Derivatives

A man has to cross a river. He has a fox, a chicken,

and a bag of corn with him.
He has a boat, and it can only carry him and one
other thing.
If the fox and the chicken are left together, the fox
will eat the chicken.
If the chicken and the corn are left together, the
chicken will eat the corn.
How does the man do it?
 Concept
Business decisions are always made in the presence
of risk.
There are two types of risk:
Some risks are associated with the underline nature
of the business, like uncertainty in sales, cost of
input price, problems related to machines or labour
etc. Recently, business firms also face the risks
related to social and environmental issues.
These risks are called Business Risk.
Another class of risks deals with the uncertainties
such as interest rates, exchange rates, stock prices etc.
These are called financial risks.
Although business activities involve risks, there are
means of dealing with risks. The term “Derivative” is
associated with managing risks.
Derivatives are financial contacts whose performance
depends on how other instruments perform.
It can be defined as a financial instrument whose
value depends on (or derives from) the values of
other, more basic underline variables.
A simple example of derivative is Curd, which
derives from milk. The price of curd depends upon
price of milk, which in turn depends upon the
demand and supply of milk.
All derivatives are based on the random
performance of of something. That ‘something’ is
often referred to s the underlying assets.
The underlying may be a stock, bond, currency etc,
which are assets. However, it can also be some
other random elements, like weather, which is not
an asset.
Hence, it is more appropriate to say derivative is
‘on an underlying’, instead of ‘on an underlying
assets’.
Based on underlying instruments, derivatives
can be classified into commodity derivatives and
financial derivatives.
In a commodity derivative, the underlying
instrument is a commodity which my be gold,
cotton, sugar, rice, jute, crude oil etc.
In financial derivatives, underlying instrument
may be stock, bonds, foreign exchange, stock
index etc.
Although the structure and functions of both the
forms of derivatives are almost same, financial
derivatives are more standardized and there are
no quality issues as compared to commodity
derivatives.
The most commonly used derivative contracts are:
Forward, Futures and Options.
Basic features of derivatives:
1. It is a contract: Derivative is defined as the future
contract between two parties. The future period
may be short or long based on the nature of
contract.
2. Derive values from underlying: The derivative
instruments have the value which is derived from
the values of other underlying instruments like,
commodities, financial assets, intangibles etc.
3. Direct or exchange traded: The derivatives
contract can be undertaken directly between two
parties or through the particular exchange.
4. Flexible value: Since the value of derivate
depends upon the value of underlying
instrument, when value of underlying instrument
change then value of derivatives also changes.
 5. Specific period: Derivatives have a maturity
or expiration date after which they become
worthless or automatically terminate. 
 Derivatives Market

Derivative markets are markets for contractual

instruments whose performance is
determined by the performance of other
instruments.
Derivative as a contract is the agreement
between two parties – a buyer and a seller.
Derivative transactions can occur both publicly
as well as privately.
 Global listed derivative trading
According to Future Industry magazine, 2015, Asia-Pacific
resign is leading in the derivative transactions, which is
about 39% of global listed derivative markets. North
America has occupied the 2nd position.
It is also evident from the report that the share of options
and future contracts are almost equal in the total trading
volume during 2007 to 2015. however, in 2016, share of
futures is considerably more than that of options.
Top five volume categories are: Equity index, individual
equities, interest rate, foreign currency and agricultural
commodities.
 Derivative Contract
1. Options
An option is a contract between two parties - a buyer and
a seller – that gives the buyer the right, but not
obligation, to purchase or sell something at a later date
at a price agreed upon.
2. Contract between two parties
3. Right to buy or sell
4. Right but not an obligation
5. For a specific period and at a specific price
 An option to buy something is referred to as a
Call
 An option to sell something is called a Put
 The seller stands ready to sell according to the
contract as and when the buyer wants to buy.
 If an option trading is conducted privately
between two parties, the market is called Over-
the –Counter market.
 A call option gives the holder the right to buy an
asset by a certain date for a certain price.
 A put option gives the holder the right to sell an
asset by a certain date for a certain price.
 The date specified in the contract is known as the
exercise date, the strike date, the expiration date
or the maturity date.
 The price specified in the contract is known as
the exercise price or strike price.
 The option buyer pays the seller a sum of money
called the price or premium.
Options can be either American or European.
American options are options that can be
exercised at any time up to the expiration date,
whereas European options are options that can
be exercised only on the expiration date.
 Problem
An investor buys a European call option to purchase
100 IMB shares with a strike price of Rs. 400. the
current stock price is Rs. 380 . The expiration date
of the option is in four months and the price of an
option to purchase one share is Rs. 50. State
whether the investor will exercise the option if
the price per share at the expiration date is i) Rs.
390; or ii)Rs. 430 or iii) Rs. 550.
Also compute the amount of gain or loss for each
case.
Since the option is European, the investor can exercise the
option only on the expiration date.
Strike price per share of IBM = Rs. 400
Option price per share = Rs. 50
Therefore, initial investment = Rs. 50 x 100 = Rs. 5000
i) If the share price is Rs. 390 at the expiration date:
Since the share price at the expiration date (390) is less than
the strike price of share (400), the investor should not
exercise the option, because the amount of loss will be
more.
If the option is not exercised, then the amount of loss = the
initial investment = Rs. 5000
If the option is exercised, the amount of loss = (400-390)x100
+ 5000 = Rs. 6000
ii) When the price per share = Rs. 430
If the option is not exercised, the amount of loss = Rs. 5000
If the option is exercised and the shares are sold
immediately, the amount of loss/ gain will be:
Sales price of shares = Rs. 430 x 100 = Rs. 43000
Less, strike price = Rs. 400 x 100 = Rs. 40000
Thus, gain = Rs. 3000
Less, initial investment = Rs. 5000
Actual loss = 2000
Although there is a loss of Rs. 2000 if the option is
exercised @ Rs. 430, but the total amount of loss will be
less. Hence, the investor should exercise the option.
 Principles of call option

A call option is an instrument with limited liability.

If the call holder finds that it is advantageous to
exercise the call, it will be exercised. If exercising
the option decrease the call holder’s wealth, the
holder will not exercise it.
The minimum value of a call is equal to the strike
price at the exercise date. If the exercise price >
strike price, exercise of the option is profitable,
otherwise it should not be exercised. The minimum
value of an option is called its intrinsic value.
 Problem

An investor buys a call option to purchase 200 shares of

Microsoft on 1st July, 2017 with a strike price of Rs. 350.
The stock price as on 1St July is Rs. 320. The expiration
date of the option is on 30th September. The premium to
purchase one share is Rs. 20. The share price of the
Microsoft at different dates are as follows:
15th July : 330; 25th July: 370; 10th August: 390; 1st
September: 387; 20th September: 360; 30th September:
355.
State whether the call option to be exercised or not, if the
option is i) American Option and ii) European Option.
Also compute the amount of gain/loss for this option.
 Put Option
Put option is a device which gives the owner of
a put the right, but not the obligation, to sell
an instrument (the underlying), at a specified
price (the strike), by a predetermined date
(the expiry or maturity).
The purchase of a put option is interpreted as a
negative sentiment about the future value of
the underlying because the holder of the put
option expects decline in the value of stock in
future.
If the price of the stock declines below the specified
price of the put option, the owner/buyer of the
put has the right to sell or not to sell the asset at
the specified price, while the other party has the
obligation to purchase the asset at the strike price
if the owner uses the right to do so.
In an American option the buyer can exercise the
put at any time until the option's maturity time.
The put yields a positive return only if the
security price falls below the strike when the
option is exercised. A European option can only
be exercised at the maturity date.
An investor buys a European Put option on 1st May,
2017 to sell 300 shares of X Ltd. with a strike price
of Rs. 200. The expiration date of the option is on
1st September. The investor purchases put option
@ Rs. 25 per share. State whether the investor
will exercise the option if the price per share at
the expiration date is i) Rs. 210; or ii)Rs. 180 or iii)
Rs. 150.
Also compute the amount of gain or loss for each
case.
 Forward Contract
A forward contract is a contract between two
parties – a buyer and a seller – to purchase or sell
something at a future date at a price agreed upon
today.
Spot rate is the rate of day on which the
transaction has taken place.
Forward Rate is the rate which is determined in
advance for the delivery of assets at a future
date
For example, on 1st March, the 3 months forward
rate is Rs. 68 per US $, while on 1st June ( i.e. after 3
months) the actual spot rate is Rs. 69 per $. If the
company purchase the US $ at 3-months forward
rate, then on 1st June the exchange rate will be Rs.
68 per $ instead of Rs. 69 per $.
 Option Vs. Forward contract
An option carries the right, not the obligation, to
go through with the transaction. If the price of the
underlying good changes, the option holder may
decide to forgo buying or selling at a fixed price.
But, two parties in a forward contract incur the
obligation to ultimately buy and sell the goods.
On 1st January, an Indian firm exports goods of
the value of US $ 10000 on 6 months credit. On
1st January, the six months forward rate is Rs. 69
per US $. The firm agrees to sell Us $ 10000 at Rs.
69 on 1st July. Suppose the actual spot rate is Rs.
67.50 per US $ on 1st July. Calculate the actual
gain/ loss of the Indian firm for this contract.
Important Concepts in Financial and Derivative Markets
Risk Preference:
Individuals may be characterized as risk neutral
and risk aversion.
If the expected outcome is equal to the actual
payment of an individual, the situation can be
described as risk neutral, which means that the
individual is indifferent to the risk.
But if the actual payment is less than the expected
outcome of an individual, it can be characterized
as risk aversion.
The difference between the expected outcome and
actual payment is called the risk premium.
Let an investor is faced with two equally likely
outcome.
The income from the 1st outcome = Rs. 50
The income from the 2nd outcome = Rs. 20.
Thus, the expected outcome = Rs. (50 x .5) + Rs.
(20 x .5) = Rs. 35.
This implies than the investor is expected to
receive Rs. 35 from that game.
Now, if the actual payment of that purpose is Rs.
35, then expected outcome = actual payment.
This is risk neutral situation.
But most of the investors are characterized by risk
aversion and wants to pay less than the expected
outcome.
If the actual payment is, say, 25, the situation is
called risk aversion.
The difference between expected outcome and
actual payment i,.e. Rs. 10 is the risk premium.
 Short Selling
In stock market one party buy stock from another
party. However, the party selling the stock does not
actually own the stock, rather borrow the stock
from a broker with an agreement to repay the stock
to the broker with in a very short period of time.
This is known as short selling.
The person involves in it is said to be selling short
or sometimes shorting.
Why this is done?
This is done in anticipation of price falling of the stock in
near future. The short seller would then buy back the stock
at lower price, capturing a profit and repaying the shares to
the broker.
Establishing a short position creates a liability.
The short seller is obligated to buy back the stock and
return it to the broker. It is like an ordinary short term loan.
However, in ordinary loan, the borrower knows exactly
how much he or she must pay back to the lender. But the
short seller does not know what would be cost of buying
back of the shares.
 Futures
A futures contract is a contract between two parties
where both parties agree to buy and sell a particular
asset of specific quantity and at a predetermined price,
at a specified date in future.

The payment and delivery of the asset is made on the

future date termed as delivery date. The underlying
asset in a futures contract could be commodities,
stocks, currencies, interest rates and bond. The futures
contract is held at a recognized stock exchange.
Futures contract evolved out of forward contracts
and possess many of the same characteristics.
However, they are different in two important
aspects:
1. Unlike forward contracts, future contracts trade
on organized exchanges, called future markets.
2. It also differ from the forward contract in that
it is subject to a daily settlement procedure.
Futures prices fluctuate from day to day. In daily
settlement, investors who incur losses pay the
loss every day to investors who makes profit.
• For example, the buyer of a future contract,
who has the obligation to buy the good at the
later date, can sell the contract in the future
market, which relieves the person of the
obligation to purchase the good.
• Likewise, the seller of a future contract, who I
obliged to sell the goods at later date, can buy
the contract back in the future market, relieving
the person of the obligation to sell the good.
Problem on Short Selling
An investor shorts 500 shares of X Ltd. in April when
the price per share is Rs. 50, and buys them back to
close out the position in July when the price is Rs.
30. A dividend of Rs. 2 per share is paid in May.
Calculate the profit or loss of the investor in selling
sort.
The investor receives in April by selling 500 shares of X
Ltd. = 500 x 50 =Rs. 25000.
The closing date of this position is in July. Since the
company declares dividend in May, the investor must
pay the total amount of dividend to the broker.
Amount of dividend = 500 x 2 = Rs. 1000
Share price in July = Rs. 30
The cost of closing out the position = 500 x 30 = 15000
Total cost of the investor = dividend + purchase price =
1000 +15000 = 16000
Net gain = 25000 – 16000 = Rs. 9000
 swaps

A swap is a financial derivative in which two

parties make a series of payments to each
other at specific date over a predetermined
period.
The more common types of swaps involve one
party making a series of fixed payments and
receiving a series of variable payments.
However, there are swaps in which both the
parties makes variable or fixed payments.
There are four primary types of swaps based on
the nature of the underlying variable: interest
rate swaps, equity swaps, currency swaps and
commodity swaps.
Swaps have an initiation date; a termination
date and the dates on which payments are to be
made. The dates on which a payment occurs is
called the settlement date and the period
between settlement dates is called settlement
period.
 Interest rate swaps:
The most common type of swap is a plain
vanilla swap, in which one party agrees to pay
other party interest on some principal at a fixed
rate, and other party pays interest on the same
principal at a floating rate over a same period of
time.
Payment of interest = (Principal Amount)x(rate
of interest)x (number of days/360 or 365 days)
Net payment = (Principal Amount)x(Floating rate
– fixed rate)x (number of days/360 or 365 days)
Let Company A enters into a 5,00,000 principal amount
swap with Company B. The initiation date is 15 th
December. A agrees to pay interest at a fixed rate of 7.5%
p.a. and B agrees to pay interest on floating rate. The
payment will be made quarterly and the floating rate will
be rate at the beginning of the settlement period.
The rates are as follows:
On 15th December: 7.68%; on 15th March : 7.50%; on 15th
June: 7.06 and on 15th September : 6.06.
Compute the payments of A and B.
Assume 360 days in a year.
 Role of derivatives in risk management
Derivative prices are associated with the prices of the
underlying instruments in the spot market. Hence
derivatives can be used to reduce risk of assets or to
assume risk with the anticipation of earning profit.

Financial derivatives can be used in two ways: to hedge

against unwanted risks or to speculate by taking a
position in anticipation of a market movement.
Hedgers are those who enter into a derivative contract
with the objective of covering risk.
Let farmer and the owner of rice meal are two parties
associated with the uncertainty of future prices.
Farmer growing rice faces uncertainty about the price
of product at the time of the harvest. Similarly, a rice
mill needing rice also faces uncertainty of price of
input. The farmer apprehends price fall while the rice
mill fears price rise. Both the parties face price risk.
How derivative instrument can be used to reduce risk?
Both the farmer and the flour mill can enter into
a forward contract for, say, 3 months. The price
of the product is determined in advance
between the two parties. After 3 months both
the parties can reduce the price risk. The farmer
will get the agreed price of product and the
owner can buy the product as specified price
irrespective of the actual spot rate.
Derivative instruments can be used to earn profits
by assuming risk. The trader associated with such
activities are called speculators.
For example, the forward price in US dollar for a
contract maturing in three months is Rs. 68.00. If
one believes that three months latter the price of
US dollar would be Rs. 70, one would buy forward
today and sell later. The difference in the price is
the gain of the investor.
On the contrary, if one believes US dollar would
depreciate to Rs.66.00 in 1 month, one would sell
now and buy later.
Sometimes speculator acts as a middlemen. If the
owner of a rice mill finds difficulty to locate a
suitable farmer to supply the exact requirements,
middlemen enters into forward contract with
both farmer and the rice meal by speculating the
future prices.
Derivatives can also be used for price stability.
Let the exchange rate between Rs. and US$ quoted in
two different forex markets are: Rs.65/$ and Rs. 67/$.
The arbitrageur would buy $ from the former market and
would sell it in the latter market to earn profit.
An arbitrageur takes risk neutral position and makes
profits because markets are imperfect. Naturally, such
imperfections cannot exist for long. These imperfections
are extremely short-lived. In the long run the price of the
product in two different markets would be same.
An investor own 1,000 shares worth 50 each.
Due to some external factors, the movement of
stock price is volatile. The investor is worried
about the value of investment after 4 months,
when he wants to sell the shares. How
derivative can be used to provide insurance
against decline in value of investor’s holding?
Investor should buy put option with a
exercise/strike price of Rs. 50 each and expiration
date of four months. If at the end of fourth
month, the share price goes less than Rs. 50,
investor should exercise the option and sell the
share at Rs. 50 each. In this way, investor can
hedge risk of fall in price of stock.
If the share price is more than Rs. 50, the investor
will not exercise the option, rather will sell the
shares at spot rate in the market.
A speculator with Rs. 7800 to invest thinks that the
price of IBM share will increase in the next three
months and he has obtained the following quotes:
Current stock price Rs. 78
IBM share December call with an Rs. 80 strike price
Rs. 3
The speculator’s hunch is correct and the price of IBM
share rises to Rs. 90 by December.
Evaluate the two alternative strategies:
1. Buy 100 shares of IMB today.
2. Buy call options on IBM with a strike price of Rs. 80
Alternative 1
Cost of buying 100 shares = Rs. 78 x100 = Rs.
7800
Sales proceeds of 100 shares in December = 100
x Rs. 90 = Rs. 9000
Net gain = Rs. 1200
Alternative 2
Total amount available = Rs. 7800
Premium per share = Rs. 3
Number of shares for call options = (7800/3) = 2600.
Strike price = Rs. 80
Actual Share price in December = Rs. 90
Thus, by executing the option and selling the shares in the
market, gain per share = Rs. 10.
Total gain from shares = 2600 x10 = 26000.
Net gain = (26000 – 7800) = Rs. 18200.
The second alternative is more profitable.
 Can the outcome of hedging be favorable always?

Hedging is widely used to reduce the future risk.

But there is no assurance that the outcome of
hedging will be better than the outcome without
hedging.
Hedging is widely used in forward and futures,
mainly to reduce the uncertainty in future
outcome.
Let today an Indian company, Company A, knows
that it will have to pay Rs. 10,00,000 in December
(after 2 months) for the import of goods from a
USA supplier.
The current exchange rate is Rs. 66.78/$ and the
exchange rate for the delivery in December is Rs.
65.89/$.
Company A could hedge its foreign exchange by
entering into the future market. The size of future
contract is (10,00,000/65.89)$ = 15177$
On the other hand, another Indian company,
company B, is exporting goods to a US company
worth Rs. 20,00,000 in December. Company B can
also hedge its foreign exchange by entering into
future contract. The size of the contract is
(20,00,000/65.89)$ = 30354$
If the exchange rate in December is Rs. 66.15/$,
evaluate the hedging strategy of A and B.
 Hedge Ratio
The hedge ratio compares the value of a
position protected through the use of a
hedge with the size of the entire position
itself. A hedge ratio may also be a comparison
of the value of futures contracts purchased or
sold to the value of the cash commodity
being hedged.
Let an investor is holding $10,000 in foreign equity,
which exposes him to currency risk. If he hedge
$5,000 worth of the equity with a currency
position, hedge ratio is 0.5 (5000 / 10000). This
means that 50% of  equity position is sheltered
from exchange rate risk. The hedge ratio is
important for investors in futures contracts, as it
identifies and minimizes basis risk.
 Optimal Hedge ratio
Optimal hedge ratio or minimum variance
hedge ratio is the product of the correlation
coefficient between the changes in the spot
and futures prices and the ratio of the
standard deviation of the changes in the spot
price to the standard deviation of the future
prices.
Let S and F are the price of spot and future
instruments respectively. Thus, changes in
future and spot instruments are ∆S and ∆F.
rS , F
Let is the correlation coefficient between
 Sthe
and changes
F in future and spot instruments.

are the standard deviation of the

rS , F  S
changes in spot and future prices.  F
Then Optimal hedge ratio =
An airline company fears that the price of jet fuel will rise
in near future. The airline company expects to purchase
15 million gallons of jet fuel over the next four months
and wishes to hedge its purchase. However, there are
not enough futures contracts available to hedge the
company's entire purchase. Assume that the correlation
between futures and the spot price of jet fuel is 0.95.
Over the past three years, the standard deviation of the
percentage changes in futures and spot jet fuel price is
6% and 3%, respectively.
Find out optimal hedge ratio.
 Credit Derivatives
A credit asset is a bundle of risks and returns.
Every credit asset is acquired to make certain
returns. However, the probability of not making
the expected return is the inherent risk
associated with every credit asset. Management
of credit risk has emerged as the crucial task for
every firm, specially for banks and financial
institutions.
In the early 1990s, credit derivative is a major
innovation in credit risk management.
A credit derivative is a privately held contract
that allows users to manage their exposure to
credit risk. It is a derivative instrument with a
payoff determined by whether a third party
makes a promised payment on a debt obligation.
Parties who want to rid themselves of credit risk can
engage in credit derivative transactions to pass the
credit risk to another party who is willing to accept it.
A credit derivative transaction involves three parties.
1. Credit derivative buyer: A party that holds credit
risk and wants to eliminate it.
2. Credit derivative seller: A party who is willing to
acquire the credit risk.
3. Reference entity: A party who is associated with
the credit.
Suppose Bank A has made a loan to company C.
The bank has evaluated the loan repaying ability
of C from different dimensions. However, the
Bank wants to reduce the risk of default and
wants to sell the credit risk. It finds another
Bank, Bank B, who is willing to take on the risk.
Here bank A is the credit derivative buyer, Bank
B is the credit derivative seller and Company C is
the reference party.
 Credit Default Swaps
Among the various types of credit derivatives, credit
default swaps, also called credit swap, is the most
widely used credit derivative.
Let Bank A issued loan to company C and Bank B is
willing to take the credit risk. Here company C is
under obligation to make a series of payment (interest
and principal amount). In case of any default, Bank B
compensate the Bank A for the loss. For this, B will get
a periodic fee or premium from Bank A.
Graphically, this can be shown as:

Periodic Fee(Premium)

Credit Derivate Credit Derivate

Buyer Seller

Recovery if default occurs

Interest plus principal

Reference Entity
The payment to buyer in case of any default can
take one of the two primary forms:
1. Cash settlement: The seller pays the buyer
the difference between the amount
defaulted less any amount recovered.
2. Fixed settlement: The seller pays the buyer a
fixed amount regardless of the amount of
loss.
 Importance

The principal feature of credit derivatives is the

separation and isolation of the credit risk from other
sources of risk such as interest rate or equity price
risk, thus facilitating the stability in asset price and
return.
The use of credit derivatives by banks has been
primarily motivated to:
(a)Hedge their credit exposure
(b)Transfer credit risk of their portfolios in part or whole
(c)Enhance portfolio diversification
(d)Improve management of credit portfolios