Derivatives Notes

CONCEPT TESTING

1. Definition of Derivatives
2. Types of underlying assets
3. Forwards
4. Futures
5. Basis
6. Option Premium
7. Delta
8. Gamma
9. Theta
10. Vega
11. Rho
12. Perfect Hedge
13. Call Option
14. Currency Swap
15. Interest Rate Futures
16. Open Interest
17. Reverse Cash and Carry Arbitrage
18. Black Sholes Model for Option Pricing

THEORY QUESTIONS

1. Illustrate how to execute a short hedge on a stock using an example. Test The
Hedge using cases
A short hedge is a risk management strategy used by investors to protect against a
decline in the price of an asset they hold. This strategy involves taking a short
position in a related asset, such as a futures contract, that is expected to move
inversely with the price of the underlying asset.

Here is an example of how to execute a short hedge on a stock:

Suppose you own 100 shares of XYZ Corporation, which is currently trading at $50
per share. You are concerned that the price of the stock may decline in the near
future, but you want to hold on to your position in the stock.

To protect against a decline in the price of XYZ Corporation, you decide to take a
short position in a futures contract for XYZ Corporation. The futures contract has a
price of $49 per share and an expiration date of three months from now.

You sell one futures contract, which represents 100 shares of XYZ Corporation, at
the current price of $49 per share. This means that you are obligated to deliver 100
shares of XYZ Corporation to the buyer of the futures contract at the expiration date,
regardless of the market price at that time.

Now, let's test the hedge using different scenarios:

Scenario 1: The price of XYZ Corporation increases to $55 per share at the
expiration date.

In this scenario, your 100 shares of XYZ Corporation are now worth $5,500.
However, the futures contract you sold for $49 per share is now worth $55 per share,
resulting in a loss of $600 ($55 - $49) per share. Since you sold one futures contract
representing 100 shares, your total loss on the futures contract is $60,000 ($600 x
100). However, the gain on your stock position is $500 ($55 - $50) per share,
resulting in a total gain of $5,000 (100 shares x $500). The net result is a loss of
$55,000 ($60,000 loss on the futures contract - $5,000 gain on the stock position).

Scenario 2: The price of XYZ Corporation decreases to $45 per share at the
expiration date.

In this scenario, your 100 shares of XYZ Corporation are now worth $4,500.
However, the futures contract you sold for $49 per share is now worth $45 per share,
resulting in a gain of $400 ($49 - $45) per share. Since you sold one futures contract
representing 100 shares, your total gain on the futures contract is $40,000 ($400 x
100). However, the loss on your stock position is $500 ($50 - $45) per share,
resulting in a total loss of $5,000 (100 shares x $500). The net result is a gain of
$35,000 ($40,000 gain on the futures contract - $5,000 loss on the stock position).

As you can see, the short hedge helped protect your stock position against a decline
in the price of XYZ Corporation in scenario 2, but resulted in a loss in scenario 1. It is
important to note that hedges are not always perfect, and investors must carefully
consider the risks and costs involved before implementing any hedging strategy.

2. What are derivatives, what are the different types of derivatives in this market
Derivatives are financial contracts, set between two or more parties, that derive their
value from an underlying asset, group of assets, or benchmark.
A derivative can trade on an exchange or over-the-counter.
Prices for derivatives derive from fluctuations in the underlying asset.
Derivatives are usually leveraged instruments, which increases their potential risks
and rewards.
Common derivatives include futures contracts, forwards, options, and swaps.

A derivative is a complex type of financial security that is set between two or more
parties. Traders use derivatives to access specific markets and trade different
assets. Typically, derivatives are considered a form of advanced investing. The most
common underlying assets for derivatives are stocks, bonds, commodities,
currencies, interest rates, and market indexes.

Futures
A futures contract, or simply futures, is an agreement between two parties for the
purchase and delivery of an asset at an agreed-upon price at a future date. Futures
are standardized contracts that trade on an exchange. Traders use a futures contract
to hedge their risk or speculate on the price of an underlying asset. The parties
involved are obligated to fulfil a commitment to buy or sell the underlying asset.

Forwards
Forward contracts, or forwards, are similar to futures, but they do not trade on an
exchange. These contracts only trade over-the-counter. When a forward contract is
created, the buyer and seller may customize the terms, size, and settlement process.
As OTC products, forward contracts carry a greater degree of counterparty risk for
both parties.

Swaps
Swaps are another common type of derivative, often used to exchange one kind of
cash flow with another. For example, a trader might use an interest rate swap to
switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.

Options
An options contract is similar to a futures contract in that it is an agreement between
two parties to buy or sell an asset at a predetermined future date for a specific price.
The key difference between options and futures is that with an option, the buyer is
not obliged to exercise their agreement to buy or sell.

3. Explain the cost of carry model for pricing of futures with an example
The cost of carry model is a pricing model used for futures contracts that takes into
account the cost of holding the underlying asset until the expiration of the futures
contract. The model assumes that the futures price should equal the spot price of the
underlying asset plus the cost of carrying the asset until expiration.

The cost of carry includes two main components: the financing cost and the storage
cost. The financing cost is the cost of borrowing money to buy the underlying asset,
while the storage cost is the cost of storing the asset until the futures contract
expiration date. In some cases, there may also be other costs associated with
carrying the asset, such as insurance or transportation costs.

Let's consider an example: suppose we want to price a futures contract on crude oil
that expires in three months. The current spot price of crude oil is $60 per barrel, and
the interest rate for borrowing money is 5% per annum. The storage cost for crude
oil is $0.50 per barrel per month.

Using the cost of carry model, we can calculate the theoretical futures price as
follows:

Futures price = Spot price + Financing cost + Storage cost

Financing cost = Spot price x (Interest rate / 12) x Time to expiration

= $60 x (5% / 12) x (3 / 12)
= $0.625

Storage cost = Storage cost per unit x Quantity x Time to expiration

= $0.50 x 1000 x (3 / 12)
= $125

Futures price = $60 + $0.625 + $125

= $185.625 per barrel

Therefore, based on the cost of carry model, the theoretical futures price for crude oil
that expires in three months is $185.625 per barrel.

4. What are futures explain its features

Futures are derivative financial contracts that obligate parties to buy or sell an asset
at a predetermined future date and price. The buyer must purchase or the seller
must sell the underlying asset at the set price, regardless of the current market price
at the expiration date.

Underlying assets include physical commodities and financial instruments. Futures

contracts detail the quantity of the underlying asset and are standardized to facilitate
trading on a futures exchange. Futures can be used for hedging or trade speculation.

Features
Organised Exchanges:
Unlike forward contracts which are traded in an over-the-counter market, futures are
traded on organised exchanges with a designated physical location where trading
takes place. This provides a ready, liquid market in which futures can be bought and
sold at any time like in a stock market.

Standardisation:
In the case of forward currency contracts, the amount of commodity to be delivered
and the maturity date are negotiated between the buyer and seller and can be
tailor-made to buyer’s requirements. In a futures contract, both these are
standardised by the exchange on which the contract is traded.

Actual Delivery is Rare:

In most forward contracts, the commodity is actually delivered by the seller and is
accepted by the buyer. Forward contracts are entered into for acquiring or disposing
off a commodity in the future for a gain at a price known today
In contrast to this, in most futures markets, actual delivery takes place in less than
one per cent of the contracts traded.

Daily Settlement
Daily settlement refers to the process whereby the exchange debits and credits all
accounts with daily profits and losses as calculated by the mark-to-market process.
Daily settlement is necessary in order to recover losses and pay profits to respective
accounts.

5. Explain the Straddle Strategy for option trading

The Straddle Strategy is a trading strategy that involves buying both a call option and
a put option on the same underlying asset with the same expiration date and strike
price. The idea behind this strategy is to take advantage of significant price moves in
the underlying asset, regardless of whether it moves up or down.

When a trader uses the Straddle Strategy, they purchase both the call and the put
options at the same time. If the stock price moves up significantly, the call option
becomes profitable, and if it moves down significantly, the put option becomes
profitable. The trader can then exercise either option to profit from the movement in
the stock price.

The key to success with the Straddle Strategy is to choose the correct time to enter
the trade. This means identifying a stock that has a high potential for a significant
price movement, but whose direction is unclear. This can be done by analyzing
fundamental and technical indicators, such as earnings reports, economic data, and
chart patterns.

Here is an example of how the straddle strategy works:

Suppose that ABC Corporation is currently trading at $100 per share. You believe
that there may be a large price movement in the stock in the near future, but you're
not sure which direction the price will move. To take advantage of this potential price
movement, you decide to use the straddle strategy.
You purchase a call option and a put option on ABC Corporation with an expiration
date of one month from now and a strike price of $100. The call option gives you the
right to buy the stock at $100 per share, while the put option gives you the right to
sell the stock at $100 per share.

If the price of ABC Corporation increases above $100 per share, your call option will
be in the money and you can exercise it to buy the stock at $100 per share.
Alternatively, if the price of ABC Corporation decreases below $100 per share, your
put option will be in the money and you can exercise it to sell the stock at $100 per
share. In either case, you stand to make a profit.

However, if the price of ABC Corporation remains relatively stable and does not
move significantly, both the call and put options may expire worthless, resulting in a
loss of the premium paid for both options.

6. Explain five types of swaps with diagram

7. Explain the binomial option pricing model with an example
The binomial option pricing model is a mathematical tool used to value options by
breaking down the time to expiration into a series of discrete intervals or steps. The
model assumes that the underlying asset can only move up or down by a certain
percentage in each time step, and that the risk-free rate is known and constant.

The binomial option pricing model is a mathematical tool used to value options. The
model assumes that the underlying asset can only move up or down by a certain
percentage in each time step, and that the risk-free rate is known and constant.

Let's consider an example: suppose you have a call option on stock XYZ with a
strike price of $50 and an expiration date in 6 months. The current stock price is $45,
and the risk-free rate is 5% per annum.

To apply the binomial model, we first need to determine the parameters for the
model. We assume that the stock can move up or down by 10% in each time step
(i.e., over a period of 3 months), and that there are two time steps until expiration.

Next, we construct a binomial tree that shows all possible stock price outcomes at
expiration, based on the assumed up and down movements. The tree has two levels,
corresponding to the two time steps. At each node in the tree, we calculate the stock
price and the corresponding option value.

At expiration, the stock price can be either $49.50 (if the stock goes up twice), $45 (if
the stock stays the same), or $40.50 (if the stock goes down twice). We then
calculate the option value at each of these prices. For example, if the stock price is
$49.50, the option value is $0.50, since the option is “in the money” by $0.50.
Working backwards through the tree, we can then calculate the option value at
earlier time steps, taking into account the probabilities of the different stock price
movements. For example, at the first time step, the stock can either go up to $49.50
with probability 0.25, or down to $40.50 with probability 0.75. We then calculate the
expected option value at this time step, which is the weighted average of the two
possible outcomes:

Expected option value at first time step = 0.25 x $0.50 + 0.75 x $0 = $0.125

We repeat this process at the second time step, and finally arrive at the current
option value, which is $1.41.

Thus, using the binomial option pricing model, we can value the call option on stock
XYZ at $1.41.

8. Explain options Greek with their example

9. Explain the strangle strategy and its execution
A strangle is a popular options strategy that involves holding both a call and a put on
the same underlying asset.
A strangle covers investors who think an asset will move dramatically, but are unsure
of the direction.
A strangle is profitable only if the underlying asset does swing sharply in price.
A strangle is similar to a straddle but uses options at different strike prices, while a
straddle uses a call and put at the same strike price.

How Does a Strangle Work?

Strangles come in two directions:

In a long strangle—the more common strategy—the investor simultaneously buys

an out-of-the-money call and an out-of-the-money put option.
The call option's strike price is higher than the underlying asset's current market
price, while the put has a strike price that is lower than the asset's market price.
This strategy has large profit potential since the call option has theoretically unlimited
upside if the underlying asset rises in price, while the put option can profit if the
underlying asset falls.

An investor doing a short strangle simultaneously sells an out-of-the-money put and

an out-of-the-money call. This approach is a neutral strategy with limited profit
potential. A short strangle profits when the price of the underlying stock trades in a
narrow range between the breakeven points. The maximum profit is equivalent to the
net premium received for writing the two options, less trading costs.
 10. What are the factors affecting option premium
The premium of an option is the price that an option buyer pays to an option seller
for the right to buy or sell an underlying asset at a specified price, known as the
strike price, on or before a specified date, known as the expiration date. The
premium is influenced by various factors, including:

Underlying asset price: The price of the underlying asset has a significant impact on
the premium of an option. As the price of the underlying asset increases, the
premium of a call option typically increases, while the premium of a put option
typically decreases, and vice versa.

Strike price: The difference between the strike price and the current market price of
the underlying asset also affects the premium. The closer the strike price is to the
market price, the higher the premium for both call and put options.

Time to expiration: The amount of time remaining until the expiration date of the
option affects the premium. The longer the time to expiration, the higher the
premium, as there is more time for the underlying asset price to move in the option
holder's favor.

Volatility: The volatility of the underlying asset, or the magnitude of price movements,
also affects the premium. Higher volatility generally leads to higher option premiums,
as there is a greater likelihood that the option will be profitable.

Interest rates: The interest rate environment also plays a role in the option premium.
Higher interest rates tend to increase call option premiums and decrease put option
premiums, as the cost of holding the underlying asset and the opportunity cost of not
investing in other assets increase.

Dividends: If the underlying asset pays dividends, this can also affect the option
premium. For example, call option premiums may decrease as the ex-dividend date
approaches, as the value of the underlying asset decreases due to the dividend
payout.

These are some of the main factors that can affect the premium of an option, and
traders and investors must consider them when analyzing options and constructing
trading strategies.

CASE STUDY

1. Butterfly Strategy
2. Hedging of a Portfolio using future