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Introduction To Introduction To Derivatives: and Present
Introduction To Introduction To Derivatives: and Present
Introduction To Introduction To Derivatives: and Present
present
Introduction to Derivatives
Pulkit Singhal & Kush Shah
FIN
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Also..
Electricity y The weather Insurance Cattle prices
In sum, if you can price the underlying asset, there can always be a derivative on it.
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Forward Contracts
An A agreement to buy or sell an asset b ll at a certain time in the future for a certain price p No daily settlement. When the contract expires, one party buys the asset for the agreed price from the other party. The contract is an over-the-counter (OTC) agreement between 2 institutions.
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Long position
Short position
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39.94
40.11
1-month
39.78
40.02
3-month 3 th
39.55 39 55
39.94 39 94
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Futures Contracts
An agreement to buy or sell an asset at a certain time in the future for f a certain price. t i i They are exchange-traded, and hence, are standardized contracts. h t d di d t t Important futures exchanges: CBOT, CME, NYMEX etc. In India: BSE, NSE, MCX, NCDEX.
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Futures Arbitrage
Suppose that: The spot price of Reliance is p p Rs. 1500 The quoted 1-year futures price is Rs. 2000 Rs 1-year interest rate is 10% Is there an arbitrage opportunity?
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Futures Arbitrage
Solution: Borrow Rs. 1500 at 10% Go long spot g p Short futures End of year profit = 2000 1500*(1+10%)
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Options
An option is a security that gives the holder the right but not the obligation to buy or sell a security for a specified price at a specified date. Basic classification of options:
Call options/Put options American options/European options
Long Call
Profit from buying European call option: option price = $5, strike price = $100, option life = 2 months
$ 30 Profit ($) 20 10 0 -5
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Short Call
Profit from writing a European call option: option price = $5, strike price = $100
Long Put g
Profit from buying an European put option: option price = $7, strike price = $70
30 Profit ($) 20 10 0 -7
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Short Put
Profit from writing an European put option: option price = $7, strike price = $70
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Portfolio C: European put on the stock + the stock Both are worth Max (ST , X) at the maturity of the options They must therefore be worth the same today y y This means that
c + Xe -rT = p + S0
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Stock price
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Delta
Delta = sensitivity of an option's theoretical y p value to a change in the price of the underlying contract. delta = change in the option price change in the stock price
What is the range of deltas for calls and g puts? Why is delta also called the hedge ratio?
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Theta
Theta () of a derivative (or portfolio of h ( ) f d ( f l f derivatives) is the rate of change of the value with respect to the passage of time
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Gamma
Gamma () is the rate of change of delta () with respect to the price of the underlying asset
The Gamma of a portfolio of derivatives on an underlying asset is the rate of change of the portfolio s delta with portfolio's respect to the price of the underlying asset. If gamma is large, delta is highly sensitive to the price of the underlying iti t th i f th d l i asset.
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Vega
Vega () is the rate of change of the value of a derivatives portfolio with respect to volatility
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Rho
Rho is the t Rh i th rate of change of f h f the value of a derivative with respect to the interest rate
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Hedging in Practice
Traders usually ensure that their portfolios are delta-neutral at least delta neutral once a day Whenever the opportunity arises arises, they improve gamma and vega As portfolio becomes larger hedging becomes less expensive
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Exotic Options
Bermudan option - non-standard American option in which early exercise is limited to certain dates during the life of the option. Also referred to as "hybrid-style" exercise. Forward start option is an option that is paid for now, but does not begin until some later date. Compound option is an option on an option. Compound options have two strike prices and two expiration dates. For example, a call on a call is purchased. At some specified p , p p date in the future, a person will have the right but not the obligation of purchasing a call option.
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Exotic Options
Chooser option also called an "as you like it" option allows option, as it option, the holder to choose after a specified period of time whether the option is a call or a put. Barrier option is an option in which the payoff depends on whether the underlying asset's price reaches a certain level during the life of the option.
Up and out Up-and-out option becomes worthless once the underlying asset price reaches a specified boundary price. Up-and-in option requires the underlying asset price to reach the boundary price before the option can be activated.
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Exotic Options
Lookback option - payoffs depend on the maximum or minimum the stock price reaches over the life of the option. Asian option (average price option) - payoff depends on the average price of the asset (not the stock price itself) over a specified amount of time during the life of the option. Spread option - strike price is the spread between two underlying assets. For example, crack spreads on the spread between the price of crude and its by-products. Basket option - payoff depends upon a portfolio of assets.
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Payoff from Payoff from Total Payoff Second Short Calls Long Call Option ST - $65 0 0 0 -2(ST - $60) 2(S -2(ST - $60) 0 0 0 $65 - ST ST -$55 0
Profit K1 K2 K3 ST
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Profit K1 K2 K3 ST
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