OFD Session_1 Introduction to Derivatives - Students
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Transcript of OFD Session_1 Introduction to Derivatives - Students
Welcome to the Welcome to the World of derivativesWorld of derivatives
Just common sense is sufficient
to have the working knowledge
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Terminology for call optionsTerminology for call options
16-Jul-2015
CALL OPTIONS contract is entered b/w 2 parties ◦ Infosys shares are the underlying asset
◦ 31-Aug-2015 call option contract is defined on it performance of obligations happens on 31-Aug-15
◦ One party holds long position i.e. right to BUY ( Receive)
◦ Other party holds short i.e. Obligation to DELIVER
31-Aug-2015
The SHORT shall be ready to deliver the UA◦ However, the long decides today whether to take delivery
To get this privilege, Krishnan paid ____________ on 15-Jul-2015
◦ If exercised, Long pays _______ to receive ______ shares
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American vs European OptionsAmerican vs European Options
An American option can be exercised at any time during its life
A European option can be exercised only at maturity
Payoff (benefit) of Put optionPayoff (benefit) of Put option
Long will exercise when beneficial◦ The stock prices shall remain below K
◦Beneficial to exercise (deliver) if ST < K
◦Not beneficial to exercise if ST > K
Payoff of a Put option◦ For long Max (K - ST , 0)
◦ For short -Max (K - ST , 0)
Terminology of Forward contractTerminology of Forward contract
Underlying EquityDelivery price (Forward price) F
◦ The price that would make the contract worth exactly zero)
◦ This may be different for contracts of different maturities
Spot price STrade date tDelivery date TDelivery instructions
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Payoff function: LONG SHORTForward ST – F -(ST – F)
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Is it naked or covered optionIs it naked or covered option
Covered optionOOM optionLong Term Equity AnticiPation Security
◦ Options on long term until expiry than others◦ Available on approximately 2,500 equities and 20
indices◦ LEAPS were created relatively recently and
typically extend for terms of 2 years out. ◦ Equity LEAPS always expire in January.◦ When LEAPS were first introduced in 1990, they
were derivative instruments solely for equities
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Are S and F related?Are S and F related?
If the spot price of gold is S and the forward price for a contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-free rate of interest.
FT = S0 [(1+rINR)/(1+r$)]T
What is a derivative?
A financial instrument (contract) whose value depends on value of other, more basic, underlying variables◦ underlying (UA) shall be price of a traded asset.
For example, price of a call option depends on◦ Price of UA (S), delivery price (K), delivery date (T), interest
rate for period T, volatility of S, dividend yield of S
Derivative can be dependent on almost any variable!
Introduction
Derivatives are everywhere◦ traded by institutions, fund managers and corporate
treasurers in OTC market.
◦ Derivatives are added to bond issues, used in compensation plans, embedded in capital investment proposals
Understanding derivatives is important! ◦ Mechanics of forwards, options and swaps
◦ How to use them in hedging, speculation, arbitrage
◦ How to value these derivative contracts
Asset classes
CurrenciesCommodities◦Metals and minerals◦Bullion◦Agricultural products◦Animal products
Equity shares and indicesBond issues and their indicesEnergy and other underlyings
RECAP!RECAP!
Futures/forward contracts are obligations that must be fulfilled at maturity.
Options contracts are rights, not obligations, to either buy (call) or sell (put the underlying financial instrument.
Swaps are the multi-period contractsDerivatives are traded in auction markets
◦ Institutions make spot and derivative markets◦ Develops new instruments to fill the gaps◦ Trading volumes in OTC are much higher
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Options: Rights & ObligationsOptions: Rights & Obligations
Holder (long position) Writer (Short position) Right to receive UA Obligation to deliver UA Obligation to pay K Right to receive K
Obligation to deliver UA Receive K Obligation to receive UA Pay K
ForwardExercises it only when
beneficialCall
optionPut
optionExercises it only when
beneficial
ON maturity date or expiration rate, do the following:
RECAP!RECAP!
Payoff in Forward/futures contractsPayoff in options contractsArbitrage and the law of one priceHedging with Forward/futures and optionsSpeculation with futures and options
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Users of Derivatives Users of Derivatives
Banks and Financial InstitutionsFund managers (Asset management cos.)Treasurers of manufacturing and service companies
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Any one who works in finance needs to understand how derivatives work, how they are used, and how they are priced.
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 15
1.6 Types of Traders1.6 Types of Traders
• Hedgers : offset the exposure to price of UA.
• Speculators: No exposure to offset.
• Arbitrageurs: To lock in a arbitrage profit
Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators (See for example Barings Bank, Business Snapshot 1.2, page 15)
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 16
Ways Derivatives are UsedWays Derivatives are Used
To lock in an arbitrage profit
To hedge risks (to lock into price)
To speculate (take a view on the future direction of the market)
To change the nature of a liability
To change the nature of an investment without incurring the costs of selling one portfolio and buying another
Ways Derivatives are UsedWays Derivatives are Used
To embed into securities to alter their payoffs (an application in corporate finance!)◦ Convertible securities
Management compensation contracts with variable pay linked to the market◦ ESOPs
Embedded in capital investment opportunities◦ Option to expand
◦ Option to delay
◦ Option to abandon
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 17
Some questions
Long Forward vs. Long callShort Call @ K vs. Long Put @ KWhy do we use F for forward delivery price
and K for delivery price on option contracts?Suppose you have 500 shares of YES bank.
How to obtain insurance against a decline in share value over 4 months?
Payoff for [Long forward + long put]Exercise 1.24
Role of Derivative InstrumentsRole of Derivative Instruments
Protect against different types of investment risks, ◦ Purchasing power risk, interest rate risk, currency risk.
Advantages:
◦ Lower transactions costs
◦ Faster to carry out transaction
◦ Greater liquidity
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 20
Futures ContractsFutures Contracts
Agreement to buy or sell an asset for a certain price at a certain time
Similar to forward contractWhereas a forward contract is traded OTC, a
futures contract is traded on an exchange◦ Tick size◦ Delivery date◦ Contract size◦ Margining
Forward vs. Futures contracts
Forward Contract Futures contract
Private contract between two parties
Traded on an exchange
Contract terms not standardized
Standardized contract
Usually one specific delivery date
Range of delivery dates
Settled at the end of contract period
Settled daily
Delivery or final cash settlement usually happens
Contract is usually closed out prior to maturity
Some credit risk Virtually no credit risk
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 22
Exchanges Trading FuturesExchanges Trading Futures
Chicago Board of TradeChicago Mercantile ExchangeLIFFE (London)Eurex (Europe)BM&F (Sao Paulo, Brazil)TIFFE (Tokyo)and many more (see list at end of book)
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 23
Exchanges Trading FuturesExchanges Trading Futures
Bombay Stock ExchangeNational Stock ExchangeMCX Stock ExchangeMCXNCDEXUnited Stock ExchangeCCIL
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 24
Examples of Futures ContractsExamples of Futures Contracts
Agreement to:
◦ Buy 100 oz. of gold @ US$1,280/oz. in Oct (NYMEX)
◦ Sell £62,500 @ 1.6500 US$/£ in June (CME)
◦ Sell 1,000 bbl. of oil @ US$114/bbl. in April (NYMEX)
◦ Buy 100 shares of Infosys Limited at Rs.3,973 in 25-Sep-2014 (NSE)
Infosys Option Prices (March 01, 2013; S =2925)Infosys Option Prices (March 01, 2013; S =2925)
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 25
Strike Price
28-Mar Call
25-Apr Call
30-May Call
28-Mar Put
25-Apr Put 30-May Put
2,850 107.30 200.00 - 30.65 - -
2,900 78.50 150.00 - 48.00 120.00 -
2,950 53.00 - - 70.70 128.65 -
3,000 34.20 - - 103.00 - -
3,050 21.00 - - 151.40 - -
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 26
Options vs Futures/ForwardsOptions vs Futures/Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price
An option gives the holder the right to buy or sell at a certain price
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 27
Hedge Funds Hedge Funds (see Business Snapshot 1.1, page 9)(see Business Snapshot 1.1, page 9)
Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly.
Mutual funds must ◦ disclose investment policies, ◦ makes shares redeemable at any time,◦ limit use of leverage◦ take no short positions.
Hedge funds are not subject to these constraints. Hedge funds use complex trading strategies; are big users of
derivatives for hedging, speculation and arbitrage
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 28
Hedge Funds strategiesHedge Funds strategies
Convertible Arbitrage Distressed Securities Emerging Markets Macro or global Market neutral
SUMMARY
5 broad asset classes. Active spot markets exist for these assets and had evolved over time.
Investment in any of these assets expose the investor to investment risks such as price risk or interest rate risks. They cover it in the derivatives market.
A forward/futures contract involves an obligation to buy or sell an asset at maturity for certain price ◦ Forward are privately negotiated and tailor-made ◦ Futures contracts are standardized & well-defined: UA, delivery price,
delivery date, locations, quality
◦ The payoff function for long position is (ST – F) while that of short position is –(ST – F).
There are 2 types of options: call option and put option ◦ Call option gives the holder the right to buy the UA by a certain date
for certain price. Its payoff function is max(ST – F,0).◦ Put option gives the holder the right to sell the UA by a certain date
for certain price. Its payoff function is max(F– ST,0).
Summary contd.
3 main types of traders can be identified in derivatives market. ◦ Hedgers have exposure to UA from their regular line of business.
They take opposite exposure in derivative markets to reduce or eliminate this risk thereby lock into price.
◦ Speculators does not have exposure to UA. They wish to bet on future movements in price of UA. They use derivatives to get extra leverage and hence adds liquidity to the market.
◦ Arbitrager looks at price of the asset in spot market and derivative market along with interest rate in money market. If they see the futures price get out of line with cash price, they will take offsetting positions in the two markets to lock into arbitrage profit.
Both hedgers and speculators find it attractive to trade a derivative than to trade the asset itself.
IN the next chapter, we look at some technical aspects of futures contracts.