An Introduction to Derivatives

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A basic knowledge about derivatives and its role in financial world

A basic knowledge about derivatives and its role in financial world

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  • 1. All About Derivatives Presented by: Anup Chakraborty #9811222713 anupchakraborty@hotmail.com
  • 2. What are Derivatives Derivatives are financial instruments whose value depend on the value of other, more basic underlying assets. Underlying asset can be a commodity, currency, equity, interest rate, exchange rate etc.
  • 3. Derivative Products Convertibles Warrants GDR’s and ADR’s Mutual Fund Units Real estate units Exchangeables Forward Futures Options
  • 4. Forward Contracts A forward contract is a particularly simple derivative. It is an agreement to buy or sell an asset at a certain future time for a certain price. The contract is negotiated privately usually between two parties. The quality and quantity of the asset is not standardized. The time and place of delivery is not standard. The parties to the contract assumes counter party risk. It is normally not traded on the exchanges.
  • 5. Futures Contract Every futures contract is a forward contract. Futures contracts: are entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades. are of standard quantity, standard quality. have standard delivery time and place.
  • 6. The Global derivatives Industry 1874 commodity futures 1972 currency futures 1973 equity options 1981 currency swaps 1982 Index futures, interest rate swaps, currency options 1983 Option on index, option on futures
  • 7. Introduction to futures Choice of initial product: Index futures Options on index Stock futures Options on stocks
  • 8. Introduction to futures Trading mechanism Contract design: Multiplier Contract size Tick size Expiration month and date Open interest, volume position
  • 9. Futures – definition A futures is a legally binding agreement to buy or sell something in the future at a price which is determined today. Pricing Futures = Spot+Cost of carry –dividend (if any)
  • 10. Operational Mechanism Cash settled Initial Margin (upfront) Mark-to-Market margin (daily)
  • 11. Salient Features of Futures Market Concept of basis: Can be both +ve or -ve. Basis may change its sign several times during the life of the contract. Turns to 0 at maturity. [Both cash and futures prices converge at maturity] B A S I S Life of the contract Maturity
  • 12. Economic Payoff for Futures Contracts -25 -20 -15 -10 -5 0 5 10 15 20 25 80 82 84 86 88 90 92 94 96 98 100 102 104 106 108 110 112 114 116 118 120 Asset Price Gain/Loss
  • 13. Option - definition option is the right given by the option seller to the option buyer to buy or sell specific asset at a specific price on or before a specific date.
  • 14. How much does an option cost? The premium is the price you pay for the option. For buyer of an option Risk : limited to the amount of premium paid Profit potential: unlimited
  • 15. Option Terminology Call Option Option to buy Put Option Option to sell Option Buyer has the right but not the obligation Option Writer/Seller has the obligation but not the right
  • 16. Option Terminology Option Premium Price paid by the buyer to acquire the right Strike Price OR Exercise Price Price at which the underlying may be purchased Expiration Date Last date for exercising the option Exercise Date Date on which the option is actually exercised
  • 17. Types of Options American Option (options on stocks) can be exercised any time on or before the expiration date European Option (options on index) can be exercised only on the expiration date (options on index)
  • 18. Call option A buyer of call option has the right but not the obligation to buy the underlying at the set price by paying the premium upfront. He can exercise his option on or before expiry.
  • 19. Break-even (Call option) Call= strike +premium +fees There are two ways you can liquidate your position. exercise your option sell back the same option contract you purchased.
  • 20. Call Buyer V/s Seller Call Buyer Pays premium Has right to exercise resulting in a long position in the underlying Time works against buyer Call Seller Collects premium Has obligation if assigned resulting in a short position in the underlying Time works in favor of seller
  • 21. Economic Payoff for Call Option -20 -15 -10 -5 0 5 10 15 20 80 82 84 86 88 90 92 94 96 98 100 102 104 106 108 110 112 114 116 118 120 Asset Price Gain/Loss Buy Call Sell Call
  • 22. Put option A buyer of Put option has the right but not the obligation to sell the underlying at the set price by paying the premium upfront. He can exercise his option on or before expiry.
  • 23. Break-even (Put option) Put= strike -premium -fees There are two ways you can liquidate your position. exercise your option sell back the same option contract you purchased.
  • 24. Put Buyer V/s Seller Put Buyer Pays premium Has right to exercise resulting in a short position in the underlying Time works against buyer Put Seller Collects premium Has obligation if assigned resulting in a long position in the underlying Time works in favor of seller
  • 25. Economic Payoff for Put Option -20 -15 -10 -5 0 5 10 15 20 80 82 84 86 88 90 92 94 96 98 100 102 104 106 108 110 112 114 116 118 120 Asset Price Gain/Loss Buy Put Sell Put
  • 26. Assignment • When holder of an option exercises the right, a randomly selected option seller is obligated to be assigned into the underlying contract.
  • 27. Option Valuation Option Premium = Intrinsic Value + Time Value Option Premium >= 0 Intrinsic Value >= 0 Time Value >= 0
  • 28. Option Valuation Intrinsic Value Difference between Exercise Price and Spot Price Cannot be negative For a Call Option St - K For a Put Option K - St St = Spot price at time t
  • 29. Time Value Amount buyers are willing to pay for the possibility that, at some time prior to expiration, the option may become profitable Cannot be negative An at-the-money option has the maximum time value of any strike price, i.e. more time value than either an in or out-of-the-money option.
  • 30. Strike Prices In-the-money Option with intrinsic value At-the-money Exercise Price = Market Price Out-of-the-money No intrinsic value some time value possible
  • 31. Factors affecting option values Current Price of the underlying asset (S) Exercise Price of the option(K) Interest Rates (Rf) Time to Expiry (T) Volatility of prices of the underlying asset (σ)
  • 32. Effect of an increase in each pricing factor on the option value, holding other factor constant Sr. No. Pricing factor Call option Put option 1 Current Asset price(St) Increase decrease 2 Strike price decrease Increase 3 volatility Increase Increase 4 Time to expiration Increase Increase 5 Interest rate Increase decrease
  • 33. Option pricing models Black-Scholes Model Pce=S*N(d1)-Ke-Rf.t *N(d2) Normal distribution function Binomial Model Pce=Ke-Rf.t *N(-d2)- S*N(-d1) Binomial distribution Function
  • 34. Option Greeks Measuring Option Price Sensitivity
  • 35. Option Greeks Option Greeks are mathematical outputs from an Option Valuation Model which help you to understand the possible future movement in Option Values based on various underlying parameters. Greeks help you in possible predictions of Option Values and help you to fine tune your buy sell hedge decisions much better. Greeks used- Delta, Gamma, Vega, Theta and Rho.
  • 36. Delta (∆) Delta stands for the change in the Option Value for a given change in the price of Shares. For example, if the Delta of a Call Option is 0.65, the meaning is: If the share price moves up by Re 1.00, the Call Option will rise up by Rs 0.65.
  • 37. Delta (∆) Bullish Positions Long futures Long call Short put Have positive (+) deltas Bearish Positions Short futures Short call Long put Have negative (-) deltas
  • 38. Delta Neutral Position The construction of a strategy where the total delta position on the long side and total delta position on the short side are equal (or approximately offsetting). Example: Sell 1 Futures Contract (Delta = 1.0) and Buy 2 At-the-money Calls (Delta = 2* (-0.5), delta of the position is 0.0
  • 39. Gamma (γ) Gamma stands for the change in Delta itself for a given change in the share price. Technically, it is called a second order derivative.
  • 40. Gamma (γ) Positive Gamma Position Long Calls Long Puts Negative Gamma Position Short Calls Short Puts (Delta)+(Gamma)=(New Delta) for incremental increase in the underlying (Delta)-(Gamma)=(New Delta) for incremental decrease in the underlying
  • 41. Vega (κ) Derivative of the option pricing formula with reference to the volatility of the asset returns (σ) Measures the estimated change in the option premium for a change in σ.
  • 42. Vega (κ) Vega indicates impact of Volatility For example: if Vega is 0.09, the meaning is that the Option Value will rise by Rs 0.09 for an increase of 1% in Volatility. If the current Volatility of Satyam is 35% and the Value of an Option is Rs 11, the implication is that were the Volatility to move up to 36%, the Option Value would rise to Rs 11.09.
  • 43. Vega (κ) Positive Vega Position Long Calls Long Puts Negative Vega Position Short Calls Short Puts
  • 44. Vega (κ) Original Option Premium + Vega = New Option Premium for 1% increase in Implied Volatility Original Option Premium - Vega = New Option Premium for 1% decrease in Implied Volatility
  • 45. Theta (τ) Theta determines precisely how much the value of the Option will decrease by passage of time(T). For example, if the Theta of an Option is –0.17, this means the value of this Option will decrease by Rs 0.17 on passage of one day.
  • 46. Rho (ρ) Derivative of the option pricing formula with reference to the risk free rate of interest (Rf) Measures the estimated change in the option premium for a change in Rf.
  • 47. Position Delta Gamma Vega Theta Long future +ve 0 0 0 Short future -ve 0 0 0 Long call +ve +ve +ve -ve Short call -ve -ve -ve +ve Long put -ve +ve +ve -ve Short put +ve -ve -ve +ve
  • 48. Trading Strategies
  • 49. Key Points • Options can be a very effective tool to take advantage of a rising or falling underlying. The following points may be kept in mind while purchasing options: • The time value of option premiums decay towards expiration, so market timing is very important. • Choose an option month that allows enough time for the anticipated move in the underlying. • In-the-money calls are initially more responsive to underlying price changes than out-of-the-money calls. • Choose a strike price level that offers a good risk/reward ratio given the expected price movement.
  • 50. Vertical Spreads • Buying a call (put) and selling a call (put) with different strike prices but the same expiration month. • Two types of vertical spreads • Bull Spreads • Bear Spreads
  • 51. Debit / Credit Spreads Debit Spreads entail a net pay-out of option premium Credit Spreads entail a net collect of option premium
  • 52. Bear Vertical Spreads Bear Call Spread (Credit Spread) Bear Put Spread (Debit Spread) Bear Spreads have a negative delta and consist of: Buying the higher strike call (put) Selling the lower strike call (put)
  • 53. Economic Payoff of Bear Spread -200 -150 -100 -50 0 50 100 150 200 3000 3100 3200 3300 3400 3500 3600 3700 3800 3900 4000 4100 4200 4300 4400 4500 4600 4700 4800 4900 5000 Sensex Level Profit/Loss
  • 54. Bear Vertical Spreads Maximum loss occurs above upper strike price Maximum profit occurs below lower strike price Breakeven level equals: Lower strike plus credit (call spread) Upper strike minus debit (put spread) Have net negative delta, that is, benefit from a decline in market price levels.
  • 55. Bull Vertical Spreads Bull Call Spread (Debit Spread) Bull Put Spread (Credit Spread) Bear Spreads have a positive delta and consist of: Buying the lower strike price call (put) Selling the higher strike price call (put)
  • 56. Economic Pay off for Bull Spread -150 -100 -50 0 50 100 150 Sensex level Profit/Loss
  • 57. Bull Vertical Spreads Maximum loss occurs below lower strike price Maximum profit occurs above upper strike price Breakeven level equals: Lower strike plus debit (call spread) Upper strike minus credit (put spread) Have net positive delta, that is, benefit from an increase in market price levels.
  • 58. Option Straddles Consist of buying a put and buying a call (Long Straddle). Both legs have the same strike price and same expiration; OR Consist of selling a put and selling a call (Short Straddle). Both legs have the same strike price and same expiration.
  • 59. Long Straddles Maximum loss is equal to net debit, or total premium paid Maximum profit is unlimited Breakeven levels are equal to: common strike price plus or minus net debit Net delta is approximately zero when strike price is at-the-money
  • 60. Economic Pay off for Long Staddle -400 -200 0 200 400 600 800 3200 3400 3600 3800 4000 4200 4400 4600 4800 5000 Sensex level Profit/Loss
  • 61. Short Straddles Maximum profit is equal to net credit Maximum loss is unlimited Breakeven levels are equal to: common strike price plus or minus net credit Net delta is approximately zero when strike price is at-the-money
  • 62. Economic Pay-off for Short Straddle -800 -700 -600 -500 -400 -300 -200 -100 0 100 200 300 3200 3300 3400 3500 3600 3700 3800 3900 4000 4100 4200 4300 4400 4500 4600 4700 4800 4900 5000 Sensex Levels Profit/(Loss)
  • 63. Option Strangles Consist of buying a put and buying a call (Long Strangle) with the put strike lower than the call strike, and both option legs have the same expiration; OR Consist of selling a put and selling a call (Short Strangle) with the put strike lower than the call strike, and both options legs have the same expiration
  • 64. Long Strangles Maximum loss is equal to net debit, or total premium paid Maximum profit is unlimited Breakeven levels are equal to: put strike minus net debit call strike plus net debit Net delta is approximately zero when strikes are equi-distant from current underlying price
  • 65. Economic Pay off for Long Strangle -200 -100 0 100 200 300 400 500 600 Sensex level Profit/Loss
  • 66. Short Strangles Maximum profit is equal to net credit Maximum is loss unlimited Breakeven levels are equal to: put strike minus net credit call strike plus net credit Net delta is approximately zero when strikes are equi-distant from current underlying price
  • 67. Economic Pay off for Short Strangle -600 -400 -200 0 200 Sensex level Profit/Loss
  • 68. Long Butterfly Consist of buying a call option with low strike (3600) and selling 2 call options with medium strike (4000) and buying one more call option with high strike (4400) price. The same position can be created with puts, but it is less common.
  • 69. Long Butterfly Maximum profit is limited and equal to the difference between the lower and middle strikes minus the net initial debit ( -400 + 2*105 - 10 = -200 ) of establishing the spread. Maximum loss is limited to the net initial debit of establishing the spread.
  • 70. Economic Pay off for Long Butterfly -300 -200 -100 0 100 200 300 Sensex level Profit/Loss
  • 71. Short Butterfly Consist of selling a call option with low strike (3600) and buying 2 call options with medium strike (4000) and selling one more call option with high strike (4400) price. The same position can be created with puts, but it is less common.
  • 72. Short Butterfly Maximum profit is equal to the net credit of the establishing the spread. Maximum loss is limited to the difference between the lower and middle strikes minus the net initial credit (+400 - 2*105 + 10 = 200 )
  • 73. Economic Pay off for Short Butterfly -300 -200 -100 0 100 200 300 Sensex level Profit/Loss
  • 74. Horizontal Spread Horizontal Spread is a spread in which two legs of the spread have different expiration date but the same strike prices. This spread may also be called as time spread or calendar spread.
  • 75. Diagonal spread Diagonal Spread is a spread in which two legs of the spread have different strike prices and different expiration date. It has a features of both vertical and horizontal spreads and so may be called a hybrid product.
  • 76. Thank You