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What is a Derivative Security?

INTRODUCTION TO • A Derivative Security is a security whose value

DERIVATIVES depends on the values of other, more basic
underlying variables.
Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore
Example:
• An Indian exporter is likely to receive USD 1000 after
one month goes to a bank and contracts to sell the
USD money for Rs. 80 per USD.
• This contract is an example of derivative contract
where the underlying is the foreign currency (USD)

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History of Derivatives Confusion about D(erivatives)

• 332 BC Greece: Thales of Miletus – first option idea D are financial weapons of mass destruction (Buffet)
The earliest known options trade dates from 4th century BC. Thales of Miletus
speculated that the year's olive harvest would be especially bountiful and put a D increase financial stability ; the more the better (Greenspan)
deposit on every olive press in his region of Greece. This gave him the right to use
D offer high leverage and cheap transaction costs (Financial Policy Forum)
the olive press if he wanted to after the harvest. The harvest was huge, demand
for olive presses skyrocketed, and Thales sold his rights, or options, at substantial Notional values are not meaningful measures (FED)
profit.
D make full disclosure even more difficult (World Bank)
• 1636 : Options on Tulips
OTC regulation would stifle market creativity (SEC)
• 1859 CBOT: First agricultural derivatives contract
D can avoid prudential safeguards, manipulate accounting, build leverage (IMF)
• The modern history of stock options trading begins with the 1973 establishment of Markets, not regulators should focus on risk management (Bankers)
the Chicago Board Options Exchange (CBOE) and the development of the Black-
Scholes option pricing model. D are hugely profitable ; but each winner finds a dumb looser (Brookings)
D are used by only 5% of large banks (Economist)

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Derivative Products Evolution of Derivatives in India

OTC Derivative Markets Exchange Traded Derivatives
$128 trn notional $29 trn notional
OTC Exchange traded
$ 5 trn market value US: 35%
$700 trn turnover • 1980s – Currency • June 2000 – Equity Index futures
EU: 34%
JP Morgan Chase
Forwards • June 2001 – Equity Index options
Chicago 28% Asia: 25%
$ 27 trn Eurex • 1997 – Long term FC – • July 2001 – Stock Options
14% Euronext
Non-Financials SGX Rupee swaps • November 2001 – Stock futures
$ 20 trn BM&F
70%
KSE/KOFEX
62% • July 1999 – Interest rate • June 2003 – Interest rate futures
swaps and FRAs
(relative size may be misleading) • Aug 2008 – Dollar-Rupee futures
Interest
40% annual growth rates • July 2003 – FC-Rupee start trading
Interest
FX
options
G-Debt • Jan 2010 – Yen, Pound, Euro
Equity Key Driving Factors
Equity-Index futures introduced
Com  Capital flows
Stocks
Credit  Leverage
Com
Other  Risk Management
FX
 Liquidity Exchange traded currency
options were launched by NSE in
 Transaction Costs
October 2010
Sources: BIS (June 2002) ; FIBV (Dec 2001)

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The Nature of Derivatives Derivatives Markets

• A derivative is an instrument whose value depends on the • Two types:
values of other more basic underlying variables – Exchange traded and Over-the-counter (OTC)
• Exchange traded
• Each derivative product has an “underlying” associated with it.
– Exchanges mostly use electronic trading.
• The value of the derivative depends on, among other things, – Contracts are standard, virtually no credit risk
the value of the underlying. – Example: Futures, Options
• The underlying can be • Over-the-counter (OTC)
– Physical commodities: Coffee, Crude oil, Wheat etc. – A computer- and telephone-linked network of dealers at financial
– Financial assets: Currencies, Stocks, Bonds, etc. institutions, corporations, and fund managers
– Financial Prices: Interest rates, stock prices, stock index – Financial institutions often act as market makers.
– Credit derivatives, Weather derivatives, emission derivatives – Contracts can be non-standard and there is some amount of credit risk
– Derivatives on derivatives – swaptions, captions, compound options – – Example: Swaps, FRAs, Exotic options
option on option

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Examples of Derivatives
Types of Derivatives
• Forward-like Derivatives
– Forward contracts, Futures, FRAs, Swaps, Forex forwards and futures, stock futures,
stock index futures, coffee futures, crude oil futures, interest rate futures, interest
rate swaps, currency swaps etc.
• Forward Contracts - OTC
• Option Products
• Futures Contracts – Exchange traded
– Stock options, currency options, index options, commodity options, interest rate
options, Interest rate caps & floors, bond options
• Swaps - OTC
• Compound Derivatives
• Options – Exchange traded / OTC
– Options on futures, options on swaps (swaptions), captions, options on options

• Structured Products
– Combinations of plain derivatives; products with customized payment patterns

• Exotic Products
– Barrier options; Balloon options; Fade-in and Fade-out options; Basket options and a
whole barrel of custom-made exotic products
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How are Derivatives Used? Forward Contract

• To hedge price risk and other risks
• To speculate with a view on the future direction of • A forward contract is an agreement to buy or sell an
the market price of a commodity or financial asset at a certain future time for a certain price.
instrument or even relative price of two commodities • It can be contrasted with a spot contract, which is an
or instruments agreement to buy or sell an asset today.
• To lock in an arbitrage profit • The contract is between two financial institutions or
• To change the nature of a liability between a financial institution and one of its
• To change the nature of an investment without corporate clients.
incurring the costs of selling one portfolio and buying • It is not traded on an exchange.
another • Forward contracts are particularly popular on
currencies and interest rates.

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Terminology Example of Forward Contract

• Long position agrees to buy the underlying asset on • On October 01, 2021, the treasurer of an
a certain specified future date for a certain specified
price. export company in India knew that it would
receive USD 1 million in 6 months (i.e., on
• Short position is the other party and agrees to sell March 31, 2022) and wants to become
that asset on same future date for the same price. indifferent against exchange rate moves.
– He can undertake currency forward contract with
• The specified price in a forward contract is referred a bank now to sell USD 1 million in 6 months at a
to as the delivery price. particular INR/USD forward rate.

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Spot and Future Quotes for INR/USD (Not Actual

Payoffs From Forward Contracts
Values)
Payoff from
Payoff from
Short Position
Long Position
Bid Price Offer Price
Spot 75.85 76.10 Price of Underlying
K at Maturity, ST
6 month 77.80 78.15 Price of Underlying K
Forward at Maturity, ST

Payoff from a long position in Payoff from a short position

• INR/USD means Rs. per USD a forward contract on one
• Bid – price at which one market maker is prepared to buy unit of an asset = ST – K
• Ask – price at which one market maker is prepared to sell
• These quotes are for inter-bank transactions, for retail investors spread (difference (K = delivery price, ST = Price
between bid and ask) is more of the underlying security at
maturity )
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in a forward contract on one
unit of an asset = K – ST
(K = delivery price, ST = Price
of the underlying security at
maturity )
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Futures Contract Swaps

• A swap is an agreement to exchange cash flows at

• Agreement (obligation) to buy or sell an asset specified future times according to certain specified
for a certain price at a certain time rules.

• Like forward contract but futures contracts are • Examples: Interest rate swap, currency swap etc.
traded on an exchange

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Options Payoff Diagram – Call

• A call / put option is an option to buy / sell a certain asset by a Payoff from
Payoff from
certain date for a certain price. Short Call
Long Call

• The price of the contract is known as strike price / exercise C

price and the date in the contract is known as expiration date / K ST K ST
-
maturity. C

• An American option can be exercised at any time during its life.

• A European option can be exercised only at maturity.
Payoff from a long position in
a call option = Max (ST – K, 0)
– The terms American or European do not refer to the location of the (K = Strike price, ST = Price of
option. the underlying security at
maturity, C = Call option
premium )
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Payoff from a short position
in a call option
= – Max (ST – K, 0) = Min (K -
ST, 0)
(K = Strike price, ST = Price of
the underlying security at
maturity, C = Call option
premium )
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Payoff Diagram – Put Types of Traders

Payoff from
Payoff from
Short Put Hedgers Speculators Arbitrageurs
Long Put Hedgers are essentially spot Speculators wish to take a position Arbitrage involves locking in a
market players. in the market either by betting riskless profit by simultaneously
that the price will go up or down. entering into transactions in two
Hedgers are interested in reducing markets.
K P price risk (that they already face in Futures and options can be used
the spot market) with derivative for speculation
contracts and options. Example:
ST K ST When a speculator uses futures Consider a stock that is traded in
-P Forward contracts are designed to then the potential gain or loss is both New York and London.
neutralize risk by fixing the price high. Suppose that the stock price is
that hedger will pay or receive for $172 in New York and £100 in
the underlying asset. When a speculator uses options, London at a time when the
speculator’s loss is limited to the exchange rate is $1.7500 per
Future contracts can be used to amount paid for the option.
Payoff from a short position pound.
Payoff from a long position in undertake minimum variation
An arbitrageur could
hedging.
a put option = Max (K – ST, 0) in a put option simultaneously buy 100 shares of
(K = Strike price, ST = Price of = – Max (K – ST, 0) = Min (ST Option strategy enables the hedger the stock in New York and sell
to insure itself against adverse them in London
the underlying security at – K, 0) exchange rate movements while He will obtain a risk-free profit of:
(K = Strike price, ST = Price of still benefiting from favorable 100*($1.75*100 –
maturity, P = Put option movements. $172) or $300 in the absence of
premium ) the underlying security at transactions costs.
maturity, P = Put option
premium )
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Problem No. 1 Problem No. 1 (Solution)

An investor enters into a short forward Part a:

contract to sell 100,000 British pounds for US
dollars at an exchange rate of 1.9000 US
dollars per pound. How much does the
investor gain or loose if the exchange rate at
the end of the contract is (a) 1.8900 and (b)
1.9200?
• The trader sells 100,000 British pounds for 1.9000 US
dollar per pound when the exchange rate is 1.8900
US dollar per pound.
• The gain is 100,000*(1.9000 – 1.8900) = $1,000
Part b:
• The trader sells 100,000 British pounds for 1.9000 US
dollar per pound when the exchange rate is 1.9200
US dollar per pound.
• The loss is 100,000*(1.9200 – 1.9000) = $2,000

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Problem No. 2 Problem No. 2 (Ans.)

You would like to speculate on a rise in the • Strategy 1: Buy 200 shares
price of a certain stock. The current stock • Strategy 2: Buy 2000 options
price is $29, and a three-month call with a • If share price does well strategy 2 will give
strike of $30 costs $2.90. You have $5,800 to better gain
invest. Identify two alternative strategies, one
involving an investment in the stock and the • If share price does badly strategy 2 will give
other involving investment in the option. greater loss
What are the potential gains and losses from
each?
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Problem No. 3 Problem No. 3 (Ans. – Part A)

The trader buys a 180-day call option and takes a short position in a 180-day
• Suppose that sterling-USD spot and forward •
forward contract
exchange rates are as follows: • If ST is the terminal spot price,
• The profit from the call option is
Spot 2.0080 = max (ST – 1.97,0) – 0.02
90-day forward 2.0056 • The profit from the short forward contract
= 2.0018 – ST
180-day forward 2.0018 • The profit from the strategy is therefore
• What opportunities are open to an arbitrageur in the = max (ST – 1.97,0) – 0.02 +2.0018 – ST
= max (ST – 1.97,0) +1.9818 – ST
following situations? • This is
1.9818 – ST when ST < 1.97
a. A 180-day European call option to buy £1 for $1.97 costs 2 0.0118 when ST > 1.97
cents. • Hence profit is always positive
b. A 90-day European put option to sell £1 for $2.04 costs 2
The time value for money has been ignored in these calculations.
cents.

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Problem No. 3 (Ans. – Part B) Problem No. 4

• The trader buys a 90-day put option and takes a long position in a 90-day forward
contract The price of gold is currently $600 per ounce.
• If ST is the terminal spot price,
• The profit from the put option is The forward price for delivery in one year is
•
= max (2.04 – ST,0) – 0.02
The profit from the long forward contract
$800. An arbitrageur can borrow money at
•
= ST – 2.0056
The profit from the strategy is therefore
10% per annum. What should the arbitrageur
= max (2.04 – ST,0) – 0.02 + ST – 2.0056 do? Assume that the cost of storing gold is
= max (2.04 – ST,0) + ST – 2.0256
• This is zero and that gold provides no income.
ST – 2.0256 when ST > 2.04
0.0144 when ST < 2.04
• Hence profit is always positive

The time value for money has been ignored in these calculations.

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Problem No. 4 (Ans.) Problem No. 5

• The arbitrageur could A bond issued by Standard Oil worked as follows. The holder
– Borrow money to buy 100 ounces of gold today and received no interest. At the bond’s maturity the company
– Short futures contracts on 100 ounces of gold for delivery in one year promised to pay $1,000 plus an additional amount based on
• This means gold the price of oil at that time. The additional amount was equal
– Purchased for $600 per ounce to the product of 170 and the excess (if any) of the price of a
– Sold for $800 per ounce barrel of oil at maturity over $25. the maximum additional
• The return = 33.3% per annum >> 10% cost of borrowing fund amount paid was $2,550 (which corresponds to a price $40 a
• The arbitrageur should do this as much he can. barrel). Show that the bond is a combination of regular bond,
• Unfortunately, this type of opportunity rarely arise in practice. a long position in call options on oil with a strike price of $25 ,
– Even if this arises this does not sustain. and a short position in call options on oil with a strike price of
$40.

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Problem No. 5 (Ans.)

• Suppose ST is the price of oil at the bond’s maturity Thank You!

• In addition to $1,000 the standard oil bond pays:
ST < $25 : 0
$40 > ST > $25 : 170(ST – 25)
ST > $40 : 2,550
• This is the payoff from 170 call options on oil with a strike
price of 25 less the payoff from 170 call options on oil with a
strike price of 40 Indian Institute of Management Bangalore
• The bond is a combination of regular bond, a long position in Bannerghatta Road, Bangalore – 560 076, INDIA
170 call options on oil with a strike price of $25 , and a short
www.iimb.ac.in
position in 170 call options on oil with a strike price of $40

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