties.parties.

Delivery and payments will take place as perDelivery and payments will take place as perthe terms of this contract on the designatedthe terms of this contract on the designated

date and place. This is a simple example ofdate and place. This is a simple example of

forward contract.forward contract.


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Risks in a forward contractRisks in a forward contract

Liquidity risk: these contracts aLiquidity risk: these contracts a

biparty and not traded on thebiparty and not traded on theexchange.exchange.

Default risk/credit risk/counter partyDefault risk/credit risk/counter party

risk.risk.Say Jay owned one share of InfosysSay Jay owned one share of Infosys

and the price went up to 4750/-and the price went up to 4750/-

three months hence, he profits bythree months hence, he profits bydefaulting the contract and sellingdefaulting the contract and selling

the stock at the market.the stock at the market.


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Futures.Futures.

Future contracts are organized/standardizedFuture contracts are organized/standardized

contracts in terms of quantity, quality, deliverycontracts in terms of quantity, quality, deliverytime and place for settlement on any date intime and place for settlement on any date infuture. These contracts are traded onfuture. These contracts are traded onexchangesexchanges..

These markets are very liquidThese markets are very liquidIn these markets, clearing corporation/houseIn these markets, clearing corporation/housebecomes the counter-party to all the trades orbecomes the counter-party to all the trades orprovides the unconditional guarantee for theprovides the unconditional guarantee for the

settlement of trades i.e. assumes the financialsettlement of trades i.e. assumes the financialintegrity of the whole system. In other words,integrity of the whole system. In other words,we may say that the credit risk of thewe may say that the credit risk of thetransactions is eliminated by the exchangetransactions is eliminated by the exchange

through the clearing corporation/house.through the clearing corporation/house.


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The key elements of a futures contractThe key elements of a futures contract

are:are:

Futures priceFutures price

Settlement or Delivery DateSettlement or Delivery Date

Underlying (infosys stock)Underlying (infosys stock)


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Illustration.Illustration.

Let us once again take the earlierLet us once again take the earlierexample where Jay and Viru enteredexample where Jay and Viru entered

into a contract to buy and sell Infosysinto a contract to buy and sell Infosys

shares. Now, assume that this contractshares. Now, assume that this contract

is taking place through the exchange,is taking place through the exchange,

traded on the exchange and clearingtraded on the exchange and clearing

corporation/house is the counter-partycorporation/house is the counter-party

to this, it would be called a futuresto this, it would be called a futurescontract.contract.


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Positions in a futures contractPositions in a futures contract

LongLong - this is when a person buys a- this is when a person buys a

futures contract, and agrees tofutures contract, and agrees to

receive delivery at a future date. Eg:receive delivery at a future date. Eg:

Virus positionVirus position

ShortShort - this is when a person sells a- this is when a person sells a

futures contract, and agrees to makefutures contract, and agrees to make

delivery. Eg: Jays Positiondelivery. Eg: Jays Position


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How does one make money in aHow does one make money in a

futures contract?futures contract?

The long makes money when theThe long makes money when theunderlying assets price rises aboveunderlying assets price rises above

the futures price.the futures price.

The short makes money when theThe short makes money when theunderlying assets price falls belowunderlying assets price falls below

the futures price.the futures price.

Concept of initial marginConcept of initial marginDegree of Leverage = 1/margin rate.Degree of Leverage = 1/margin rate.


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OptionsOptionsAn option isAn option is a contract giving thea contract giving the

buyer the right, but not thebuyer the right, but not theobligation, to buy or sell anobligation, to buy or sell an

underlying asset at a specific priceunderlying asset at a specific price

on or before a certain dateon or before a certain date. An option. An optionis a security, just like a stock or bond,is a security, just like a stock or bond,

and is a binding contract with strictlyand is a binding contract with strictly

defined terms and properties.defined terms and properties.


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Options LingoOptions Lingo

Underlying:Underlying: This is the specificThis is the specific

security / asset on which an optionssecurity / asset on which an optionscontract is based.contract is based.

Option Premium:Option Premium: Premium is thePremium is the

price paid by the buyer to the sellerprice paid by the buyer to the sellerto acquire the right to buy or sell. Itto acquire the right to buy or sell. Itis the total cost of an option. It is theis the total cost of an option. It is thedifference between the higher pricedifference between the higher price

paid for a security and the security'spaid for a security and the security'sface amount at issue. The premiumface amount at issue. The premiumof an option is basically the sum ofof an option is basically the sum ofthe option's intrinsic and time value.the option's intrinsic and time value.


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Strike Price or Exercise PriceStrike Price or Exercise Price ::price ofprice of

an option is the specified/ pre-an option is the specified/ pre-

determined price of the underlying assetdetermined price of the underlying assetat which the same can be bought or soldat which the same can be bought or sold

if the option buyer exercises his right toif the option buyer exercises his right to

buy/ sell on or before the expiration day.buy/ sell on or before the expiration day.Expiration dateExpiration date:: The date on which theThe date on which the

option expires is known as Expirationoption expires is known as Expiration

DateDate

Exercise:Exercise: An action by an option holderAn action by an option holder

taking advantage of a favourable markettaking advantage of a favourable market

situationsituation .Trade in the option for stock..Trade in the option for stock.


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Exercise Date:Exercise Date: is the date on which theis the date on which theoption is actually exercisedoption is actually exercised..

European style of options:European style of options: TheTheEuropean kind of option is the one whichEuropean kind of option is the one whichcan be exercised by the buyer on thecan be exercised by the buyer on theexpiration day only & not anytime beforeexpiration day only & not anytime before

that.that.American style of options:American style of options: AnAnAmerican style option is the one whichAmerican style option is the one which

can be exercised by the buyer on orcan be exercised by the buyer on orbefore the expiration date, i.e. anytimebefore the expiration date, i.e. anytimebetween the day of purchase of thebetween the day of purchase of theoption and the day of its expiry.option and the day of its expiry.

A i l f i h i b


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Asian style of optionsAsian style of options: these are in-between: these are in-between

European and American. An Asian option's payoffEuropean and American. An Asian option's payoff

depends on the average price of the underlyingdepends on the average price of the underlying

asset over a certain period of time.asset over a certain period of time.Option HolderOption Holder

Option seller/ writerOption seller/ writer

Call optionCall option: An option contract giving the owner: An option contract giving the owner

thethe right to buyright to buy a specified amount of ana specified amount of anunderlying security at a specified price within aunderlying security at a specified price within a

specified time.specified time.

Put OptionPut Option: An option contract giving the owner: An option contract giving the owner

the right to sell a specified amount of anthe right to sell a specified amount of an

underlying security at a specified price within aunderlying security at a specified price within a

specified timespecified time

h ll


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In-the-money:In-the-money: For a call option, in-For a call option, in-

the-money is when the option's strikethe-money is when the option's strike

price is below the market price of theprice is below the market price of the

underlying stock. For a put option, inunderlying stock. For a put option, inthe money is when the strike price isthe money is when the strike price is

above the market price of theabove the market price of the

underlying stock. In other words, thisunderlying stock. In other words, thisis when the stock option is worth moneyis when the stock option is worth money

and can be turned around and exercisedand can be turned around and exercised

for a profit.for a profit.

i i lI t i i V l h l fTh i t i i l f


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Intrinsic Value:Intrinsic Value: The intrinsic value of anThe intrinsic value of an

option is defined as the amount by which anoption is defined as the amount by which an

option is in-the-money, or the immediateoption is in-the-money, or the immediate

exercise value of the option when theexercise value of the option when theunderlying position is marked-to-market.underlying position is marked-to-market.

For a call option: Intrinsic Value = SpotFor a call option: Intrinsic Value = SpotPrice - Strike PricePrice - Strike Price

For a put option: Intrinsic Value = StrikeFor a put option: Intrinsic Value = StrikePrice - Spot PricePrice - Spot Price


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Example of an OptionExample of an Option

Elvis and crocodiles.Elvis and crocodiles.


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PositionsPositionsLong Position:Long Position: The term used when aThe term used when a

person owns a security or commodityperson owns a security or commodityand wants to sell.and wants to sell. If a person is long inIf a person is long in

a security then he wants it to go up ina security then he wants it to go up in

price.price.Short positionShort position: The term used to: The term used to

describe the selling of a security,describe the selling of a security,

commodity, or currency. Thecommodity, or currency. Theinvestor's sales exceed holdingsinvestor's sales exceed holdings

because they believe the price will fall.because they believe the price will fall.


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Profit/Loss Profile of aProfit/Loss Profile of a LongLong callcallPositionPosition

0

-3

100 103

Profit

Loss

Price ofAsset

XYZatexpiratio

n

Option Price = Rs3

Strike Price = Rs100

Time to expiration =

Profit /Loss Profile for a Short CallProfit /Loss Profile for a Short Call


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Profit /Loss Profile for a Short CallProfit /Loss Profile for a Short Call

PositionPosition

100 103

0

Profit

Loss

Price oftheAssetXYZ atexpiration

+3

Initial price of the asset =Rs100Option price= Rs3

Strike price = Rs100Time to ex iration = 1


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Profit/LossProfit/Loss

Profile for a Long Put PositionProfile for a Long Put Position

0

-2

98 100

Price oftheAssetXYZ atexpiration

Profit

Loss

Initial price of the asset XYZ =Rs100

Option Price = Rs2

Strike price = Rs100


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SummarySummary


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SummarySummaryThe profit and loss profile for a short putThe profit and loss profile for a short put

option is the mirror image of the long putoption is the mirror image of the long put

option. The maximum profit from thisoption. The maximum profit from thisposition is the option price. The theoriticalposition is the option price. The theoritical

maximum loss can be substantial shouldmaximum loss can be substantial should

the price of the underlying asset fall.the price of the underlying asset fall.Buying calls or selling puts allows investorBuying calls or selling puts allows investor

to gain if the price of the underlying assetto gain if the price of the underlying asset

rises; and selling calls and buying putsrises; and selling calls and buying puts

allows the investors to gain if the price ofallows the investors to gain if the price ofthe underlying asset falls.the underlying asset falls.


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Long Call

Short Put

Long Put

Short Call

Price rises

Price Falls


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Stock Index OptionStock Index OptionTrading in options whose underlyingTrading in options whose underlying

instrument is the stock index.instrument is the stock index.Here if the option is exercised, theHere if the option is exercised, the

exchange assigned option writer paysexchange assigned option writer pays

cash to the options buyer. There is nocash to the options buyer. There is nodelivery of any stock.delivery of any stock.

Dollar Value of the underlying index =Dollar Value of the underlying index =

Cash index value * Contract multiple.Cash index value * Contract multiple.

The contract multiple for the S&P100 isThe contract multiple for the S&P100 is

$100. So, for eg, if the cash index$100. So, for eg, if the cash index

value for the S&P is 720,then dollarvalue for the S&P is 720,then dollar

value will be $72,000value will be $72,000

For a stock option the price at which the buyer ofFor a stock option the price at which the buyer of


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For a stock option, the price at which the buyer ofFor a stock option, the price at which the buyer ofthe option can buy or sell the stock is the strikethe option can buy or sell the stock is the strikeprice. For an index option, the strike index is theprice. For an index option, the strike index is theindex value at which the buyer of the option canindex value at which the buyer of the option can

buy or sell the underlying stock index.buy or sell the underlying stock index. For Eg:For Eg: IfIfthe strike index is 700 for an S&P index option, thethe strike index is 700 for an S&P index option, theUSD value is $70,000. If an investor purchases a callUSD value is $70,000. If an investor purchases a calloption on the S&P100 with a strike of 700, andoption on the S&P100 with a strike of 700, andexercises the option when the index is 720, then theexercises the option when the index is 720, then theinvestor has the right to purchase the index forinvestor has the right to purchase the index for$70,000 when the USD value of the index is$70,000 when the USD value of the index is$72000. The buyer of the call option then$72000. The buyer of the call option thenreceive$2000 from the option writer.receive$2000 from the option writer.

Binomial Model for OptionBinomial Model for Option


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Binomial Model for OptionBinomial Model for Option

ValuationValuation

Current Price of the stock = SCurrent Price of the stock = STwo possible values it can take nextTwo possible values it can take next

year :- uS or dS ( uS> dS)year :- uS or dS ( uS> dS)

Amount B can be borrowed or lent at aAmount B can be borrowed or lent at arate of r. The interest factor (1+r) mayrate of r. The interest factor (1+r) may

be represented , for sake of simplicity ,be represented , for sake of simplicity ,

as R.as R.d


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Value of a call option, just before expiration, ifValue of a call option, just before expiration, if

the stock price goes up to uS isthe stock price goes up to uS is

Cu = Max(uS-E,0)Cu = Max(uS-E,0)

Value of a call option, just before expiration, ifValue of a call option, just before expiration, ifthe stock price goes down to dS isthe stock price goes down to dS is

Cd = Max(dS-E,0)Cd = Max(dS-E,0)

The value of the call option isThe value of the call option is

C=^S+BC=^S+B

^ = (Cu-Cd)/ S (u-d)^ = (Cu-Cd)/ S (u-d)

B = uCd-dCu/(u-d)RB = uCd-dCu/(u-d)R

Illustration:Illustration:


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Illustration:Illustration:

S=200, u=1.4, d=.9 E=220 r=0.15 R=1.15S=200, u=1.4, d=.9 E=220 r=0.15 R=1.15

Cu = Max(uS-E,0)Cu = Max(uS-E,0) = Max(280-220,0)=60= Max(280-220,0)=60

Cd = Max(dS-E,0)Cd = Max(dS-E,0) = Max(180-220,0)=0= Max(180-220,0)=0

^=Cu-Cd/(u-d)S^=Cu-Cd/(u-d)S = 60/(1.4-.9)200== 60/(1.4-.9)200=0.60.6

B=uCd-dCu/(u-d)RB=uCd-dCu/(u-d)R = -0.9(60)/0.5(1.15) == -0.9(60)/0.5(1.15) =

-93.91-93.91 (A negative value for B means that(A negative value for B means thatfunds are borrowed).funds are borrowed).

Thus the portfolio consists of 0.6 of a share plusThus the portfolio consists of 0.6 of a share plus

a borrowing of 93.91( requiring a payment ofa borrowing of 93.91( requiring a payment of

93.91(1.15) = 108 after one year.93.91(1.15) = 108 after one year.

C=^S+B= 0.6*200-93.91 = 26.09C=^S+B= 0.6*200-93.91 = 26.09


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SwapsSwaps

An agreement between two parties toAn agreement between two parties toexchange one set of cash flows forexchange one set of cash flows for

another. In essence it is a portfolio ofanother. In essence it is a portfolio of

forward contracts. While a forwardforward contracts. While a forward

contract involves one exchange at acontract involves one exchange at aspecific future date, a swap contractspecific future date, a swap contract

entitles multiple exchanges over aentitles multiple exchanges over a

period of time. The most popular areperiod of time. The most popular areinterest rate swaps and currencyinterest rate swaps and currency

swaps.swaps.


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Interest Rate SwapInterest Rate Swap

A B

Fixed Rate of12%

LIBOR

A is the fixed rate receiver andvariable rate payer.

B is the variable rate receiver and

Rs50,00,00,000.00 Notional Principle

CounterParty

Counter Party

The only Rupee exchanged between theThe only Rupee exchanged between the


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The only Rupee exchanged between theThe only Rupee exchanged between the

parties are the net interest payment, notparties are the net interest payment, not

the notional principle amount.the notional principle amount.

In the given eg A pays LIBOR/2*50crs to BIn the given eg A pays LIBOR/2*50crs to Bonce every six months. Say LIBOR=5% thenonce every six months. Say LIBOR=5% then

A pays be 5%/2*50crs= 1.25crsA pays be 5%/2*50crs= 1.25crs

B pays A 12%/2*50crs=3crsB pays A 12%/2*50crs=3crsThe value of the swap will fluctuate withThe value of the swap will fluctuate with

market interest rates.market interest rates.

If interestIf interest rates declinerates declinefixed rate payerfixed rate payeris at ais at a lossloss, If interest, If interest rates riserates risevariablevariable

rate payerrate payer is at ais at a lossloss. Conversely if rates. Conversely if rates

rise fixed rate payer profits and floatingrise fixed rate payer profits and floating

rate payer looses.rate payer looses.


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How Swaps work in real lifeHow Swaps work in real life

Maruti BOA

BOT

LIBOR +3/8%

10.5%Fixed

LIBOR +3/8%

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Derivatives(2)