DERIVATIVES AND COMMODITY EXCHANGES

Dr. Monika Goel monikagoelfcs@gmail.com

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.

Examples of RISK /Uncertainity???

Case-1 An Indian Garments

company has received an order to supply I,00,000 units of shirts from USA. The price of $ 500,000 is receivable after six months. The current exchange rate is Rs.39.76/$. At the current exchange rate, the company would get: 39.76 500,000 = Rs 1,98,80,000. But the company anticipates appreciation of Indian rupee over time. Does the company loose/gain due to appreciation in the Indian Rupee? How does company minimise the risk?

Case 2
You have imported machinery for $ 100,000 on 180

days credit at zero interest. The dollar quotes at Rs 39. Is this deal risk free? This deal is not free of risk because after six months when you pay the loan, if the dollar quotes anything more than Rs39., say Rs 40, you will end up paying more [Rs 1 extra for every $ 1, which is equivalent to Rs 100,000 additional cost]. On the other hand, if the dollar quotes anything less than Rs 39, you will stand to gain The question here is not whether you stand to gain or loose it is the risk you are taking

Case 03
You have surplus cash for investment. You

think of investing in Wipro, currently quoting at Rs 3,500, which you believe will rise to Rs 3,950 in six months. Is this deal risk free? This deal is not free of risk because there is no guarantee that Wipros shares would touch Rs 3,950 in six months time. The share prices could rise beyond Rs 3,950 or could also fall below Rs 3,500 giving you no return on investment and you could stand to loose some portion of your investment

How do you protect yourself ?

Use Derivative instruments. What is derivatives?

See the next example.

Example
You [along with two friends] want to go for the

Aero India January 2008 air show, for which tickets are sold out. Through one of your close friends, you obtain a recommendation letter, which will enable you to buy three tickets. The price of a ticket is Rs 1,000. Which is the commodity that you are suppose to buy? In order to buy the________ what are required now? Money/recommendation letter (instrument) or both?

Financial instruments
The recommendation letter is a derivative

instrument. It gives you a right to buy the ticket The underlying asset is the ticket The letter does not constitute ownership of the ticket It is indeed a promise to convey ownership The value of the letter changes with changes in the price of the ticket. It derives its value from the value of the ticket

Different risk coverage

Firms are exposed to several risks in the ordinary

course of operations and borrowing funds. For some risks, management can obtain protection from an insurance company(fire,loss of profit,loss of stock,marine insurance) Similarly, there are capital market products available to protect against certain risks. Such risks include risks associated with a rise in the price of commodity purchased as an input, a decline in a commodity price of a product the firm sells, a rise in the cost of borrowing funds and an adverse exchange rate movement. The instruments that can be used to provide such protection are called derivative instruments

Meaning
A financial contract of pre-determined

duration, whose value is derived from the value of an underlying asset A derivative contract is a financial instrument whose payoff structure is derived from the value of the underlying asset These instruments include futures contracts, forward contracts, options contracts, swap agreements, and cap and floor agreements

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. The derivative market thus helps people meet diverse objectives such as: Hedging Profit making through price changes Profit making through arbitrage

uses
Price discovery Most price changes are first reflected in the derivative market. That way derivative market feeds the spot market For instance, if the dollars are going down, it means that the professional investors are expecting dolor price to go down in the future this is a good sign for you to buy in the spot market

Risk transfer A derivative market is like an insurance company Derivative instruments redistribute the risk amongst market players However, if you want protection against adverse price movements, you must pay a price, ie the premium

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)

Derivative Instruments.
Forward contracts Futures
Commodity

Financial (Stock index, interest rate & currency )

Options
Put Call

Swaps.
Interest Rate Currency

Underlying Asset Class

It is important to understand the underlying asset

class before using derivatives Asset classes can be classified into two broad categories- financial which includes currencies and commodities Financial asset classes can be broadly categorised into interest rates, equities and currencies Commodities range from agricultural commodities to minerals and metals

Derivative Positions and Types of Derivative Market Players :

Speculators :Naked open position taking a

directional call on the markets Hedgers : Hedge against underlying asset class Arbitrageurs : Arbitrage position within an asset class

Hedging or Leveraging
Derivatives are viewed as a hedging instrument

The holder of an underlying asset can hedge

fluctuations in prices of the asset using derivatives However derivatives are increasingly being used for taking up leveraged positions in an underlying asset This enables higher returns for taking on higher risk

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 Degree of Leverage = 1/margin rate.

Exchange Traded and OTC Derivatives

Derivatives traded on an exchange such as NSE

are exchange traded derivatives Derivatives not traded on exchange are over the counter derivatives eg- Overnight index swaps (OIS) Exchange traded derivatives are standardised in contract size, settlement, maturity OTC derivatives can be structured to suit different needs Equity and bond derivatives are usually exchange traded while interest rate swaps, currency derivatives and exotics are usually OTC

OTC or 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 (infosys stock)

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.

Example
An investor buys a NIFTY futures contract for

Rs.2,80,000 (lot size 200 futures). On the settlement date, the NIFTY closes at 1,378. Find out his profit or loss, if he pays Rs.1,000 as brokerage. What would be the amount of profit or loss, if he has sold the futures contract ? In this case , the total value is Rs.2,80,000 and lot is 200, So, the NIFTY Futures on the transaction date is 1400 (i.e. 2,80,000/200). Now on the settlement date, the NIFTY is1378 therefore, it has reduced by 22 points. The loss to the investor is
Loss = (1400 1378) x 200 + 1000 = 4400 + 1000 = 5400

In case, he has sold the futures contract, his profit would

have been
Profit = (1400-1378) x 200 Rs. 1000 = 4400 1000 = 3400

Assumption : The brokerage of Rs.1000 would be

payable in both the cases.

Pricing of Futures
Futures should theoretically trade at a fair price The fair price is the price adjusted for cost of

carry for delivery at a later date The cost of carry is the interest cost on the amount actually paid for an asset on a spot purchase Cost of carry is adjusted for any dividends receivable in case of equities Cost of carry = Interest cost over period expected dividend yield The fair price of a future contract is always at a premium to the spot price

Example
A futures contract is available on a company that pays

an annual dividend of Rs.5 and whose stock is currently priced at Rs.200. Each futures contract calls for delivery of 1,000 shares of stock in one year, daily marking to market, an initial margin of 10% and a maintenance margin of 5%. The corporate treasury bill rate is 8%. (i) Given the above information, what should the price of one futures contract be? (ii) If the company stock price decreases by 7%, what will be the change, if any, in futures price ? (iii) As a result of the company stock price decrease, will an investor that has a long position in one futures contract of this company realises a gain or loss? Why ? What will be the amount of this gain or loss ?

Solution
(i) Annual dividend (D) = Rs.5
Current Stock Price(S) = Rs.200 Initial Margin = 10% Maintenance Margin = 5% Corporate Treasury bill rate (C) = 8% Price of One Future Contract F = S + (S x C) D = 200 + (200 x 0.08) 5 = Rs. 211
(ii)

(iii)

If the company stock prices decrease by 7%, then price of futures contract F = [200 x (1 0.07)] + [200 x (1- 0.07) x 0.08] 5 = 186 + 14.88 5 = Rs. 195.88 An investor with a long position in one future contract agrees to buy 1,000 shares of the company in one year at Rs.211. Therefore, this investor will benefit only if the future prices increase. In this case, the future prices has decreased and the investor will therefore realize a loss of (Rs. 195.88 Rs. 211) x 1,000 = () Rs. 15,120.

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

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.

Options Lingo
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. The premium of an option is basically the sum of the option's intrinsic and time value.

 Strike Price or Exercise Price :price of an option is the

specified/ pre-determined 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. Index options in India are European options while stock options are American options

 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

Option Pricing :
Black Scholes formula is the most widely used for

pricing options The factors going into the pricing of options are the share price(S), time to expiry (t), risk free rate of interest r, and risk of underlying asset measured by standard deviation or volatility These are also called the greeks as changes in any one of these variables affect the option price Options contracts can be classified into out of the money, at the money and in the money

The Greeks
Delta is the change in option price to the change

in the underlying Gamma is the rate at which an options delta changes as the price of the underlying changes Theta is the time decay factor and is the rate at which option loses value as time passes Vega or Kappa is the change in option price to change in the volatility of the option Rho is the change in value of option to change in interest rates

 Intrinsic Value: The intrinsic value of an option is defined as

the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.
For a call option: Intrinsic Value = Spot Price - Strike Price
For a put option: Intrinsic Value = Strike Price - Spot Price

Profit/Loss Profile of a Long call Position Profit

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

Summary The profit and loss profile for a short put option is the mirror image of the long put option. The maximum profit from this position is the option price. The theoritical maximum loss can be substantial should the price of the underlying asset fall. Buying calls or selling puts allows investor to gain if the price of the underlying asset rises; and selling calls and buying puts allows the investors to gain if the price of the underlying asset falls.

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. Dollar Value of the underlying index = Cash index value * Contract multiple. The contract multiple for the S&P100 is $100. So, for eg, if the cash index value for the S&P is 720,then dollar value will be $72,000

 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.

Binomial Model for Option Valuation

Current Price of the stock = S Two possible values it can take next year :- uS or dS ( uS>

dS) Amount B can be borrowed or lent at a rate of r. The interest factor (1+r) may be represented , for sake of simplicity , as R. d<R<u. Exercise price is E.

 Value of a call option, just before expiration,

if the stock price goes up to uS is Cu = Max(uS-E,0) Value of a call option, just before expiration, if the stock price goes down to dS is Cd = Max(dS-E,0) The value of the call option is C=^S+B ^ = (Cu-Cd)/ S (u-d) B = uCd-dCu/(u-d)R

Illustration: S=200, u=1.4, d=.9 E=220 r=0.15 R=1.15 Cu = Max(uS-E,0) = Max(280-220,0)=60 Cd = Max(dS-E,0) = Max(180-220,0)=0 ^=Cu-Cd/(u-d)S = 60/(1.4-.9)200=0.6 B=uCd-dCu/(u-d)R = -0.9(60)/0.5(1.15) = -93.91 (A negative value for B means that funds are borrowed). Thus the portfolio consists of 0.6 of a share plus a borrowing of 93.91( requiring a payment of 93.91(1.15) = 108 after one year. C=^S+B= 0.6*200-93.91 = 26.09

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. Kunal Rawal: mam please register my email id knlrwl1@gmail.com

Interest Rate Swap

Counter Party
LIBOR

Counter Party B

A
Fixed Rate of 12%

Rs50,00,00,000.00 Notional Principle

A is the fixed rate receiver and variable rate payer. B is the variable rate receiver and fixed rate payer.

 The only Rupee exchanged between the parties are the net

interest payment, not the notional principle amount. In the given eg A pays LIBOR/2*50crs to B once every six months. Say LIBOR=5% then A pays be 5%/2*50crs= 1.25crs B pays A 12%/2*50crs=3crs The value of the swap will fluctuate with market interest rates. If interest rates decline fixed rate payer is at a loss, If interest rates rise variable rate payer is at a loss. Conversely if rates rise fixed rate payer profits and floating rate payer looses.

Review Questions
Distinguish between
Index futures and index options. Initial margin and maintenance margin. Financial derivatives and commodity derivatives.

Short notes
Types of swaps

Comment Counter party risk is faced in forward

transactions.

Illustration
Two companies Rita Ltd. and Gita Ltd. are considering to enter

into a swap agreement with each other. Their corresponding borrowing rates are as follows: Name of Company Floating Rate Fixed Rate Rita Ltd. LIBOR 11% Gita Ltd. LIBOR + 0.3% 12.5% Rita Ltd. requires a floating rate loan of 8.million while Gita Ltd. requires a fixed rate loan of 8 million. (i) Show which company had advantage in floating rate loans and which company has a comparative advantage in fixed loans. (ii) If Rita Ltd. and Gita Ltd. engage in a swap agreement and the benefits of the swap are equally split, at what rate will Rita Ltd. be able to obtain floating finance and Gita Ltd. be able to obtain fixed rate finance ? Ignore bank charges.

Solution
Assuming LIBOR say for 10% company Gita Ltd.

floating rate is 0.3% per cent more expensive than company Rita Limited rate; but its fixed rate is 12.5% which is more expensive than Rita Ltd.. Hence the company Rita Ltd. has a more comparative advantage in fixed rate loans and company Gita Ltd. has a comparative advantage in floating rate loans. (b) Net Potential Gain = (LIBOR - (LIBOR + 0.3) + (12.5 - 11) = - 0.3 + 1.5 = 1.2 per cent i.e. 0.6 per cent benefit to each company Net floating rate cost to Rita Ltd. would be = LIBOR .6% And net fixed rate cost to Gita Ltd. would be 12.5% - .6% = 11.9% So the swapping the interest rate obligations, both companies would be benefitted to the extent of .6%.