FUTURES AND OPTIONS

Derivative

Derivatives are contracts, agreements between two parties: a buyer and a seller.

Buyer Seller

Derivative

A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc.

Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps.

The instrument requires little or no investment at the inception of the contract.

Derivative Markets

The over-the-counter (OTC) market

The exchanges

OTC advantage

the terms of a contract do not have to be those

specified by an exchange.

Market participants are free to negotiate any

mutually attractive deal.

OTC disadvantage

there is usually some credit risk in an over-the-

counter trade.

Less controlled.

Futures Contract

A futures contract is an agreement between two parties, a buyer and a seller, to exchange an asset at a later date for a price agreed to in advance, when the contract is first entered into.

We call this price the futures price.

Trades on a futures exchange.

To make trading possible, the exchange specifies certain standardized features of the contract.

Role of future exchange:

it acts as intermediary

it mitigate the risk of default by either party in the intervening period

For this, both parties put up an initial amount of cash called as margin

The difference between the prior agreed-upon price and the actual daily futures price is settled on a daily basis. Also called as Variation or Mark-to-Market Margin.

If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account. This process is known as "marking to market“.

Example:

IBM enters into a future contract with a broker for delivery of 10,000 shares of Google stock in three months at its current price of $110 per share. => $1,100,000

IBM has received the right to receive 10,000 shares in three months and incurred an obligation to pay $110 per share at that time.

Options

An option gives the buyer the right, but not the obligation, to buy/sell the underlying at a later date for a price agreed to in advance, when the contract is first entered into.

We call this price the strike/exercise price.

The option buyer pays the seller a sum of money called the option price or premium.

Trades OTC or on an exchange.

Example:

IBM enters into a contract with a broker for an option (right) to purchase 10,000 shares of Google shares at its current price of $110 per share.

The broker charges $3,000 for holding the contract open for two weeks at a set price.

IBM has received the right, but not the obligation to purchase this stock at $110 within the next two weeks.

Types of options

Call option: an option to buy the underlying at the strike price

Put option: an option to sell the underlying at the strike price

Example: (Call Option)

A company enters into a call option contract on January 2, 2007, with Baird Investment Co., which gives it the option to purchase 1,000 shares of Google stock at $100 per share. On January 2nd, the Google shares are trading at $100 per share. The option expires on April 30, 2007. The company purchases the call option for $400.

If the price of Google stock increases above $100, the company can exercise this option and purchase the shares for $100 per share.

If Google’s stock never increases above $100 per share, the call option is worthless.

Example: (Put Option) An investor buys one Put option on Stock 'B' at the strike price

of Rs. 300, at a premium of Rs. 25.

If the market price of Stock 'B', on the day of expiry is less than Rs. 300, the option can be exercised. The investor's Break-even point is Rs. 275 (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275.

Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Stock 'B' from the market @ Rs. 260 & exercises his option selling the Stock 'B' at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}.

In another scenario, if at the time of expiry, market price of Stock 'B' is Rs 320; the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25), which shall be the profit earned by the seller of the Put option

Uses of derivatives

Derivatives can be used by individuals, corporations, financial institutions, and governments to reduce a risk exposure or to increase a risk exposure.

Traders of derivatives

Hedgers

Speculators

Arbitrageurs

Hedgers

Hedgers use derivatives to reduce the risk that they face from potential future movements in a market variable.

Example: Heartland –Large producer of potatoesMcDonald –Large consumer of potatoes (French fries)

The objective is not to gamble on the outcome or to profit but to lock in a price at which both of them obtain an acceptable profit.

Hedge against changes in the price of fuel, interest rates, exchange rates etc.

Speculators

Speculators use them to bet on the future direction of a market variable. Example:

It is May.

The price of Nortel Networks stock is $28.30.

A December call option on Nortel stock with a $29 strike price is selling for $2.80.

A speculator thinks the stock price will rise.

To make a profit, the speculator might:

Buy, say, 100 shares of Nortel stock for $2,830.

Buy 1,000 options for $2,800

Suppose the speculator is right. The stock price rises to $33 by December.

Strategy Profit

Buy the stock (33-28.30)x100

=$470

Buy options (33-29)x1000-2800

=$1200

Suppose the speculator is wrong. The stock price falls to $27 by December.

Strategy Loss

Buy the stock (28.30-27)x100

=$130

Buy options $2800

Conclusion:

Over the years, derivatives have attracted the investors as an important instrument whether it be for purpose of hedging or speculation and there has been a significant increase in investments in them.

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