Derivatives

A financial contract of pre-determined duration, whose value is derived from the value of an underlying asset
Securities commodities precious metals currency livestock index interest rates, exchange rates

What do derivatives do?

Derivatives attempt either to minimize the loss arising from adverse price movements of the underlying asset Or maximize the profits arising out of favorable price fluctuation. Since derivatives derive their value from the underlying asset they are called as derivatives.

Types of Derivatives (UA: Underlying Asset)

Based on the underlying assets derivatives are classified into.
Financial Derivatives (UA: Fin asset) Commodity Derivatives (UA: gold etc) Index Derivative (BSE sensex)

How are derivatives used?

Derivatives are basically risk shifting instruments. Hedging is the most important aspect of derivatives and also their basic economic purpose Derivatives can be compared to an insurance policy. As one pays premium in advance to an insurance company in protection against a specific event, the derivative products have a payoff contingent upon the occurrence of some event for which he pays premium in advance.

What is Risk?
The concept of risk is simple. It is the potential for change in the price or value of some asset or commodity. The meaning of risk is not restricted just to the potential for loss. There is upside risk and there is downside risk as well.

What is a Hedge
To Be cautious or to protect against loss. In financial parlance, hedging is the act of reducing uncertainty about future price movements in a commodity, financial security or foreign currency . Thus a hedge is a way of insuring an investment against risk.

Derivative Instruments.
Forward contracts Futures
Commodity Financial (Stock index, interest rate & currency )

Options
Put Call

Swaps.
Interest Rate Currency

Forward Contracts.
A one to one bipartite contract, which is to be performed in future at the terms decided today. Eg: Jay and Viru enter into a contract to trade in one stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties. Delivery and payments will take place as per the terms of this contract on the designated date and place. This is a simple example of forward contract.

Risks in a forward contract

Liquidity risk: these contracts a biparty and not traded on the exchange. Default risk/credit risk/counter party risk. Say Jay owned one share of Infosys and the price went up to 4750/three months hence, he profits by defaulting the contract and selling the stock at the market.

Futures.
Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges. These markets are very liquid In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing corporation/house.

The key elements of a futures contract are:

Futures price Settlement or Delivery Date Underlying asset Margin

Illustration.
Let us once again take the earlier example where Jay and Viru entered into a contract to buy and sell Infosys shares. Now, assume that this contract is taking place through the exchange, traded on the exchange and clearing corporation/house is the counter-party to this, it would be called a futures contract.

Examples

Solution

Solution

Positions in a futures contract

Long - this is when a person buys a futures contract, and agrees to receive delivery at a future date. Eg: Virus position Short - this is when a person sells a futures contract, and agrees to make delivery. Eg: Jays Position

How does one make money in a futures contract?

The long makes money when the underlying assets price rises above the futures price. The short makes money when the underlying assets price falls below the futures price. Concept of initial margin , Maintenance Margin and Variation margin Mark to market

Options
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.

Option: key elements

Underlying: This is the specific security / asset on which an options contract is based. Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of an option. It is the difference between the higher price paid for a security and the security's face amount at issue.

Strike Price or Exercise Price :price of an option is the specified/ predetermined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Expiration date: The date on which the option expires is known as Expiration Date Exercise: An action by an option holder taking advantage of a favourable market situation .Trade in the option for stock.

Exercise Date: is the date on which the option is actually exercised. European style of options: The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that. American style of options: An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry.

Option Holder Option seller/ writer Call option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time. Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time

In-the-money: For a call option, inthe-money is when the option's strike price is below the market price of the underlying stock. For a put option, in the money is when the strike price is above the market price of the underlying stock. In other words, this is when the stock option is worth money and can be turned around and exercised for a profit.

Positions
Long Position (Buyer or Holder ): The term used when a person wants to purchase UA in the future period Short position (Seller or writer): The term used to describe the selling of a security, commodity, or currency. fall.

Profit/Loss Profile of a Long call Position

Profit

0 100 -3 103

Loss

Option Price = Rs3 Strike Price = Rs100

Price of Asset XYZ at expira tion

Time to expiration = 1month

Profit /Loss Profile for a Short Call Position

Profit
+3

0 100 103

Price of the Asset XYZ at expiration

Loss

Initial price of the asset = Rs100 Option price= Rs3 Strike price = Rs100 Time to expiration = 1 month

Profit/Loss Profile for a Long Put Position

Profit

0 98 100

Price of the Asset XYZ at expiration

-2

Initial price of the asset XYZ = Rs100

Option Price = Rs2 Strike price = Rs100

Loss

Time to expiration = 1 month

Profit/Loss Profile for a Short Put Position

Profit
+2

0 94 100

Price of the Asset XYZ at expiration Initial price of the asset XYZ = Rs100 Option Price = Rs2 Strike price = Rs100 Time to expiration = 1 month

Loss

Long Call
Short Put
Price rises

Price Falls

Long Put Short Call

Stock Index Option

Trading in options whose underlying instrument is the stock index. Here if the option is exercised, the exchange assigned option writer pays cash to the options buyer. There is no delivery of any stock.

For a stock option, the price at which the buyer of the option can buy or sell the stock is the strike price. For an index option, the strike index is the index value at which the buyer of the option can buy or sell the underlying stock index. For Eg: If the strike index is 700 for an S&P index option, the USD value is $70,000. If an investor purchases a call option on the S&P100 with a strike of 700, and exercises the option when the index is 720, then the investor has the right to purchase the index for $70,000 when the USD value of the index is $72000. The buyer of the call option then receive$2000 from the option writer.

Example
An investor buys ten call options on shares in ABC plc at a strike price of 450. Each option contract if for 1,000 shares and the premium paid was 37 pence. What would happen if, at expiry the share price is

Example
The price of a six-moth European call option on shares in Moss plc is 53 pence. The strike price for the options is 260 pence and the current market price of the shares is 290. What should be the price of a six-month European put option for the same expiry date and the same strike price, if you are given that the present value of the exercise price is 252 pence?

HEDGING WITH CURRENCY OPTIONS

To construct a hedge against currency risk with currency options, you need to: Establish what the exposure is, and identify the future currency receipt or payment Work out whether a call or a put option is required to give the right to buy or sell the currency Decide on a strike price. Several strike prices might be available, each with a different premium. There is no right or wrong strike price

HEDGING WITH CURRENCY OPTIONS

Having constructed the hedge by buying options, you will now: Exercise the option if it is in-the money at expiry, and buy or sell the currency at the strike price Let the option lapse if it is out-ofthe-money and buy or sell the currency at the current spot rate

Example
1. It is late September and the spot sterling/US dollar $1.6000 A UK company will be required to pay $1.2 million to a US supplier in December and has decided to hedge the exposure with currency options. To do this, the company will either buy call options on dollars or sell put option on sterling. A bank is willing to sell put options on sterling at a strike price of $1.6000 for a premium of 1.5 cents per sterling

Example
The company will want to buy $1.2 million in December and it can obtain an option to do this by buying a put option on sterling at a strike price of $1.60. it will need to have a put option of sterling 750,000 ($1.2 million/1.60) The cost of this option will be $11,250 (0.015 x sterling 750,000).

Example
The company will have to buy dollars spot to pay this premium, and at a spot price of $1.60, this will cost sterling 7,031.25 The hedge has been constructed. The eventual outcome will depend on what the spot exchange rate is in December when the option expires. (a) Suppose the spot exchange rate in December is $1.8000

If the spot rate is $1.800, the dollar has weakened in value since September, and it will be cheaper to buy dollars (sell sterling) in the spot market at this rate, and let option lapse.

Gains or losses on hedging with options

It is possible to calculate the gain or loss from using options. This calculation is useful for a company or investor that speculates with options, but is of little relevance to companies that use options for hedging.

In the example above, the gain o loss from buying the put option would be as follows Put options on sterling at strike price of $ 1.600

Solution

Swaps
An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and currency swaps.

Features of swap
Counter parties Facilitators Cash Flows Documentation Transaction cost Benefit to parties Default risk Termination Benefit to parties

Types of swap
Interest rate swap Currency swap Equity Swap

Example 1 of interest rate Swap

Mortgage Portfolio
8.5% 6.5%
$100 (M) 5 Years maturity

Firm -A
LIBOR

Big bank

LIBOR+0.5%

Floating rate Lenders

Contd.
Firm A interest rate agreement with Big Bank
Receipt on Portfolio : 8.50% Pay big bank: 6.50% Received from Big bank:LIBOR Pay on Loan: (LIBOR+0.50%) Locked in spread : 1.50%

Example 2 of Interest rate Swap

Loan Portfolio
$100 (M) 5 Years maturity

LIBOR+075% LIBOR

Firm -B
6.40%

Big bank

6%

Euro Bond

$100 (M) 5 Years maturity

Contd.
Firm B interest rate agreement with Big Bank Receipt on Portfolio : LIBOR+075% Pay big bank: LIBOR Received from Big bank:6.40% Pay on Loan:6% Locked in spread : 075+0.40=1.15%

Currency swap
Initial Exchange of principal amount Ongoing excahnge of interest Re-exchange of principal on maturity

Step 1 : This transaction is carried out at the prevailing spot rate in the market.
Swiss franc

Transaction under currency swap:

Firm -A
US Dollar

Firm-B

Step 2: Settlement of notional annual Interest

Notional Swiss franc interest

Firm -A

Firm-B

Notional US Dollar interest

Contd.
Step 3: Exchange of final contract

Swiss Franc Forward Contract

Firm -A
US Dollar Forward Contract

Firm-B

Summary
Forward contract Forward contract may give profit to the person in long position(Buyer), if forward Spot/Market price is higher than the contract price. Further if forward Spot/Market price is less than the forward price, there will be loss. In case of Short Position(seller), He will be in a profit if the forward/ future price is less than to contract price. In the opposite situation there will be loss

Contd
Future contract In Future contract it is beneficial to the party in long position(Buyer), if future /spot price of U/A will go up whereas in the short position there will be loss. On the other hand if the future price of U/A comes down then person in Short position(seller) will get profit and the person in long position will be in loss

Contd.
Option In Call Option buyer has to exercise it, if future market price of U/A is greater than the strike price either to minimise loss or to get the profit In Put Option Buyer exercises it if, future spot price of U/A is less than the strike price either to minimise the loss or maximise the profit

Contd.
SWAP It is need based private agreement between the counter parties to exchange predetermined amount of cash flows in future as per desired predetermined formula along with other terms and conditions

Thank You!