602,EcoSpaceITPar k,Ol

dNagar dasRoad,
MograVil
lage,Nat
warNagar ,AndheriEast
,

Der
ivat
ives
Mumbai,Maharashtr
a,400069
r
eachus@zel
leducat
ion.
com

_______________
www.
zel
leducat
ion.
com
+919004692555
ZELLNOTES

2023
1

Table of Contents
Derivative Markets and Instruments .............................................................................................. 2
Basics of Derivative Pricing and Valuation ...................................................................................... 7
2

Derivative Markets and Instruments

Basics of Derivatives

• A derivative derives its value from the performance of an underlying asset

• A forward contract is an over-the-counter derivative contract in which the buyer agrees to
buy, and a seller agrees to sell an underlying asset at a future date on a specific price that is
agreed upon when the contract is signed
• Futures and options trade on exchanges like the BSE, NSE, LSE, NYSE, etc.
• Exchange-traded derivatives are standardized and regulated
• Over-the-counter derivatives hold much higher default risk counterparty risk

Forward Commitments and Contingent Claims

Forward Commitment Contingent Claims

Forward Contract Commitment to pay a
certain amount for an
underlying asset at a
forward point in time
Futures Contract The buyer and seller
must both fulfil their
obligations
An option is a
contingent claim
Options The holder of the
contract has the right
but not the obligation
to exercise the option
to either buy or sell an
Credit Default Swaps asset

Forwards and Futures

Forwards Futures
Over the counter contracts Exchange-traded contracts
Largely unregulated Regulated
High counterparty risk Low counterparty risk - a clearinghouse acts as
a counterparty to all futures contracts
Customised Standardized
Not marked-to-market Marked-to-market
Settled at the end of the contract Daily settled
No payment is made at the initiation of a forward contract
The value at initiation is 0
The price of the contract is fixed
Value of the contract changes during the life of the contract depending on price movements in the
underlying asset

Used either for speculation or to hedge an existing exposure

The party that buys the asset is called the long leg, and the party that sells or delivers the asset is
called the short leg

Physical delivery and cash delivery

3

Futures Terminology

Clearinghouse

• Mitigate counterparty risk by taking the other side of the trade for both legs
• Makes up for differences in settlement that either party cannot fulfil

Mark-to-Market

• Value of the futures contract moves with value of underlying

• Each party must settle the changes in value every day

Margin

• Traders must post an initial margin when entering a futures contract

• This is like a deposit – it is proof that each party has sufficient funds to meet their obligations
• Maintenance margin must be always held in the account
• Investor will receive a margin call when funds must be added to maintain the margin

Settlement Price

• Average price of futures during the closing period (set by the exchange) is taken
• Ensures that the settlement price is not biased by volatility
• Price limits ensure that neither leg pays too much money into the margin account
• Limit up move is when the settlement price moves higher than the upper limit
• Limit down move is when the settlement price moves lower than the lower limit
• No trade takes place above or below the limit – termed as “locked limit”

Open Interest

• Measures the volume of open contracts (i.e., those that are not settled)
• Varies for different futures and options prices and expiry dates
• Increases when traders make fresh positions
• Decreases when traders close their positions
• Does not change if a contract is traded to another party because that party still has an open
contract that has not been settled or closed yet

Speculators

• Liquidity providers of derivative markets

• Do not engage for physical deliver
• Trade contracts to profit from movements in the price of the underlying

Swaps

• Agreement to exchange a series of payments with another party on fixed dates over a period
• Plain vanilla interest rate swap entails paying a fixed interest rate of interest and receiving a
floating interest rate and basis swap is exchanging one floating rate for another
• LIBOR (London Interbank Offered Rate) or SOFR (Secured Overnight Financing Rate) can be
used as benchmarks for the floating interest rate
• Value of the swap is taken on a net basis – payments and receipts are determined based on
the differences in fixed and floating rates
• Notional principal is not traded, it simply determines the value of payments and receipts
4

• Swaps are like forwards in that:

o No money changes hands at the start of the trade
o The value at initiation is 0
o They are over-the-counter contracts
o They are custom contracts
o They are unregulated
o They hold default risk
o Usually, large institutions engage in such contracts

Options

• Owner of an options contract has the right but not the obligation to buy or sell an underlying
asset at a particular price, either on or before the expiration date
• Seller (writer) of the option has the obligation but not the right to sell or buy the underlying
asset depending on the type of contract
• Types:
o A call option allows the owner of the option to buy the underlying asset at a specified
price before or on the expiration date
o A put option allows the owner of the option to sell the underlying asset at a specified
price before or on the expiration date
• The option's price is also called the option premium
• American-style options can be exercised at any time between the time that the option is
purchased and the expiration date
• European-style options can be exercised only on the expiration date
• Bermuda-style options can be exercised on specific dates until the expiry date

The Four Possible Positions in an Options Trade

Long Call Long Put

Right but not the obligation to buy the Right but not the obligation to sell the
underlying asset either on or before the expiry underlying asset either on or before the expiry
date, depending on the type of contract date, depending on the type of contract

Short Call Short Put

Obligation to sell (or deliver) the underlying Obligation to buy the underlying asset when
asset when the long party exercises their option the long party exercises their option to sell the
to buy the asset asset

Credit Derivatives

• Protection to bondholders
• Insurance against default
• Holder must pay regular premiums just like an insurance policy
• Gives a pay-out to the holder when the company
5

Payoff and Profit for Calls and Puts

Basic Terminology

S = Spot Price (i.e., price of the underlying asset)

X = Strike Price (i.e., exercise price of the option – the price at which one can buy or sell the asset)

Four Possible Payoff Spaces (Cash Flows) in Option Contracts

Long Call Long Put

Payoff = Max (S - X, 0) Payoff = Max (X - S, 0)

Profit = Payoff - Premium Profit = Payoff - Premium

Premium is shown as negative because this Premium is shown as negative because this
must be paid to buy the contract must be paid to buy the contract

Beneficial when spot price exceeds the strike Beneficial when spot price is lower than the
price by enough to cover the premium strike price by enough to cover the premium

Short Call Short Put

Payoff = -Max(S - X, 0) Payoff = -Max(X - S, 0)

Profit = Payoff + Premium Profit = Payoff + Premium

Premium is shown as positive because this is Premium is shown as positive because this is
received when the contract is sold received when the contract is sold

Beneficial when spot price is lower than the Beneficial when spot price is higher than the
strike price because the long party will not strike price because the long party will not
exercise the option and the payoff for the short exercise the option and the payoff for the short
leg is 0 leg is 0
6

Graphical Representation of Calls and Puts

Long Call Long Put

Short Call Short Put

Benefits and Risks of Derivative Markets

Benefits

• Can be used to hedge existing exposure

• Allow for price discovery of underlying asset
• Gauge of general expectations of underlying over different expiry dates
• Leverage helps to reduce the transaction cost of a position

Risks

• Leverage can be harmful if risk management is inadequate

• Complexity of instruments means complex cash flow payoffs
• Losses are theoretically unlimited for short positions

Arbitrage and Law of One Price

• Key assumption of derivatives pricing

• Refers to the principle where traders can earn a riskless profit
• This is not the same as the risk-free rate or that derivatives trading is risk-free
• Essence is that traders take advantage of mispriced assets and the prices converge to a no-
arbitrage price
• Assumes frictionless markets, no taxes, no transaction costs, perfect information
7

Basics of Derivative Pricing and Valuation

Basic Principles

• Price of contract (cash flow to be paid or received) and expiry date is known
• Discount the cash flow at the risk-free rate
• Assumes risk aversion
• Assumes arbitrage and law of one price
• Follows risk-neutral pricing
• Follows the replication principle:
o Cash flow received at the end of the contract can be discounted back to find the spot
price:

o Spot price can be compounded in the future to find the futures price:

F(T) = S0 x (1 + rf)T

• Same principle applies to credit protection with bonds:

Risky Bond + Credit Protection = Value of a Bond at the Risk-Free Rate

• Forwards and futures prices are fixed throughout the contract and are decided at the start of
the contract
Value of Futures and Forwards
• Forwards and futures both have a value of 0 at initiation
• Values change throughout the life of the contract depending on the changes in underlying

V(T) = S0 - F(T)0
or
F(T)
V(T) = S0 - (1 + r )T
f

• Remember to draw a timeline and compare the spot price at any given date to the
discounted futures price on that date
• Adjust for the monetary costs and benefits of holding a futures contract:
o Convenience yield (carry benefits) must be subtracted: dividends, interest received
o Carry costs must be added: storage costs

F(T) = [S0 + PV (Costs) - PV(Benefits)] × (1 + rf)T

8

Differences Forwards and Futures Prices

• Purely theoretical difference

• Futures are settled daily, so the party whose value increases has cash in hand
• The cash can be invested at the risk-free rate
• For identical contracts, futures prices are:
o Higher than forwards prices when interest rates are expected to increase
o Lower than forwards prices when interest rates are expected to decrease
Forward Rate Agreements

• 6×12 FRA means that the FRA starts 6 months from now and expires 6 months after it starts
• The value of the FRA is the difference between the locked-in rate and the floating rate
• Floating rate can be LIBOR or SOFR
• It is mainly used to hedge interest rate uncertainty:
o If you think interest rates will increase, then you will enter a long position in an FRA (pay
a fixed rate and receive the floating rate)
o If you think interest rates will decrease, then you will take the short position
(receive a fixed rate and pay a floating rate)
• FRAs are settled at the start of the contract while interest rate swaps are settled in arrears
• One can make a synthetic FRA by using a combination of floating rates
Interest Rate Swaps
• Can be seen as a series of FRAs
• Settled at the end of the expiry date, not at the start of the contract
• Contract’s rate is based on the fixed rate
• Value of the swap can be non-zero at initiation – this is called an off market forward
• The swap value increases:
o For the long leg, when floating rates increase
o For the short leg, when floating rates decrease
• The swap value decreases:
o For the long leg, when floating rates decrease
o For the short leg, when floating rates increase

Moneyness, Exercise Value and Time Value

• An option that has a positive payoff is in-the-money

• An option that has a payoff of exactly 0 is at-the-money or out-of-the-money
• At-the-money or out-of-the-money options are not exercised
• Exercise value is simply the payoff of the option
• Time value accounts for the logic that many events can take place until the expiry of the
option, so even if the exercise value is 0 the time value can still be positive
Premium = Exercise Value + Time Value

• Time value cannot be observed directly

9

Factors Affecting Option Prices (For the Long Leg)

Factor Notation Call Option Put Option

Price of Underlying Asset S + -

Strike Price X - +

Risk-Free Rate rf + -

Volatility σ + +

Time T + +

Net Carry Cost θ (Theta) + -

Net Carry Benefit γ (Gamma) - +

“+” denotes positive relationship between the factor and the option price

“-” denotes negative relationship between the factor and the option price

Put-Call Parity

• Based on principle of replication

• Has two sides:
o Fiduciary call is a combination of a call option and a bond that pays the same value as
the strike price of the option
o Protective put is a put option with same expiry as call option and underlying asset
• Payoff of a fiduciary call is the same as the payoff of a protective put

Payoff of Fiduciary Call = Payoff of Protective Put

X
c+ =p+S
(1 + rf )T

• The same applies to forward contracts: “S” is replaced by the discounted forward price

X F0 (T)
c+ T =p+
(1 + rf ) (1 + rf )T

American and European Options

• American-style options can be exercised at any point up to and including the expiration date
• European-style options must be exercised only on the expiration date
• American call option is more beneficial when there is a dividend payment
• Option holder can exercise the right to buy the underlying before the ex-dividend date
• Put options have no such early exercise value
10

Binomial Pricing Models

• Accounts for the path of movement of the underlying asset’s price

• Calculates the expected payoff dependent on the path of the price

Details Notation

Size of up-move U

Size of down-move D

Probability of up-move πU

Probability of down-move πD (or 1 - πU)

Risk-free rate rf

• Steps:
o Calculate the risk-neutral probability of an up-move

1 + rf - D
πU =
U-D

o Calculate the path of the prices for the up move and the down move:
▪ Multiply the current price by U
▪ Multiply the current price by D
▪ Draw the branches of up and down moves
o Calculate the payoff of the option for each move
o Calculate the probability-weighted payoff
▪ Multiply the up-move payoff by πU
▪ Multiply the down-move payoff by πD
o Add the probability-weighted payoffs
o Discount the payoff back to today by the risk-free rate of return
602,EcoSpaceITPar k,Ol
dNagar dasRoad,
MograVil
lage,Nat
warNagar ,AndheriEast
,

Al
ter
nat
iveI
nvest
ment
s
Mumbai,Maharashtr
a,400069
r
eachus@zel
leducat
ion.
com

_______________
www.
zel
leducat
ion.
com
+919004692555
ZELLNOTES

2023