Derivatives 120821000932 Phpapp02

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Derivatives

Management


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UNIT 1 INTRODUCTION

Derivatives definition types forwardcontracts Options swaps difference

between cash and future markets typesof traders OTC and Exchange TradersSecurities types of Settlement Usesand Advantages of derivatives - Risks in

Derivatives.


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Definition

A security whose price is dependent

upon or derived from one or moreunderlying assets. The derivative itself ismerely a contract between two or more

parties. Its value is determined byfluctuations in the underlying asset. Themost common underlying assetsinclude stocks,

bonds, commodities, currencies, interestrates and market indexes. Mostderivatives are characterized by highleverage.


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Derivatives

A financial contract of pre-determined

duration, whose value is derived from thevalue of an underlying assetSecurities

commodities

bullion

precious metals

currency

livestock

index such as interest rates, exchange rates


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What do derivatives do?

Derivatives attempt either to minimize theloss arising from adverse price movements ofthe underlying asset

Or maximize the profits arising out offavorable price fluctuation. Since derivativesderive their value from the underlying assetthey are called as derivatives.


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Types of Derivatives

(UA: Underlying Asset)

Based on the underlying assetsderivatives are classified into.

Financial Derivatives (UA: Finasset)

Commodity Derivatives (UA: gold

etc)Index Derivative (BSE sensex)


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How are derivatives used?

Derivatives are basically risk shiftinginstruments. Hedging is the most importantaspect of derivatives and also their basiceconomic purpose

Derivatives can be compared to an insurancepolicy. As one pays premium in advance to aninsurance company in protection against aspecific event, the derivative products have a

payoff contingent upon the occurrence of someevent for which he pays premium in advance.


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What is Risk? The concept of risk is simple. It is the

potential for change in the price or valueof some asset or commodity. The meaning

of risk is not restricted just to thepotential for loss. There is upside risk andthere is downside risk as well.


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What is a Hedge

To Be cautious or to protect against loss. In financial parlance, hedging is the act of

reducing uncertainty about future pricemovements in a commodity, financial

security or foreign currency . Thus a hedge is a way of insuring an

investment against risk.


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What is derivatives in stock market,how it is different from equity

shares?In derivatives u can buy a future stock

by paying 20% amount of the stock. itsalways in lot sizes, and there are 3 wayavailable for trading in derivative1)current month 2) next month 3)next tonext month.


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It expires on the last Thursday ofevery month. where in equity u can by a

stock by paying the price at spot. and ucan hold the stock for as much time asmuch u want.

long term investments are done inequity shares we can do short termtrading also but in derivatives we can doonly short term trading which can last for

maximum 3 months.There are other options also in

derivatives like call , put ,forward options


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12

Growth of Derivatives Market

Analytical techniques

Technology

Globalization


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importance of derivativesThere are several risks inherent in

financial transactions. Derivatives areused to separate risks from traditionalinstruments and transfer these risks toparties willing to bear these risks.


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. The fundamental risks involved in derivativebusiness includes:

Credit Risk This is the risk of failure of a counterparty to

perform its obligation as per the contract.Also known as default or counterparty risk, itdiffers with different instruments.

Market Risk Market risk is a risk of financial loss as aresult of adverse movements of prices of theunderlying asset/instrument.


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Liquidity RiskThe inability of a firm to arrange a

transaction at prevailing market prices istermed as liquidity risk. A firm faces twotypes of liquidity risks

Related to liquidity of separate products

Related to the funding of activities of thefirm including derivatives.

Legal Risk Derivatives cut across judicial boundaries,

therefore the legal aspects associatedwith the deal should be looked intocarefully.


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Who are the operators in thederivatives market?

Hedgers - Operators, who want totransfer a risk component of theirportfolio.

Speculators - Operators, whointentionally take the risk from hedgers inpursuit of profit.

Arbitrageurs - Operators who operate in

the different markets simultaneously, inpursuit of profit and eliminate miss-pricing.


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Derivative Instruments. Forward contracts

Futures Commodity

Financial (Stock index, interest rate & currency)

Options Put

Call

Swaps.

Interest Rate Currency


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Forward Contracts An agreement where one party agrees

to buy (or sell) the underlying asset ata specific future date and a price is setat the time the contract is entered into.

Characteristics Flexibility Default risk Liquidity risk

Positions in Forwards Long position Short position


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Hedging with Futures

Hedging: Generally conductedwhere a price change couldnegatively affect a firms profits. Long hedge: Involves the purchase of

a futures contract to guard against aprice increase.

Short hedge: Involves the sale of afutures contract to protect against a

price decline in commodities or financialsecurities.

Perfect hedge: Occurs when gain/losson hedge transaction exactly offsets

loss/gain on unhedged position.


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Option Contracts

The right,but not the obligation, to buyor sell a specified asset at a specifiedprice within a specified period of time.

Option Terminology

Call option versus put option Holder versus writer or grantor Exercise or strike price Option premium

American versus European option Market Arrangements


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Swap Contracts

Financial contracts obligating one party toexchange a set of payments it owns foranother set of payments owed by anotherparty.

Currency swaps Interest rate swaps

Usually used because each party prefersthe terms of the others debt contract.

Reduces interest rate risk or currency riskfor both parties involved.


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Using Derivatives to Reduce Risk

Commodity Price Exposure The purchase of a commodity futures contractwill allow a firm to make a future purchase ofthe input at todays price, even if the marketprice on the item has risen substantially in theinterim.

Security Price Exposure The purchase of a financial futures contract willallow a firm to make a future purchase of thesecurity at todays price, even if the marketprice on the asset has risen substantially in theinterim.


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Using Derivatives to Reduce Risk

Foreign Exchange Exposure The purchase of a currency futures or options

contract will allow a firm to make a futurepurchase of the currency at todays price, evenif the market price on the currency has risensubstantially in the interim.


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Risks to Corporations fromFinancial Derivatives

Increases financial leverage

Derivative instruments are too complex

Risk of financial distress


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Forward Contracts.

A one to one bipartite contract,which is to be performed infuture at the terms decidedtoday.


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Eg: Jay and Viru enter into a contract totrade in one stock on Infosys 3 months

from today the date of the contract @ aprice of Rs4675/-

Note: Product ,Price ,Quantity & Timehave been determined in advance by boththe parties.

Delivery and payments will take place asper the terms of this contract on the

designated date and place. This is asimple example of forward contract.


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The key elements of a futures contract are: Futures price

Settlement or Delivery Date Underlying (infosys stock)


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Illustration.

Let us once again take the earlier examplewhere Jay and Viru entered into a contract tobuy and sell Infosys shares. Now, assume thatthis contract is taking place through the

exchange, traded on the exchange andclearing corporation/house is the counter-party to this, it would be called a futurescontract.


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Positions in a futures contract Long - this is when a person buys a

futures contract, and agrees to receivedelivery at a future date. Eg: Virus

position Short - this is when a person sells a

futures contract, and agrees to makedelivery. Eg: Jays Position


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How does one make money ina futures contract? The long makes money when the

underlying assets price rises above thefutures price.

The short makes money when the

underlying assets price falls below thefutures price.

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


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Options

An option is a contract giving thebuyer the right, but not theobligation, to buy or sell anunderlying asset at a specific price

on 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.


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Options Lingo

Underlying: This is the specific security /

asset on which an options contract isbased.

Option Premium: Premium is the pricepaid by the buyer to the seller to acquire

the right to buy or sell. It is the total costof an option. It is the difference betweenthe higher price paid for a security and thesecurity's face amount at issue. The

premium of an option is basically the sumof the option's intrinsic and time value.


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Strike Price or Exercise Price :price of anoption is the specified/ pre-determined price ofthe underlying asset at which the same can bebought or sold if the option buyer exercises hisright to buy/ sell on or before the expiration

day. Expiration date: The date on which the option

expires is known as Expiration Date

Exercise: An action by an option holder taking

advantage of a favourable market situation.Trade in the option for stock.


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Exercise Date: is the date on which the optionis actually exercised.

European style of options: The Europeankind of option is the one which can beexercised by the buyer on the expiration dayonly & not anytime before that.

American style of options: An Americanstyle option is the one which can be exercisedby the buyer on or before the expiration date,i.e. anytime between the day of purchase of

the option and the day of its expiry.


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Asian style of options: these are in-betweenEuropean and American. An Asian option'spayoff depends on the average price of theunderlying asset over a certain period of time.

Option Holder Option seller/ writer Call option: An option contract giving the

owner 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


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In-the-money: For a call option, in-the-money is when the option's strike price isbelow the market price of the underlyingstock. For a put option, in the money is whenthe strike price is above the market price of

the underlying stock. In other words, this iswhen the stock option is worth money andcan be turned around and exercised for aprofit.


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Intrinsic Value: The intrinsic value of an option isdefined as the amount by which an option is in-the-money, or the immediate exercise value of the optionwhen the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price -

Strike Price

For a put option: Intrinsic Value = Strike Price- Spot Price


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Example of an Option

Elvis and crocodiles.


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Positions Long Position: The term used when a

person owns a security or commodity andwants to sell. If a person is long in asecurity then he wants it to go up in price.

Short position: The term used to describethe selling of a security, commodity, orcurrency. The investor's sales exceedholdings because they believe the price will

fall.


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Profit/Loss Profile of a Long call Position

0

-3

100 103

Profit

Loss

Priceof

AssetXYZ

atexpiration

Option Price = Rs3

Strike Price = Rs100

Time to expiration = 1month


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Profit /Loss Profile for a Short Call Position

100 103

0

Profit

Loss

Price of theAsset XYZatexpiration

+3

Initial price of the asset = Rs100Option price= Rs3Strike price = Rs100

Time to expiration = 1 month


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Profit/Loss

Profile for a Long Put Position

0

-2

98 100

Price ofthe AssetXYZ atexpiration

Profit

Loss

Initial price of the asset XYZ = Rs100

Option Price = Rs2

Strike price = Rs100



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Profit/Loss Profile for a Short Put

Position

0

+2

94 100

Price ofthe AssetXYZ atexpiration

Profit

Loss

Initial price of the asset XYZ =Rs100Option Price = Rs2Strike price = Rs100


Summary


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Summary

The 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 the

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

gain if the price of the underlying asset rises;

and selling calls and buying puts allows theinvestors to gain if the price of theunderlying asset falls.


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Long Call

Short Put

Long Put

Short Call

Price rises

Price Falls

S k I d O i


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Stock Index Option

Trading in options whose underlying instrument is the

stock index. Here if the option is exercised, the exchange assigned

option writer pays cash to the options buyer. There isno delivery of any stock.

Dollar Value of the underlying index = Cash indexvalue * Contract multiple.

The contract multiple for the S&P100 is $100. So, foreg, if the cash index value for the S&P is 720,thendollar value will be $72,000


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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 strike indexis the index value at which the buyer of theoption can buy or sell the underlying stockindex.


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For Eg: If the strike index is 700 for an S&Pindex option, the USD value is $70,000. If an

investor purchases a call option on the S&P100with a strike of 700, and exercises the optionwhen the index is 720, then the investor has the

right to purchase the index for $70,000 whenthe USD value of the index is $72000. Thebuyer of the call option then receive$2000 from

the option writer.

Binomial Model for Option


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Binomial Model for OptionValuation

Current Price of the stock = S Two possible values it can take next year :- uS

or dS ( uS> dS)

Amount B can be borrowed or lent at a rate ofr. The interest factor (1+r) may be represented, for sake of simplicity , as R.

d


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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:


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Illustration:

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

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

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

^=Cu-Cd/(u-d)S = 60/(1.4-.9)200=0.6

B=uCd-dCu/(u-d)R= -0.9(60)/0.5(1.15) = -93.91

(A negative value for B means that funds areborrowed).

Thus the portfolio consists of 0.6 of a share plus a

borrowing of 93.91( requiring a payment of93.91(1.15) = 108 after one year.

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


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Swaps

An agreement between two parties toexchange one set of cash flows for another.In essence it is a portfolio of forward

contracts. While a forward contract involvesone exchange at a specific future date, aswap contract entitles multiple exchanges

over a period of time. The most popular areinterest rate swaps and currency swaps.


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Interest Rate Swap

A B

Fixed Rate of 12%

LIBOR

A is the fixed rate receiver and variable rate payer.

B is the variable rate receiver and fixed rate payer.

Rs50,00,00,000.00Notional Principle

Counter Party Counter Party

The only Rupee exchanged between the parties are the net


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y p g pinterest payment, not the notional principle amount.

In the given eg A pays LIBOR/2*50crs to B once every six

months. Say LIBOR=5% then A pays be 5%/2*50crs=1.25crs

B pays A 12%/2*50crs=3crs

The value of the swap will fluctuate with market interest

rates. If interest rates declinefixed rate payer is at a loss, If

interest rates risevariable rate payer is at a loss.

Conversely if rates rise fixed rate payer profits and floatingrate payer looses.

Derivatives 120821000932 Phpapp02

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