Edinburgh Business School

Boulis Ibrahim:
Introduction to Derivatives
Definition of a Derivative

• Derivative instrument = financial instrument

whose value is dependent upon (or derived
from) the value of one or more underlying
variables.
• A derivatives contract involves fixing today the
rate or price at which a transaction will (or may)
take place at (or within) a specified time in the
future.
Types of Derivative Instruments
Forwards and Futures
• Forward contract is where the parties agree to
undertake a transaction at some specified time
in the future at terms and conditions determined
when contract entered into.
• Spot rate = rate or price available for
transactions undertaken today, with immediate
delivery
• Forward rate is price specified in contract.
Party signing forward contract agreeing to
buy asset in the future is said to have a
long position, while party agreeing to sell
asset in the future is taking on a short
position.
Example – Use of Forward Contracts

• Hightech plc is a manufacturer of computer

equipment and gold forms a vital part of the raw
material required for their production.
• However, due to recent volatility in gold prices,
Hightech seeks to protect itself against
fluctuations in gold prices.
• May do this through a forward contract,
whereby they fix today the price they will
have to pay for gold which they will need at a
specified time in the future.

• Shine Ltd, a gold-mining company, is willing

to enter into a forward contract with
Hightech, whereby Hightech will purchase
1,000 ounces of gold from Shine one year
from today at $295 per ounce.
• Hightech is thus assuming a long position,
while Shine is assuming the corresponding
short position.
• In one year's time, Hightech will pay $2.95m
in exchange for receiving the 1,000 ounces
of gold. The price is thus fixed.
• The value of this forward contract is
dependent (i.e. derived from) the
development of the gold spot price during
the life of the forward contract.
• If at the end of the contract the current
market value of gold is more than $295 per
ounce (e.g., $302), Hightech will have
gained from the forward contract, as they
will be able to purchase the 1,000 of gold at
the fixed price of $295 rather than at the
going spot market rate of $302.

• Their gain will thus be $7,000.

• Conversely, if the market value at the end of
the contract was below $295, Hightech
would have lost, as they would still be
obliged to purchase the gold from Shine at
$295, even if gold is currently worth less.

• Note that the gains and losses to the two

parties exactly match each other.
• If the market value of gold upon delivery
is more than the price specified in the
forward contract (the forward rate), the
party who assumed the long position
(i.e., the party who agreed to buy the
asset at the fixed price) will have gained.

• This gain will be identical to the loss to

the party who assumed the short
position (i.e., the party who agreed to
sell the asset at the fixed price).
• Forward contracts are flexible. Parties can
agree on any terms and conditions that suit
their particular needs. Forward contracts
can thus be customised.

• However, due to this customisation, there

will normally not be a secondary market for
forward contracts (have to hold till expiry).
• These contracts are traded in what is
known as the over-the-counter, or the OTC
market.

• Futures contracts are very similar to

forward contracts. However, rather than
being customised, terms and conditions of
futures contracts are standardised.
• This allows for liquid markets, as a large
number of identical contracts can be
issued.

• Futures contracts are generally traded on

derivatives exchanges, such as
Euronext.LIFFE, CBoT, CME, Eurex, …
etc.
Types of Derivative Instruments
Swaps
• A Swap is similar to a series of forward
contracts. While forward contracts involve
exchange of assets or cash flows at one point
in the future, swap contract involves exchange
of a series of cash flows.
Types of Derivative Instruments
Options
• An Option contract gives holder of option (the
party who buys the contract) the right but not
the obligation to carry out a transaction at (or
within) a specified time in the future (the expiry
date) at a price fixed in the contract (the
exercise or strike price).
 Options

• Party who has purchased option thus has a

choice whether or not to exercise option or to
let it expire unexercised.
• Party who has sold (or written) option does not
have a choice - choice rests with holder of
option.
Options

• Party writing option receives small cash

payment (the option premium) when contract
signed.
• Call option gives right (but not obligation) to buy
asset at a fixed price.
• put option gives right (but not obligation) to sell
asset at a fixed price.
Derivative Contracts
• Derivative instruments are available on numerous
different underlying variables.
• Commodity derivatives, include natural resources
such as various precious metals (e.g., gold, silver,
and platinum), oil, and agricultural products (e.g.,
grain, soya, orange juice and pork bellies).
• Financial derivatives, the focus of this course
include derivatives on interest rates, exchange
rates, and equity.
Settlement
• Settlement is the finalisation of the transaction
that involves a transfer of money and the
receipt of the underlying asset or its cash
equivalent.
• For financial derivatives, settlement usually
occurs in cash rather than the underlying asset
physically being exchanged. This is called cash
settlement.
Settlement – Example
• if Hightech and Shine had agreed cash
settlement, cash payment at the end of contract
from Hightech to Shine would have been:
• ($295 - Spot price of gold at delivery) per ounce
of gold contracted.
 Settlement - Example

• If the price of gold had risen to $302, Hightech

would have to pay Shine: ($295 - $302) * 1,000
= -$7,000 (negative means Shine would have to
pay Hightech $7,000)
• Even if gold is not transacted, Hightech will be
protected against increases in gold prices, as
$7,000 cash settlement will compensate them
for having to purchase gold at spot price of $302
rather than at $295.
Derivatives and Risk Management
• Risk management = active management of
risk/return tradeoff.
• Derivatives are `zero-sum games,' i.e., gain to
one party = loss to the other party.
• However, they perform useful function, as allow
cheap and efficient allocation of risk from those
who wish to reduce exposure, to those who are
willing to assume more risk (obviously in
exchange for higher expected return).
• Also allows for protection of opposite cash flows
(e.g., British Petroleum exposed to falls in oil
prices, while British Airways exposed to rises in
oil prices. Derivative can protect both parties).
Margin and Gearing
• Small margin (good faith) deposit usually made
when contract signed. However, this is only a
small fraction of the value of the asset the
parties commit themselves to transact.
• => Derivatives are highly geared/leveraged
instruments
• => Can take a large position in market relative
to investment made.
Hedging

• Reduce or possibly eliminate risk through hedging.

`Locking-in' position, whereby one would no longer
be exposed to fluctuations in prices or the level of
the underlying variable.
• Hedging involves the reduction or elimination of
the potential for both unexpected losses and
gains.
Hedging –
Example with Forward Contract
• Bits&Bobs (UK) Plc has signed a contract with
Speed, a Malaysian car manufacturer to supply
them with parts for their car production. The
payment of Malaysian Ringits (MR) 5 million will
be made in 90 days time.
• While contract profitable for Bits&Bobs if
Malaysian Ringits can be exchanged into
Sterling at a rate similar to current exchange
rate, Bits&Bobs are concerned that an
unexpected fall in the Ringit may turn this
profit-making contract into a loss-making
venture.

• To protect themselves, Bits&Bobs may hedge

their position through using e.g., a forward
contract.
• When contacting their bank, Bits&Bobs
are quoted a three-month forward
exchange rate of 7.0177. They may thus
sign a forward contract with the bank,
whereby Bits&Bobs will in 90 days time
exchange the MR5m received from
Speed into 5m/7.0177 = £712,484.10.
• Bits&Bobs are thus protected against
changes in the spot MR/£ exchange rate,
as they have fixed the exchange rate.
Their position is hedged.
• Note that hedging involves sacrifice of
potential for unexpected gains as well as
protection against unexpected losses.

• Had Malaysian Ringits been stronger at time

of delivery than the 7.0177 forward rate
(e.g., at MR6.95/£), the Sterling income for
Bits&Bobs would have been higher
(£719,424.50) had they not used a forward
contract.
• Position perfectly hedged if gain (or loss)
on derivatives contract exactly matches loss
(or gain) on underlying asset.

• Derivative instruments such as forwards,

futures, swaps and options suitable for
hedging.
 Insuring
• Insurance involves protection against losses
while still maintaining potential for making
unexpected gains. In exchange for this
protection, investor has to pay an insurance
premium.
• Options can be used to insure an asset,
whereby the investor is covered against losses
in the value of the asset, but may still gain if the
value of the asset increases.
 Insuring- Example
Insuring Share Portfolio with Put options
• The investment company Save&Prosper holds a
portfolio of shares in the 100 largest UK
companies, in proportion to the market
capitalisation of these companies (i.e., the
portfolio matches the FTSE100 index).
• The current market value of the share portfolio is
£252.25m. (In addition, they hold a small
amount of cash).
• Save&Prosper is concerned that the level of
the stock market index may fall substantially
over the next three months.

• However, there is also a possibility of the

share prices rising significantly, and they are
therefore reluctant to either sell the shares
or to use a forward contract.
• They wish to insure against a loss in value to
less than £250m, while still being able to
benefit if the stock market rallies.

• Save&Prosper may insure their portfolio

using FTSE100 index options
• The current level of the index is 5,045 points,
and the three month index put options with
an exercise price of 5,000 are quoted at 276
pence (the details of how options are priced
will be discussed later).

• Index options are settled in cash (rather than

in actual delivery of the shares of the 100
companies constituting the index).
• Euronext.LIFFE, where these options are
traded, have attached a monetary value of
£10 per whole index point.
• If the current market value of the portfolio of
shares which match the FTSE100 index is
£252.25m and the level of index is 5,045, the
value of the portfolio will change
by:£252.25/5,045 = £50,000 for each point
change in the level of the stock market index.
• As the option contract specifies each point
being worth £10, Save&Prosper will require
to purchase 5,000 index put options in
order to insure the portfolio against falling
in value to less than £250m.

• The total cost of buying these options will

be:
5,000 contracts * £2.76 = £13,800.
• At expiry, a put option will be valuable if the
spot price of the asset is less than the
exercise price.
• If the FTSE100 index is below 5,000 on the
expiry of the options in three months time,
Save&Prosper will be paid £10 per index
point per contract.
• However, if the level of the index is above
5,000 at expiry, the options will expire
worthless.
Two exhaustive cases

• Let us look at two examples.

• What will be the value of the
Save&Prosper fund if the level of the
index:
1. falls to, say, 4,850 points, or
2. rises to, say, 5,075 points?
1. If index falls to, say, 4850

• The value of the shares held by Save&Prosper

will have fallen by £9.75m (£50,000 per index
point) from £252.25 to £242.50.
•
• However, Save&Prosper will have made a gain
of (5,000-4,850)*£10 = £1,500 on each of their
5,000 options, giving a total option gain of
£7.5m.
• Thus, the net loss on the share portfolio has
been restricted to £9.75m-$7.5m = £2.25m, from
£252.25m to £250m. (In addition,
Save&Prosper will have spent £13,800 on the
option premium).
• The portfolio was successfully insured against a
large loss in value.
• The cost of the insurance was the total option
premium of £13,800.
2. If index rises to, say, 5075

• Will not exercise options, as shares now worth

£253.75m.
• Will allow options (which cost £13,800) to expire
worthless.
Take Away Points - Summary
• Spot contract = Normal purchase or sale for
immediate delivery.
• Forward / futures contract = Effectively a
deferred spot contract. Fix today the terms
and conditions of a transaction which will take
place at a specified time in the future.
Take Away Points - Summary
Options:
• Buyer of contract has choice whether or not to
undertake a transaction (at a specified price) in
the future.
• Seller of contract has no choice. Must sell/buy
asset if buyer of contract exercise option.
Take Away Points - Summary

• Hedging eliminates potential for loss and

potential for gain - `lock in' position.
• Position risk free if perfectly hedged (perfect
negative correlation between assets).
• Options and forwards/futures suitable for
hedging. E.g., spot purchase of security can be
offset by sale of futures contract, neutralising
risk of holding security.
Take Away Points - Summary

• Insurance eliminates downside risk, but

maintains upside potential.
• Pay premium.
• Options can be used to insure. E.g., option to
sell asset would be exercised if asset value
falls, but not if asset value increases.
Take Away Points - Summary
Derivative Instruments

• Value of security (instrument) dependent upon

(derived from) value of another, underlying,
asset/ security/variable.
• E.g., value of stock index futures dependent
upon level of stock market index.
Take Away Points – Summary:
Derivative Instruments

• Derivatives are leveraged (geared) instruments

• Advantage: with small initial investment can
incur large ‘position’ in market with limited initial
investment.
• Disadvantage: leverage magnifies gains/losses
END