Derivatives A financial contract of pre-determined duration, whose value is derived from the value of an underlying asset Securities commodities bullion precious metals currency livestock index such as interest rates, exchange rates
What do derivatives do?Derivatives attempt either to minimizethe loss arising from adverse pricemovements of the underlying assetOr maximize the profits arising out offavorable price fluctuation. Sincederivatives derive their value from theunderlying asset they are called asderivatives.
Types of Derivatives (UA: Underlying Asset) Based on the underlying assets derivatives are classified into. Financial Derivatives (UA: Fin asset) Commodity Derivatives (UA: gold etc) Index Derivative (BSE sensex)
How are derivatives used?Derivatives are basically risk shiftinginstruments. Hedging is the mostimportant aspect of derivatives and alsotheir basic economic purposeDerivatives can be compared to aninsurance policy. As one pays premium inadvance to an insurance company inprotection against a specific event, thederivative products have a payoffcontingent upon the occurrence of someevent for which he pays premium inadvance.
What is Risk?The concept of risk is simple. It isthe potential for change in the priceor value of some asset orcommodity. The meaning of risk isnot restricted just to the potential forloss. There is upside risk and there isdownside risk as well.
What is a HedgeTo Be cautious or to protect against loss.In financial parlance, hedging is the actof reducing uncertainty about future pricemovements in a commodity, financialsecurity or foreign currency .Thus a hedge is a way of insuring aninvestment against risk.
Forward Contracts.A one to one bipartite contract, which is to beperformed in future at the terms decided today.Eg: Jay and Viru enter into a contract to tradein one stock on Infosys 3 months from todaythe date of the contract @ a price of Rs4675/-Note: Product ,Price ,Quantity & Time havebeen determined in advance by both theparties.Delivery and payments will take place as perthe terms of this contract on the designateddate and place. This is a simple example offorward contract.
Risks in a forward contractLiquidity risk: these contracts abiparty and not traded on theexchange.Default risk/credit risk/counter partyrisk.Say Jay owned one share of Infosysand the price went up to 4750/-three months hence, he profits bydefaulting the contract and sellingthe stock at the market.
Futures.Future contracts are organized/standardizedcontracts in terms of quantity, quality, deliverytime and place for settlement on any date infuture. These contracts are traded onexchanges.These markets are very liquidIn these markets, clearing corporation/housebecomes the counter-party to all the trades orprovides the unconditional guarantee for thesettlement of trades i.e. assumes the financialintegrity of the whole system. In other words,we may say that the credit risk of thetransactions is eliminated by the exchangethrough the clearing corporation/house.
The key elements of a futures contractare:– Futures price– Settlement or Delivery Date– Underlying (infosys stock)
Illustration.Let us once again take the earlierexample where Jay and Viru enteredinto a contract to buy and sell Infosysshares. Now, assume that this contractis taking place through the exchange,traded on the exchange and clearingcorporation/house is the counter-partyto this, it would be called a futurescontract.
Positions in a futures contractLong - this is when a person buys afutures contract, and agrees toreceive delivery at a future date. Eg:Viru’s positionShort - this is when a person sells afutures contract, and agrees to makedelivery. Eg: Jay’s Position
How does one make money in a futures contract?The long makes money when theunderlying assets price rises abovethe futures price.The short makes money when theunderlying asset’s price falls belowthe futures price.Concept of initial marginDegree of Leverage = 1/margin rate.
OptionsAn option is a contract giving thebuyer the right, but not theobligation, to buy or sell anunderlying asset at a specific priceon or before a certain date. An optionis a security, just like a stock or bond,and is a binding contract with strictlydefined terms and properties.
Options LingoUnderlying: This is the specificsecurity / asset on which an optionscontract is based.Option Premium: Premium is theprice paid by the buyer to the sellerto acquire the right to buy or sell. Itis the total cost of an option. It is thedifference between the higher pricepaid for a security and the securitysface amount at issue. The premiumof an option is basically the sum ofthe options intrinsic and time value.
Strike Price or Exercise Price :price ofan option is the specified/ pre-determined price of the underlying assetat which the same can be bought or soldif the option buyer exercises his right tobuy/ sell on or before the expiration day.Expiration date: The date on which theoption expires is known as ExpirationDateExercise: An action by an option holdertaking advantage of a favourable marketsituation .’Trade in’ the option for stock.
Exercise Date: is the date on which theoption is actually exercised.European style of options: TheEuropean kind of option is the one whichcan be exercised by the buyer on theexpiration day only & not anytime beforethat.American style of options: AnAmerican style option is the one whichcan be exercised by the buyer on orbefore the expiration date, i.e. anytimebetween the day of purchase of theoption and the day of its expiry.
Asian style of options: these are in-betweenEuropean and American. An Asian optionspayoff depends on the average price of theunderlying asset over a certain period of time.Option HolderOption seller/ writerCall option: An option contract giving theowner the right to buy a specified amount ofan underlying security at a specified pricewithin a specified time.Put Option: An option contract giving theowner the right to sell a specified amount of anunderlying security at a specified price within aspecified time
In-the-money: For a call option, in-the-money is when the options strikeprice is below the market price of theunderlying stock. For a put option, inthe money is when the strike price isabove the market price of theunderlying stock. In other words, thisis when the stock option is worth moneyand can be turned around and exercisedfor a profit.
– Intrinsic Value: The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.For a call option: Intrinsic Value = SpotPrice - Strike Price For a put option: Intrinsic Value = StrikePrice - Spot Price
Example of an OptionElvis and crocodiles.
PositionsLong Position: The term used when aperson owns a security or commodityand wants to sell. If a person is long ina security then he wants it to go up inprice.Short position: The term used todescribe the selling of a security,commodity, or currency. Theinvestors sales exceed holdingsbecause they believe the price will fall.
Profit/Loss Profile of a Long call Position Profit 0 Price of 100 103 Asset XYZ -3 at Option Price = Rs3 expira Loss tion Strike Price = Rs100 Time to expiration = 1month
Profit /Loss Profile for a Short Call Position Profit +3 Price of the 0 Asset XYZ at 100 103 expiration Initial price of the asset = Rs100 Option price= Rs3 Strike price = Rs100 Loss Time to expiration = 1 month
Profit/Loss Profile for a Long Put Position Profit Price of0 the Asset 98 100 XYZ at expiration-2 Initial price of the asset XYZ = Rs100 Option Price = Rs2 Loss Strike price = Rs100 Time to expiration = 1 month
Profit/Loss Profile for a Short Put Position Profit+2 Price of the Asset 0 XYZ at expiration 94 100 Initial price of the asset XYZ = Rs100 Option Price = Rs2Loss Strike price = Rs100 Time to expiration = 1 month
SummaryThe profit and loss profile for a short putoption is the mirror image of the long putoption. The maximum profit from thisposition is the option price. The theoriticalmaximum loss can be substantial should theprice of the underlying asset fall.Buying calls or selling puts allows investor togain if the price of the underlying asset rises;and selling calls and buying puts allows theinvestors to gain if the price of the underlyingasset falls.
Long CallShort Put Price rises Price FallsLong PutShort Call
Stock Index OptionTrading in options whose underlying instrumentis the stock index.Here if the option is exercised, the exchangeassigned option writer pays cash to the optionsbuyer. There is no delivery of any stock.Dollar Value of the underlying index = Cashindex value * Contract multiple.The contract multiple for the S&P100 is $100.So, for eg, if the cash index value for the S&P is720,then dollar value will be $72,000
For a stock option, the price at which the buyerof the option can buy or sell the stock is thestrike price. For an index option, the strikeindex is the index value at which the buyer ofthe option can buy or sell the underlying stockindex. For Eg: If the strike index is 700 for anS&P index option, the USD value is $70,000. Ifan investor purchases a call option on theS&P100 with a strike of 700, and exercises theoption when the index is 720, then the investorhas the right to purchase the index for $70,000when the USD value of the index is $72000.The buyer of the call option then receive$2000
Binomial Model for Option ValuationCurrent Price of the stock = STwo possible values it can take nextyear :- uS or dS ( uS> dS)Amount B can be borrowed or lent at arate of r. The interest factor (1+r) maybe represented , for sake of simplicity ,as R. d<R<u.Exercise price is E.
Value of a call option, just before expiration,if the stock price goes up to uS is Cu = Max(uS-E,0)Value of a call option, just before expiration,if the stock price goes down to dS is Cd = Max(dS-E,0) The value of the call option is C=^S+B ^ = (Cu-Cd)/ S (u-d) B = uCd-dCu/(u-d)R
Illustration:S=200, u=1.4, d=.9 E=220 r=0.15 R=1.15Cu = Max(uS-E,0) = Max(280-220,0)=60Cd = Max(dS-E,0) = Max(180-220,0)=0^=Cu-Cd/(u-d)S = 60/(1.4-.9)200=0.6B=uCd-dCu/(u-d)R = -0.9(60)/0.5(1.15) = -93.91 (A negative value for B means that funds are borrowed).Thus the portfolio consists of 0.6 of a share plus a borrowing of 93.91( requiring a payment of 93.91(1.15) = 108 after one year. C=^S+B= 0.6*200-93.91 = 26.09
SwapsAn agreement between two parties toexchange one set of cash flows for another.In essence it is a portfolio of forwardcontracts. While a forward contract involvesone exchange at a specific future date, aswap contract entitles multiple exchangesover a period of time. The most popular areinterest rate swaps and currency swaps.
Interest Rate SwapCounter Party Counter Party LIBOR A B Fixed Rate of 12% Rs50,00,00,000.00 – Notional Principle ‘A’ is the fixed rate receiver and variable rate payer. ‘B’ is the variable rate receiver and fixed rate payer.
The only Rupee exchanged between the parties arethe net interest payment, not the notional principleamount.In the given eg A pays LIBOR/2*50crs to B onceevery six months. Say LIBOR=5% then A pays be5%/2*50crs= 1.25crsB pays A 12%/2*50crs=3crsThe value of the swap will fluctuate with marketinterest rates.If interest rates decline fixed rate payer is at aloss, If interest rates rise variable rate payer is at aloss. Conversely if rates rise fixed rate payer profitsand floating rate payer looses.
How Swaps work in real life 10.5%Maruti Fixed BOA LIBOR +3/8% LIBOR +3/8% BOT