A derivative is a financial instrument whose value is dependent on an underlying asset. The main types of derivatives are forwards, futures, options, and swaps. Forwards are customized contracts to buy or sell an asset at a future date at a fixed price. Futures are exchange-traded contracts with standardized terms. Options provide the right but not obligation to buy or sell an asset at a future date at a specified price. Swaps involve exchanging cash flows of two parties over time based on some underlying factors. Derivatives allow for hedging risks and speculating on market movements.

1. Nature of Derivatives
A derivative is an instrument whose value
depends on the values of underlying
instrument.

2. Derivatives
 Forward Contracts:
 Custom made contracts to buy/sell the underlying asset
in the future at a fixed price. Maturity and size of the
contract can be determined individually to almost exactly
hedge the desired position.

3.  Futures Contracts:
 Ready-made contracts to buy/sell foreign exchange in
the future at a specific price.
 Contract’s liquidity is guaranteed by the exchange on
which it is traded.
 Too structured, margin requirements cause cash flow
uncertainty.

4.  Options Contracts:
 Offerthe right, but not the obligation, to buy/sell foreign
exchange in the future at a specified price.
 Allow hedging contingent risks.

5.  Swap Contracts:
 Contractswhich involve two counter parties exchange
over an agreed period, two streams of payments.

6. Forward Contract
 Early Delivery
 Customer receives/requires the foreign currency earlier
than the original contract date.

7.  Extension
 When he informs that he expects to receive/pay at a
later date than the contract date.
 Cancellation
 Customer receives/requires the foreign currency earlier
than the original contract date

8.  Cancellation
 Customer requests the banker to cancel the contract
because he may not receive/pay foreign currency that
was originally supposed to have been received/paid.

9. Early Delivery
 Forward Purchase Contract for the customer/Forward sale for
the banker
 Original: Bank buys forward from market.
 Now: Buys spot and sells forward to square up the buy position
entered earlier.
 Swap charges: If loss is incurred, the same would be received
from the customer. In case of gain the same would be paid.

10. Extension
 Customer requests for extension
 Existing contract is cancelled
 Rebook the forward date

11. Extension
 Forward Purchase Contract
 Original: Bank buys forward
 Now: Banker would sell spot to square the buy position.
 Purchases forward for new due date.
 Cancellation charges: If loss is incurred, the same
would be recovered. If gain, the same would be paid
to the customer.

12. Cancellation
 Thebank shall recover or pay as the case
may be, the difference between the
contracted rate and the rate at which the
cancellation is effected.

13. Early Delivery -Charges
 If loss is incurred, the same would be
recovered from the customer.
 If gain, the same would be paid to the
customer.

14. Options-Types
 Call Option
 Put Option

15. Options -Exercise
 ITM
 ATM
 OTM

16. Options- Styles
 American
 European

17. Option Premium
 Intrinsic Value
 Time Value

18. Option Strategies
 Buy a call
 Market view
 Risks
 Reward
 E.g An oil refiner is concerned that crude oil prices
may rise but he does not want to lock in a firm price
by purchasing a futures contract. The refiner then
buys a crude oil call.

19.  Sell a call
 Market View
 Risks
 Reward

20.  E.g A Fund manager investing in T-bonds wishes to
enhance the yield on her portfolio. She has the view
that market will remain stable or fall slightly over the
next few months. The current T-bond price is $100
and so the manager sells a call a 100 call with a
premium of $4.
 If the option is exercised she has to deliver the T-
bonds from her portfolio.
 If the option is not exercised the premium received
enhances the profits.

21.  Buy a Put
 Market view
 Risks
 Reward

22.  Sell a put
 Market view
 Risks
 Reward

23.  Straddle – Simultaneous buying/selling
options of different types with the same strike
price.

24.  Long Straddle:
 Buy a call and Buy a put with the same strike price.
 Market view: Significant price changes
 Risks: Limited to the premium
 Reward: Call option exercise with unlimited profit
potential, if price rises. Put option exercise with large but
limited profit, if price falls.

25.  E.g.
 Buy 1 March 5.00 Call 0.10
 Buy 1 March 5.00 Put 0.10
 Break-even point: 4.80 or 5.20

26.  Short Straddle:
 Sella call and sell a put with the same strike price.
 Market view: Little or no movement
 Risks: Call option gets exercised, with potential
unlimited loss for the writer.
 Reward: Limited to the premium paid.

27.  Strangle: Simultaneous buying or selling of
options of different types with different strike
prices.

28.  Long Strangle:
 Buy a put with a low strike price and buy a call with high
strike price.
 Market view: Major movement, unknown direction.
 Risks: Limited to the net premium paid.
 Reward: Huge profit potential, if movement is
substantial. Cost of strangle is cheap.

29.  E.g
 Buy 1 March 3.00 Put 0.05
 Buy 1 March 4.00 Call 0.10
 Break-even point: 2.85 or 4.15

30.  Short Strangle:
 Sell a call with a high strike price and sell a put with low
strike price.
 Market view: Little or no movement.
 Risks: Unlimited loss potential
 Reward: Limited to the net premium.

31.  Spread:Simultaneous buying and selling of
options of the same type with different strike
prices.

32.  Bull Call Spread: (Long Call Spread)
 Buy a call with low strike price and Sell a call with high strike
price.
 Market View/Strategy/Advantage/Disadvantage
– Market will rise to a certain level.
– Take advantage of bullish opinion
– Reduce cost by selling a call
– Sacrifice potential unlimited profit
 Risks: Limited to the net premium
 Reward: Limited to the difference between the two strike price
less net premium received.

33.  E.g:
 Buy 1 April 4.00 Call 0.50
 Sell 1 April 4.50 Call 0.30
 Break-even: 4.20
 Maximum Profit: 0.30
 Maximum Loss: 0.20

34.  Bear Put Spread:
 Buy a put with high strike price and Sell a put with low
strike price.
 Market View/Strategy/Advantage/Disadvantage
– Market will fall to a certain level.
– Take advantage of bearish opinion
– Reduce cost by selling a put
– Sacrifice potential large profit

35.  On April 28, you purchased a European call option
on GBP at a strike price of $1.4000 for a premium of
$0.07. The spot rate at the time was 1.4500. The
expiry date is October 16.The amount of underlying
is GBP 62500.
 Compute the premium
 Check whether is ITM/ATM/OTM
 Check the intrinsic value/time value of the option
 On expiry, suppose the spot rate is GBP/USD 1.4800, what is
the net gain/loss?

36.  Premium = $(62500x0.07) = $4375
 Strike price < Current spot = ITM
 Intrinsic value = USD 0.05 per GBP.
 Time value = USD 0.02 per GBP.
 Should exercise the option
 Gross profit = 1.4800-1.4000 = 0.08
 Net Profit = 0.08 – 0.07 = 0.01
 Total profit = 0.01 x 62500 = 625 per option contract.

37.  The current CHF/USD spot is 0.6675. The following 90-day call
options on CHF are available:
 Your view is that CHF is going to make a strong up-move
during the next 90 days. Your risk appetite is moderate. What
strategy is suitable for you?
– STRIKE PREMIUM
 USD per CHF USD per CHF
 0.6000 0.075
 0.6500 0.030
 0.7000 0.010
 0.7500 0.002

38.  A bullish call spread
 Buy a call with strike 0.6000 and sell a call with
0.7000. Net premium is USD 0.07.
 If the CHF moves above 0.67 you will make net gain.
 If CHF is 0.72, purchased call makes a profit of 0.12
and sold call makes a loss of 0.02. Net premium is
0.07
 Profit = 0.12-0.02-0.07 = 0.03

39.  A German firm buys a call option on $100,000 with a
strike price of DEM 1.60/$ and a premium of DEM
0.03/$.The interest opportunity cost is 6% p.a and
maturity is 180 days.
 What is the B.E maturity spot rate beyond which the firm
makes a net gain?
 Suppose the 6-month forward rate at the time the option was
bought was DEM 1.62/$. What is the range of maturity spot
rate for which the option would prove to be better than the
forward cover?

40.  The premium would be DEM 30000 and
interest on it for 180 days would be
DEM 900. Thus per dollar cost of premium
and interest would be DEM 0.0309.
 Since the strike price is DEM 1.60, the
breakeven rate will be DEM 1.6309 per
dollar.

41.  Formaturity spot rate up to DEM (1.6200-
0.0309) = DEM 1.5891, option would
be better than forward. Beyond that forward
would be better.

42.  A French exporter to U.K has 90 day Pound
receivable. He purchases a put option on GBP
250,000 at a strike price of FRF 8.0550/GBP at a
premium of FRF 0.20 per Pound. The current spot
rate is FRF 8.1000/GBP and the 90-day forward is
8.0750. The interest opportunity cost for the firm is
9%p.a.
 Calculate the maximum FRF/GBP rate at the end of 90 days
below which the firm will make a net gain from the Put.
 Calculate the range of maturity spot over which the option
would be better than the forward and vice-versa.

43.  Including interest, the premium cost is FRF
0.205 per pound. Maturity spot must be
below (8.0550-0.2050) = FRF 7.8500 for the
put to make money on a net basis.
 For maturity spot rate above
(8.0750+0.2050) = 8.2800, put is better than
forward; below that forward is better.

44. Futures
 On April 29, you bought a June futures
contract on GBP at price of $1.5450. The
contract size is 62500 GBP, the initial margin
is 5%. On April 30, May 1 and May 2 the
prices closed at 1.5490,1.5460 and 1.5410.
Determine the variation margins and the
balance in your account at the close of April
29,30, May 1 and 2nd.

45.  The initial margin is $0.05(62500x1.5450) =
$4515.62
Cl.Price Gain(Loss) Balance
 April 29
4828.13
 April 30 1.5490 0.0040(62500) 5078.13
 May 1 1.5460 -0.0030(62500) 4890.63
 May 2 1.5410 -0.0050(62500) 4578.13

46. Futures Price Determination
A futures contract on CHF expires 82 days
from today.
 Spot CHF/USD :
0.6050
 Futures price : 0.6565
 82 day Euro dollar interest rate : 5.25%
 Euro CHF rate : 4.50%

47.  Borrow $100
 Repayment = 101.17 (1.17% for 82 days)
 Convert to spot CHF = 165.28
 Invest CHF = 166.67 (1.01% for 82 days)
 Sell CHF futures = 109.42
 Profit = 8.25

48.  Assume the futures price was 0.6060
 Covered interest arbitrage would have been
close to Zero.

49. Futures Price & Spot Price
 Crude oil producers are worried about falling oil
prices. They would like to hedge their risk by selling
futures contract which will fix their delivery prices.
 Purchasers –Crude oil refiners
 Assume Refiners demand fall short of supply.
 Speculators, if they expect a price rise will fill the gap
so that they can make profit

50.  Difference between spot price and futures
price – Basis
 Current futures price > Expected spot price
at maturity – Normal Backwardation
 Current spot price < Current futures price
Contago (Positive Basis)
 Current spot price > Futures price –
Backwardation

51.  On Feb12 you see the following quotes:
 GBP/USD spot : 1.4650
 March GBP futures : 1.4425 June : 1.4250
 Sep : 1.3850 Dec : 1.3550
 You agree with the direction of movement in the GBP/USD rate
implied by these prices but feel that the market is overstating
the extent of likely movement. In particular you feel the market
is overstating the movement between Sep & Dec. You wish to
profit from your view but do not wish to take too much risk. You
feel your view would materialize by early Sep. What should you
do?

52.  GBP will fall by 3 cents between Sep and
Dec.
 Dec contract is underpriced
 Sell Sep at 1.3850 and buy Dec at 1.3550

53.  On Sep 2 the GBP/USD spot is 1.3950, Sep
futures are 1.3940 and Dec futures are
1.3895. Work out gains/losses for the
strategies.

54.  Sep 2 – Square off
 Buy Sep at 1.3940 and Sell Dec at 1.3895
 Loss on the former:
 $(+1.3850-1.3940) = $0.09 per GBP
 Gain on the latter:
 $(-1.3550+1.3895) = $0.0345 per GBP

55.  The current CHF/USD spot is 0.6675. The following 90-day call
options on CHF are available:
 Strike Price Premium
0.6000 0.075
0.6500 0.030
0.6800 0.010
0.7000 0.005
0.7500 0.002
 Your view is that CHF is going to make a strong up-move
during the next 90 days. Your risk appetite is moderate. What
strategy is suitable for you?

56.  Bullish call spread
 Buy a call with strike 0.6000 and sell a call with
0.7000. Net premium is USD 0.07.
 If the CHF moves above 0.67 you will make net gain.
 If CHF is 0.72, purchased call makes a profit of 0.12
and sold call makes a loss of 0.02. Net premium is
0.07
 Profit = 0.12-0.02-0.07 = 0.03
 Max Loss = 0.07 if CHF moves below 0.07

57.  The current $/Yen spot rate is 123. 6 month
European calls with strike $0.0087 and
$0.0083 are trading at premia of 0.015cents
per Yen and 0.02 cents per Yen respectively.
A speculator is expecting a fairly strong
appreciation of yen over the next six months.
What option strategy should he adopt to
profit from this forecast? What is break even
rate?

58.  A limited risk speculative strategy would be the
bullish call spread i.e. buy the call with strike $0.0083
or 0.83 cents per yen and sell the call with strike
$0.0087 or 0.87cent per yen.
 The initial investment would be (0.02-0.015) = 0.005
cent per yen. The breakeven spot rate would be
0.83+0.005 = 0.8350 cent per yen.
 Maximum profit potential would be (0.87-0.83) –
(0.02-0.015) = 0.035 cent per yen.

59.  The current USD/NLG spot rate is 0.5410.The
following 2 month calls and puts are available:
 A speculator expects the USD/NLG rates to hold
fairly steady over the coming quarter with only small
movements around the current spot rate. What
strategy should he adopt to profit from this view if at
the same time he wishes to limit his max loss?

60.  Sell a butterfly spread
 Sell two calls with strike 0.55 and buy one call each
with strike 0.50 and 0.60.
 Profit over the range (0.5000+0.0080) and (0.6000-
0.0080) i.e. 0.5080 and 0.5920.
 Maximum profit will be (0.05-0.008) or 0.0420 and
the maximum loss would be 0.008.