Derivatives Management

UNIT – 1 INTRODUCTION

Derivatives –definition – types – forward contracts – Options – swaps – difference between cash and future markets – types of traders – OTC and Exchange Traders Securities – types of Settlement – Uses and Advantages of derivatives - Risks in Derivatives.

Definition – “A security whose price is dependent

upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage”. 

DerivativesA 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 minimize the loss arising from adverse price movements of the underlying asset

Or maximize the profits arising out of favorable price fluctuation. Since derivatives derive their value from the underlying asset they are called as derivatives.

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 shifting

instruments. Hedging is the most important aspect of derivatives and also their basic economic purpose

Derivatives can be compared to an insurance policy. As one pays premium in advance to an insurance company in protection against a specific event, the derivative products have a payoff contingent upon the occurrence of some event for which he pays premium in advance.

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

potential for change in the price or value of some asset or commodity. The meaning of risk is not restricted just to the potential for loss. There is upside risk and there is downside risk as well.

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

reducing uncertainty about future price movements in a commodity, financial security or foreign currency .

Thus a hedge is a way of insuring an investment against risk.

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. its always in lot sizes, and there are 3 way available for trading in derivative 1)current month 2) next month 3)next to next month.

It expires on the last Thursday of every month. where in equity u can by a stock by paying the price at spot. and u can hold the stock for as much time as much u want.

long term investments are done in equity shares we can do short term trading also but in derivatives we can do only short term trading which can last for maximum 3 months.

There are other options also in derivatives like call , put ,forward options

12

Growth of Derivatives Market

Analytical techniques

Technology

Globalization

importance of derivativesThere are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks.

. The fundamental risks involved in derivative business includes:

Credit RiskThis is the risk of failure of a counterparty to

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

Market RiskMarket risk is a risk of financial loss as a result of

adverse movements of prices of the underlying asset/instrument.

Liquidity RiskThe inability of a firm to arrange a

transaction at prevailing market prices is termed as liquidity risk. A firm faces two types of liquidity risks

Related to liquidity of separate productsRelated to the funding of activities of the

firm including derivatives.Legal RiskDerivatives cut across judicial boundaries,

therefore the legal aspects associated with the deal should be looked into carefully.

Who are the operators in the derivatives market?

Hedgers - Operators, who want to transfer a risk component of their portfolio.

Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.

Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate miss-pricing.

Derivative Instruments.Forward contractsFutures

◦Commodity◦Financial (Stock index, interest rate & currency )

Options◦Put◦Call

Swaps. ◦Interest Rate◦Currency

18

Forward ContractsAn agreement where one party agrees

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

Characteristics◦Flexibility◦Default risk◦Liquidity risk

Positions in Forwards◦Long position◦Short position

19

Hedging with FuturesHedging: Generally conducted

where a price change could negatively affect a firm’s profits.◦Long hedge: Involves the purchase of a futures contract to guard against a price increase.

◦Short hedge: Involves the sale of a futures contract to protect against a price decline in commodities or financial securities.

◦Perfect hedge: Occurs when gain/loss on hedge transaction exactly offsets loss/gain on unhedged position.

20

Option ContractsThe right, but not the obligation, to buy

or sell a specified asset at a specified price 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

21

Swap ContractsFinancial contracts obligating one party to

exchange a set of payments it owns for another set of payments owed by another party.◦Currency swaps◦Interest rate swaps

Usually used because each party prefers the terms of the other’s debt contract.

Reduces interest rate risk or currency risk for both parties involved.

22

Using Derivatives to Reduce Risk

Commodity Price Exposure◦The purchase of a commodity futures contract

will allow a firm to make a future purchase of the input at today’s price, even if the market price on the item has risen substantially in the interim.

Security Price Exposure◦The purchase of a financial futures contract will

allow a firm to make a future purchase of the security at today’s price, even if the market price on the asset has risen substantially in the interim.

23

Using Derivatives to Reduce Risk

Foreign Exchange Exposure◦The purchase of a currency futures or options

contract will allow a firm to make a future purchase of the currency at today’s price, even if the market price on the currency has risen substantially in the interim.

24

Risks to Corporations from Financial Derivatives

Increases financial leverage

Derivative instruments are too complex

Risk of financial distress

Forward Contracts.

◦A one to one bipartite contract, which is to be performed in future at the terms decided today.

Eg: Jay and Viru enter into a contract to trade in one stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/-

Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties.

Delivery and payments will take place as per the terms of this contract on the designated date and place. This is a simple example of forward contract.

The key elements of a futures contract are:◦Futures price◦Settlement or Delivery Date◦Underlying (infosys stock)

Illustration.Let us once again take the earlier example

where Jay and Viru entered into a contract to buy and sell Infosys shares. Now, assume that this contract is taking place through the exchange, traded on the exchange and clearing corporation/house is the counter-party to this, it would be called a futures contract.

Positions in a futures contractLong - this is when a person buys a

futures contract, and agrees to receive delivery at a future date. Eg: Viru’s position

Short - this is when a person sells a futures contract, and agrees to make delivery. Eg: Jay’s Position

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

underlying assets price rises above the futures price.

The short makes money when the underlying asset’s price falls below the futures price.

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

OptionsAn option is a contract giving the

buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.

Options LingoUnderlying: This is the specific security /

asset on which an options contract is based.

Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of an option. It is the difference between the higher price paid for a security and the security's face amount at issue. The premium of an option is basically the sum of the option's intrinsic and time value.

Strike Price or Exercise Price :price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right 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.

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

European style of options: The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that.

American style of options: An American style option is the one which can be exercised by 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.

Asian style of options: these are in-between European and American. An Asian option's payoff depends on the average price of the underlying 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 of an underlying security at a specified price within a specified time.

Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time

In-the-money: For a call option, in-the-money is when the option's strike price is below the market price of the underlying stock. For a put option, in the money is when the strike price is above the market price of the underlying stock. In other words, this is when the stock option is worth money and can be turned around and exercised for 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 = Spot Price - Strike Price

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

Example of an Option

Elvis and crocodiles.

Positions Long Position: The term used when a

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

Short position: The term used to describe the selling of a security, commodity, or currency. The investor's sales exceed holdings because they believe the price will fall.

Profit/Loss Profile of a Long call Position

0

-3

100 103

Profit

Loss

Price of Asset XYZ at expiration

Option Price = Rs3

Strike Price = Rs100

Time to expiration = 1month

Profit /Loss Profile for a Short Call Position

100 103

0

Profit

Loss

Price of the Asset XYZ at expiration

+3

Initial price of the asset = Rs100Option price= Rs3Strike price = Rs100Time to expiration = 1 month

Profit/Loss Profile for a Long Put Position

0

-2

98 100

Price of the Asset XYZ at expiration

Profit

Loss

Initial price of the asset XYZ = Rs100

Option Price = Rs2

Strike price = Rs100

Time to expiration = 1 month

Profit/Loss Profile for a Short Put Position

0

+2

94 100

Price of the Asset XYZ at expiration

Profit

Loss

Initial price of the asset XYZ = Rs100Option Price = Rs2Strike price = Rs100Time to expiration = 1 month

SummaryThe profit and loss profile for a short put option is the mirror image of the long put option. The maximum profit from this position is the option price. The theoritical maximum 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 the investors to gain if the price of the underlying asset falls.

Long Call

Short Put

Long Put

Short Call

Price rises

Price Falls

Stock Index OptionTrading 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 is no delivery of any stock.

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

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

For a stock option, the price at which the buyer of the option can buy or sell the stock is the strike price. For an index option, the strike index is the index value at which the buyer of the option can buy or sell the underlying stock index.

For Eg: If the strike index is 700 for an S&P index option, the USD value is $70,000. If an investor purchases a call option on the S&P100 with a strike of 700, and exercises the option when the index is 720, then the investor has the right to purchase the index for $70,000 when the USD value of the index is $72000. The buyer of the call option then receive$2000 from the option writer.

Binomial Model for Option Valuation

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

or dS ( uS> dS)Amount B can be borrowed or lent at a rate of r.

The interest factor (1+r) may be 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=1.15

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=0.6B=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 to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and currency swaps.

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.

Rs50,00,00,000.00 – Notional Principle

Counter Party

Counter Party

The only Rupee exchanged between the parties are the net interest 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=3crsThe value of the swap will fluctuate with

market interest rates.If interest rates decline fixed rate payer is

at a loss, If interest rates rise variable rate payer is at a loss. Conversely if rates rise fixed rate payer profits and floating rate payer looses.