DFO Session 1&2

7/30/2019 DFO Session 1&2

1/24

Derivatives, Futures & Options

Session 1

Rachna Nawhal


2/24

Financial Derivatives

Financial instrument whose price is dependent upon or

derived from the value of underlying assets

The underlying not necessarily has to be an asset. It could beany other random/uncertain event like temperature/weather

.

The most common underlying assets includes: Stock

Bonds

Commodities Currencies

Interest rates


3/24

Derivative Security Derivative securities, more appropriately termed as derivative

contracts, are assets which confer the investors who take

positions in them with certain rights or obligations.

They owe their existence to the presence of a market for an

3

un er y ng asse or por o o o asse s, w c may econsidered as primary securities.

Thus if there was to be no market for the underlying assets,

there would be no derivatives.


4/24

Broad Categories of Derivatives Forward Contracts

Futures Contracts

Options Contracts

Swaps

4


5/24

Definition of a Forward Contract A forward contract is an agreement between two parties that

calls for the delivery of an asset on a specified future date at

a price that is negotiated at the time of entering into thecontract.

Every forward contract has a buyer and a seller.

5

e uyer as an o ga on o pay cas an a e e very on

the future date.

The seller has an obligation to take the cash and make

delivery on the future date.


6/24

Definition of a Futures Contract A futures contract too is a contract that calls for the delivery of

an asset on a specified future date at a price that is fixed at

the outset.

It too imposes an obligation on the buyer to take delivery and

on the seller to make delivery.

6

us s essen a y s m ar o a orwar con rac .


7/24

Forward versus FuturesYet there are key differences between the two types of contracts.

A forward contract is an Over-the-Counter or OTC contract : This

means that the terms of the agreement are negotiated individuallybetween the buyer and the seller.

Futures contracts are however traded on organized futures

exchan es, ust the wa common stocks are traded on stock

7

exchanges. The features of such contracts, like the date and place of delivery,

and the quantity to be delivered per contract, are fixed by the

exchange.

The only job of the potential buyer and seller while negotiating acontract, is to ensure that they agree on the price at which they wish

to transact.


8/24

Options An options contract gives the buyer the right to transact on or

before a future date at a price that is fixed at the outset.

It imposes an obligation on the seller of the contract totransact as per the agreed upon terms, if the buyer of thecontract were to exercise his right.

We have said that an option holder acquires a right to

8

.

There are two possible transactions from an investorsstandpoint purchases and sales.

Consequently there are two types of options Calls and Puts.

A Call Option gives the holder the right to acquire the asset.

A Put Option gives the holder the right to sell the asset. If a call holder were to exercise his right, the seller of the call

would have to make delivery of the asset.


9/24

Options If the holder of a put were to exercise his right, the

seller of the put would have to accept delivery.

We have said that an option holder has the right totransact on or before a certain specified date.

Certain options permit the holder to exercise his

9

right only on a future date. These are known as European Options.

Other types of options permit the holder to exercisehis right at any point in time on or before a specifiedfuture date.

These are known as American Options.


10/24

Rights What is the difference between a Right and an Obligation.

An Obligation is a binding commitment to perform.

A Right however, gives the freedom to perform if desired. It need be exercised only if the holder wishes to do so.

In a transaction to trade an asset at a future date, bothparties cannot be given rights.

10

,transaction when the time comes, it obviously will not be inthe interest of the other.

Consequently while obligations can be imposed on both theparties to the contract, like in the case of a forward or afutures contract, a right can be given to only one of the twoparties.

Hence, while a buyer of an option acquires a right, the sellerhas an obligation to perform imposed on him.


11/24

Longs & Shorts The buyer of a forward, futures, or options contract

is known as the Long.

He is said to have taken a Long Position.

The seller of a forward, futures, or options contract,is known as the Short.

11

He is said to have taken a Short Position. In the case of options, a Short is also known as the

option Writer.


12/24

Comparison of Futures/Forwardsversus Options

InstrumentInstrumentInstrumentInstrument Nature of LongsNature of LongsNature of LongsNature of LongsCommitmentCommitmentCommitmentCommitment

Nature of ShortsNature of ShortsNature of ShortsNature of ShortsCommitmentCommitmentCommitmentCommitment

Forward/Futures Obligation to buy Obligation to sell

12

Contract

Call Options Right to buy Obligation to sell

Put Options Right to sell Obligation to buy


13/24

Swaps A swap is a contractual agreement between two parties to

exchange specified cash flows at pre-defined points in time.

There are two broad categories of swaps Interest Rate

Swaps and Currency Swaps.

13


14/24

Interest Rate Swaps In the case of these contracts, the cash flows being

exchanged, represent interest payments on a specified

principal, which are computed using two different

parameters.

For instance one interest a ment ma be com uted usin a

14

fixed rate of interest, while the other may be based on avariable rate such as LIBOR.


15/24

Interest Rate Swaps (Cont) There are also swaps where both the interest payments are

computed using two different variable rates For instance

one may be based on the LIBOR and the other on the Prime

Rate of a country.

Since both the interest a ments are denominated in the

15

same currency, the actual principal is not exchanged. Consequently the principal is known as a notional principal.

Also, once the interest due from one party to the other is

calculated, only the difference or the net amount isexchanged.


16/24

Currency Swaps These are also known as cross-currency swaps.

In this case the two parties first exchange principal amountsdenominated in two different currencies.

Each party will then compute interest on the amountreceived by it as per a pre-defined yardstick, and exchange it

16

periodically. At the termination of the swap the principal amounts will be

swapped back.

In this case, since the payments being exchanged aredenominated in two different currencies, we can have fixed-floating, floating-floating, as well as fixed-fixed swaps.


17/24

Actors in the Market

There are three broad categories of market participants: Hedgers

Speculators

17

Arbitrageurs


18/24

Hedgers These are people who have already acquired a position in the

spot market prior to entering the derivatives market.

They may have bought the asset underlying the derivatives

contract, in which case they are said to be Long in the spot.

18

market without owning it, in which case they are said to have

a Short position in the spot market.

In either case they are exposed to Price Risk.


19/24

Hedgers (Cont) Price risk is the risk that the price of the asset may move in

an unfavourable direction from their standpoint.

What is adverse depends on whether they are long or short

in the spot market.

19

, .

For a short, rising prices represent an undesirable

movement.

Both longs and shorts can use derivatives to minimize, and

under certain conditions, even eliminate Price Risk.

This is the purpose of hedging.


20/24

Speculators Unlike hedgers who seek to mitigate their exposure to risk,

speculators consciously take on risk.

They are not however gamblers, in the sense that they do not

play the market for the sheer thrill of it.

20

,

position, only if they perceive that the expected return is

commensurate with the risk.

A speculator may either be betting that the market will rise,

or he could be betting that the market will fall.


21/24

Hedgers & Speculators The two categories of investors complement each other.

The market needs both types of players to functionefficiently.

Often if a hedger takes a long position, the corresponding

21

.


22/24

Arbitrageurs These are traders looking to make costless and risk-less profits.

Since derivatives by definition are based on markets for an

underlying asset, it is but obvious that the price of a derivatives

contract must be related to the price of the asset in the spot

market.

22

Arbitrageurs scan the market constantly for discrepancies from therequired pricing relationships.

If they see an opportunity for exploiting a misaligned price

without taking a risk, and after accounting for the opportunity

cost of funds that are required to be deployed, they will seize it

and exploit it to the hilt.


23/24

Arbitrageurs (Cont) Arbitrage activities therefore keep the market efficient.

That is, such activities ensure that prices closely conform totheir values as predicted by economic theory.

Market participants, like brokerage houses and investmentbanks have an advantage when it comes to arbitrage vis a vis

23

individuals. Firstly, they do not typically pay commissions for they can

arrange their own trades.

Secondly, they have ready access to large amounts of capitalat a competitive cost.


24/24

Thank you

24

Documents

DFO Session 1&2