Chapter Six

Introduction to
Derivative
Markets
Prepared By:-
Section 3&4 Group 5 team

1.Liya Eyob Hamda

2.Mastewal Woldemariam
3.Mekdes Gizaw Behabtu
4.Sefene Sahilu Ayele
5.Zemichael Tesfamariam
Chapter Contents
1.Introduction to Derivative Markets
2.Discounting and the time value of Money
3.Forward and Future Markets
4.Plain Vanilla options and Basic Strategies
5.Black-Sholes Valuation
6.Interest rate Swaps and Related topics
7.Credit Derivatives
8.Trading Volatility
9.Exotic Derivatives
 1.Introduction to Derivative Market
Derivative is a financial instrument that has a value derived from the value of another asset.
A derivative is not a product, it is just a contract that derives its value/price from
change/fluctuations/ in the value of the underlying assets.
Underlying assets:- Stocks, Bonds, Commodities, Currencies and Interest rates
We can use derivatives for
 Risk Management,
 Speculation,
 Reduced Transaction costs and
 Regulatory Arbitrage

Derivative Markets
is the financial market for derivatives financial instruments like future and forward contracts,
option contracts & swaps are traded.
The Four major types of Derivative contracts in Derivative markets are:

*Forwards & Futures- obligates the buyers to purchase an asset at a pre agreed price on a
specific future date.(Futures only traded on Exchange markets)
*Options- provides the buyer of the contracts the right but not the obligation to purchase or sell
the underlying asset at a pre-determined price.
Call Option-a right/not the obligation to BUY a given quantity of underlying asset at a given price.
Put Option- a right /not the obligation to SELL a given quantity of underlying asset at a given price.
*Swaps- allows the exchange of cash flows between two parties.
 Types of Derivative Markets
Exchange-traded Derivative Markets
 contracts are standardized with specific delivery or
settlement terms.
 Negotiation between traders traditionally was
conducted by shouting on the trading floor (open
outcry) but currently by electronic trading system.
 publicly reported and cleared in a clearing house.
 The clearing house will be obliged to honor the
trade if the seller defaults
 Better price transparency and lesser Counterparty
risk(incompletion of operation) than OTC Markets
Over the counter Derivative Markets
 All contract terms such as delivery quality, quantity, location, date and prices are negotiable between the two
parties.
 Transactions can be arranged by telephone or other communication means.
 OTC markets are flexible -they suit better for trades that do not have high order flow and or with special
requirements.
 OTC markets perform the role as an incubator for new financial products.
2. Discounting and Time Value of Money
The time value of money (TVM) is the concept that a sum of money is worth more
now than the same sum will be at a future date due to its earnings potential in the
interim.
A sum of money in the hand has greater value than the same sum to be paid in the
future. The time value of money is also referred to as the present discounted value.
Discounting is the process of determining the present value of a payment that is to
be received in the future.
Time Value is any premium in excess of intrinsic value before expiration. It is the
amount an investor is willing to pay for an option above its intrinsic value.
Or as an extrinsic value as other factors influence an option’s premium outside of
intrinsic value
 3. Forward and Future contracts
3.1.Foward
A forward Contract is an agreement between two counterparties that obligates them to
transact in the future.
The counterparties in forward contract are called long position/forward who is obligated to
buy the asset and short position/forward who is obligated to sell the asset at future point.
The asset is called underlying assets mostly stocks, bonds, currencies and commodities.

The future period in time when the transaction occurs is called the “Expiration date”.
The price at which the underlying assets is purchased is called “Forward Price”.

At the time of initiation of a forward contract all the fours details like the counterparties, the
underlying assets, the future price and the expiration date are set.
 Forward Payoff

Payoff is the cash flow that occurs at the time of expiration.

Long forward payoff is the value of the underlying asset that receives at expiration minus the forwards
prices it pays.
Here the value of the underlying asset at expiration is the market price.

Positive forward payoff is when price of the asset received is greater than the forward price paid.

Negative forward payoff is when the price of the asset received is less than the forward price paid.

Zero payoff is when the price of the asset received is equal to the forward price paid.

Long forward Payoff= underlying asset price at the expiration date - forward price
Long forward payoff=ST-F
Long Forward Profit and Loss
Long forward profit and loss is the same as long forward’s payoff. As there is no payment
done at the time of initiation.

Long forward P & L= ST-F

Long forward may experience profit, incur loss or breakeven.

Profit occurs when price of the asset received is greater than the forward price paid.

Loss occurs when the price of the asset received is less than the forward price paid.

Breakeven occurs when the price of the asset received is equal to the forward price paid
Short Forward Payoff

Short forward payoff at expiration is the forward price received minus the price of the asset
it delivers. It can be positive, negative or zero.
Positive short forward payoff occurs the forward price received is greater than the price of
the asset delivered.
Negative short forward payoff occurs the forward price received is less than the price of the
asset delivered.
Zero short forward payoff occurs the forward price received is equal to the price of the
asset delivered.

Short forward payoff= F- ST

Short Forward Profit & Loss

Short Forward Profit & Loss is the difference between the cash flow that occur at initiation and expiration.

Short Forward Profit & Loss= Short Forward payoff=F- ST

Here the short forward may experience profit, suffer loss or breakeven.
Profit occurs when the forward price received is greater than the price of the asset delivered.

Loss occurs when the forward price received is less than the price of the asset delivered.

Breakeven occurs when the forward price received is equal to the price of the asset delivered.

Forwards are zero-sum games. Any profit that one of the counterparties receives is exactly equal to the loss
that the other counterparty suffers.
Counterparty Credit Risk
Each of the counterparties must fulfill their obligations whether it results in a positive or
negative payoff.
Counterparty Credit Risk is the risk of suffering loss because of one counterparty does not
fulfill its obligations.
Mechanisms used to minimize counterparty credit risk are
• Careful screening of potential counterparties
• Using legal contracts that carefully specify the terms of the agreement
• Netting agreements
• Margin requirements
• Periodic cash resettlement
• Central counterparty clearing house –is an organization that can become a counter party to each
through a process known as “novation”
3.2. Future contracts
Future Contracts are standardized forward contracts that trade on the exchanges.
They are heavily standardized and regulated.
Derivatives exchange in the US are regulated by the Commodities Futures Trading Commission.
Futures Price- is the price at which the asset is purchased at future contracts.
The CME Group is a prominent example of a company that owns several exchanges that trade futures as
well as other products.
CME Group includes Chicago Board of Trade(CBOT), Chicago Mercantile Exchange(CME), Commodity
Exchange(COMEX) and New York Mercantile Exchange(NYMEX)
The underlying assets associated that are traded in the CME Group include Commodity
Futures(agriculture, energy and metal), Forex futures, interest rate futures, Equity Index futures and
other future product
 4.Plain Vanilla Options and Basic Strategies
Options are agreements between two counterparties that provide one of the
counterparties a right, but not an obligation, to transact in the future.
What Is Plain Vanilla?
Plain vanilla is the most basic or standard version of a financial instrument, usually
options, bonds, futures and swaps.
A vanilla option gives the holder the right to buy or sell the underlying asset at a
predetermined price within a specific timeframe.
This call or put option comes with no special terms or features. It has a simple
expiration date and strike price.
Investors and companies will use them to hedge their exposure to an asset or to
speculate on an asset's price movement.
Plain Vanilla Options Cont..
Call premium/call price is payment made by the long call at time initiation of an option.
Two types of call options European Style and American Style.
In a European-style call option the right to exercise is only at expiration.
In an American-style call option the long call has the right to exercise either at expiration or before
expiration. Both American-style and European-style call options trade in the United States.
All detailed are maintained at the time of initiation like
• The counterparties
• The underlying asset
• The strike price
• The call premium
• The expiration date and
• Whether the option is American-style or European-style
Options can trade either OTC (over-the-counter) or through an exchange.
A prominent example of an options exchange is the Chicago Board Options Exchange (CBOE).
Options
There are two types of option contracts:
Call options that provide the right to purchase and
Put options that provide the right to sell.
Call Options is an agreement between two counterparties in which one of the counterparties
has the right to purchase an underlying asset from the other counterparty in the future.
The two counterparties to a call option are the long call(the buyer) and the short call(the
seller/the writer).
A call option gives the long call the right, but not the obligation, to purchase an underlying
asset from the short call in the future. Hence, the long call can choose in the future whether
or not to exercise its right to purchase. The expression “exercise” means “take advantage of.”
The price at which the long call has the right to purchase the underlying asset is known as
the “strike price/exercise price.”
Call Options Cont..
Long Call Payoff
Payoff is the cash flow that occurs at expiration.
The long call can either exercise or not exercise.
If the long call exercises then the payoff is the difference between the price of the underlying
asset that the long call receives and the strike price that it pays.
If the long call does not exercise then the payoff is zero as no transaction takes place.
The long call’s payoff will never be less than zero. Instead, the long call earns the larger of two
possible payoffs, either ST − K or zero.
The difference between the underlying asset price and the strike price is the call option’s
“intrinsic value.”
An equation that describes the payoff to the long call is:
Long call payoff = max(ST − K, 0)
Call Options Cont..

Example 1
Strike price = $125
Underlying asset price at expiration = $135
The payoff is:
Long call payoff = max(ST − K, 0) = max($135–$125, 0) = $10
Example 2
Strike price = $823 , Underlying asset price at expiration = $721
The payoff is:
Long call payoff = max(ST − K, 0) = max($721–$823, 0) = 0
The payoff of zero indicates that the long call will not exercise the option.
Call Options Cont..
Long Call Profit and Loss
P&L is the difference between the cash flows that occur at initiation and expiration. Hence, P&L takes
into account the premium that is paid by the long call at initiation.
Long call P&L = max(ST − K, 0) − c0
Where c0 = Call premium paid by long call to the short call at initiation
A positive value for the long call’s P&L represents profit, and a negative value represents loss.

Example 1
Strike price = $145
Underlying asset price at expiration = $154
Call premium paid at initiation = $8
Long Call P&L = max(ST − K, 0) − c0 = max($154–$145, 0) − $8 = $1
Example 2
Strike price = $112.50
Underlying asset price = $113.00
Call premium paid at initiation = $7
Long Call P&L = max(ST − K, 0) − c0 = max($113–$112.5, 0) − $7 = −$6.5
Call Options Cont..
Short Call Payoff
A short call is obligated to sell the underlying asset to the long call should the long call exercise its right
to purchase.
The long call exercises: The price of the underlying asset that the short call must deliver is greater than
the strike price that the short call receives, and the short call’s payoff is negative.
The long call does not exercise: If the underlying asset price is less than the strike price, the long call will
not exercise, and the short call’s payoff is zero.
Short call payoff = min(K − ST, 0)
Example 1
Strike price = $125
Underlying asset price at expiration = $135
Short call payoff = min(K − ST, 0) = min($125 − $135, 0) = −$10
Example 2
Strike price = $823
Underlying asset price at expiration = $721
Short call payoff = min(K − ST, 0) = min($823 − $721, 0) = 0
Call Options Cont..
Short calls profit and Loss
The short call’s P&L at expiration can be expressed as:
Short call P&L = min(K − ST, 0) + c0
A positive value for the short call’s P&L represents profit while a negative value represents
loss.
Example 1
Strike price = $145
Underlying asset price = $154
Call premium paid at initiation = $8
Short call P&L = min(K − ST, 0) + c0 = min($145 − $154, 0) + $8 = −$1
Example 2
Strike price = $112.50
Underlying asset price = $113.00
Call premium paid at initiation = $7
Short call P&L = min(K − ST, 0) + c0 = min($112.5 − $113, 0) + $7 = $6.5
Call Options Cont..

Call options are Zero –Sum Games

Any profit that one of the counterparties receives is exactly equal to the loss that the other
counter party suffers.
Example
Call premium = $5
Strike price = $75
Underlying asset price at expiration = $85
Long call P&L = max(ST − K, 0) − c0 = max($85 − $75, 0) − $5 = $5
Short call P&L = min(K − ST, 0) + c0 = min($75 − $85, 0) + $5 = −$5
Net call P&L = long call P&L + short call P&L = $5 − $5 = 0
Call Options Cont..
Call option Moneyness
“Moneyness” is whether a long option position will earn a positive payoff if it exercises. It has
three options
In-the-money (ITM) –A call option is ITM when the value of the underlying asset is greater than
the strike price
Out-of-the-money (OTM)- When the long position will earn a negative payoff if it exercises the
option.
At-the –money(ATM): An option is ATM if the long position will earn a payoff of zero if it
exercises the option.
Moneyness is not a function of profitability. It is determined by the long positions payoff being
exercised.
Moneyness does not apply to forwards and futures contracts where both counterparties face
obligations.
From OTM to ATM to ITM, Moneyness is described as increasing.
Call Options Cont..

Exercising Call Options Early

A long position in an American-style call option has the right to exercise early. Two things to
consider here are
Intrinsic value: The difference between the underlying asset price and the strike price
Optionality value: The value of having the right to decide whether to exercise or not
Disadvantage and Advantage of Early Exercise
Disadvantages:-
• Early exercise destroys the optionality value of the option.
• Early exercise means that the strike price will have to be paid earlier. The earlier a payment takes
place, the higher the payment is in present value terms.
Advantages:-
Early exercise means the investor receives any income that flows from the underlying asset.
Call Options Cont..
Example:- If the underlying asset is a share that pays a dividend at some point in time
between initiation and expiration. The dividend is only paid to those that hold title to the
share before the ex-dividend date.
If the investor exercises the option before the ex-dividend date, the investor will hold title to
the share and will therefore receive its dividend.

The premium associated with an American-style call option will only be greater than the
premium associated with a European-style call option if early exercise may make sense.
Otherwise, an American-style call option should only be exercised at expiration.
The ability to exercise early can be valuable when the underlying asset pays a dividend. An
investor that fails to exercise early when it should has failed to take advantage of a right for
which it has paid.
Put Options characteristics

A put option is an agreement between two counterparties in which one of the counterparties
has the right to sell an underlying asset to the other counterparty in the future.
The two counterparties to a put option are the long put and the short put.
The price at which the long put has the right to sell the asset is known as the strike price or
exercise price.
The long put must pay a fee to the short put for providing the right. The fee is known as the
“put premium.”
A European-style put option provides the long put the right to exercise only at expiration.
An American-style put option provides the right to exercise either at expiration or before
expiration.
Put Options
Long Put Payoffs
Long put payoff = max(K − ST, 0)
Example 1
Strike price = $22
Underlying asset price at expiration = $32
Long put payoff = max(K − ST, 0) = max($22 − $32, 0) = 0
Example 2
Strike price = $25
Underlying asset price at expiration = $23
Long put payoff = max(K − ST, 0) = max($25 − $23, 0) = $2
Put Options Cont..
Long Put Profit & Loss
Long put P&L = max(K − ST, 0) − p0
p0 = Put premium paid by long put to the short put at initiation.
A positive value for the long put’s P&L represents profit and a negative value represents
loss.
Example 1 Strike price = $122 , Underlying asset price at expiration = $133
Put premium paid at initiation = $7
Long put P&L = max(K − ST, 0) − p0 = max($122 − $133, 0) − $7 = −$7
Example 2 Strike price = $118.50, Underlying asset price at expiration = $109
Put premium paid at initiation = $7
Long put P&L = max(K − ST, 0) − p0 = max($118.5 − $109, 0) − $7 = $2.5
Put Options Cont..
Short Put Payoffs
The short put is obligated to purchase the underlying asset from the long put should the
long put exercise its right to sell. The payoff to the short put depends on whether the long
put exercises or not.
The long put will exercise at expiration when the underlying asset price is less than the
strike price. In this scenario the price of the underlying asset that the short put receives is
less than the strike price that it pays.
If the underlying asset price is greater than the strike price, the long put will not exercise.
Short put payoff = min(ST − K, 0)
Example 1 Strike price = $115, Underlying asset price at expiration = $125
Short put payoff = min(ST − K, 0) = min($125 − $115, 0) = 0
Example 2 Strike price = $33, Underlying asset price at expiration = $31
Short put payoff = min(ST − K, 0) = min($31 − $33, 0) = −$2
Put Options Cont..
Short Put P& L
Short put P&L = min(ST − K, 0) + p0
(+) value for the short put’s P&L represents profit while (- )value represents loss.
Example 1
Strike price = $125, Price of the underlying asset = $134
Put premium paid at initiation = $8
Short put P&L = min(ST − K, 0) + p0 = min($134 − $125, 0) + $8 = $8
Example 2
Strike price = $102.50 , Underlying asset price = $100
Put premium paid at initiation = $7
Short put P&L = min(ST − K, 0) + p0 = min($100 − $102.5, 0) + $7 = $4.5
5.Black-Scholes Valuation

Black Scholes Merton Valuation model is a mathematical model of a financial market

used for Valuation of stock options
 Demonstrated to yield prices very close to the observed market prices.
 Considers five variables that determine/drive the value of an option.
1.Value of underlying asset
2.Exercise price/strike price
3.Time to the options expiry
4. Risk free rate/ TVM
5.Volatility of the Stock price
 Black-Scholes Valuation Cont.…
Underlying Assumptions
1.The options are European calls.
2.There are no transaction costs or taxes.
3.The investor can borrow at the risk-free rate.
4.The risk-free rate of interest and the share’s volatility is constant over the life of the option.
5.The future share-price volatility can be estimated by observing past share price volatility.
6.The share prices are based on a normal distribution.
7.No dividends are payable before the option expiry date.

In practice these unrealistic assumptions can be relaxed and the basic model can be
developed to reflect a more complex situation.
Black-Scholes Valuation Cont.…
The value of an option is made up of two components. Intrinsic value & time value
1.The intrinsic value-
looks at the exercise price compared with the price of the underlying asset.

The value of the call option will increase –when share price increases or
exercise price decreases
An option can never have a negative intrinsic value.
If the option is out of the money, then the intrinsic value is zero.
On the expiry date, the value of an option is equal to its intrinsic value.
 Black-Scholes Valuation Cont.…
2.Exercise /Strike price is a price at which an option can be exercised.
For most real options (e.g. option to expand, option to delay), the capital investment
required can be substituted for the exercise price these options are examples of call
options.
For an option to abandon use the salvage value on abandonment which is an example of
put option.
3.Time to expiry is the time between calculation and an option’s exercise date
As the period to expiry increases, the chance of a profit before the expiry date grows,
increasing the option value.
 Black-Scholes Valuation Cont.…
4.The risk-free rate is the minimum return required by investors from a risk-free investment.
 Treasury bills or other short-term (usually three months). Government borrowings are
regarded as the safest possible investment and their rate of return is used.
 Risk-free rate is widely used for real options. However, some argue that a higher rate be
used to reflect the extra risks when replacing the share price with the PV of future cash
flows.’
 The higher the interest rates the lower the present value of the exercise price. This
reduces the cost of exercising and thus adds value to the current call option value.
 Since having a call option means that the share purchase can be deferred, owning a call
option becomes more valuable when interest rates are high, since the money left in the
bank will be generating a higher return.
 Black-Scholes Valuation Cont.…
5. Volatility-the standard deviation of day-to-day price changes in a security, expressed as an
annualized percentage.
 Two measures of volatility are commonly used in options trading:

1.Historical volatility can be measured by observing price changes of a security over a period of time.
It is not necessarily a forecast of future volatility, but can be used to determine the option price.
2.Implied volatility can be calculated by taking current quoted options prices and working backwards.
The holder of a call option does not suffer if the share price falls below the exercise price,
i.e. there is a limit to the downside.
However the option holder gains if the share price increases above the exercise price,
i.e. there is no limit to the upside.
The greater the volatility the better, as this increases the probability of a valuable increase in share
price.
The volatility of the underlying asset (here the future operating cash flows) can be measured using
 Black-Scholes Valuation Cont.…
-rt
• Value of a call option = PaN(d1) – Pee N(d2)

d1 = In (Pa/Pe) + (r + 0.5s²)t d2 = In (Pa/Pe) + (r - 0.5 s ²)t

Where:- s √t
s √t
or d2 = d1 – s√t
Pa=Current price of
underlying asset (Share Price)
N(d) = equals the area under the normal curve up to d
Pe= Exercise Price
(see normal distribution tables)
r=Risk free rate of interest₀
e = 2.71828, the exponential constant
t=time until expiry of option
In = the natural logarithm (logarithm base 'e')
s= volatility of the share price
Pee = present value of the exercise price calculated by using continuous
discounting factors
 Black-Scholes Valuation Cont.…
Example-of B Co
Current Share price Pa=$100, the exercise price Pe=$95 ,the risk free rate of interest is 10% r =.10
Standard deviation =50% s=.5
Time to expiry is 3 months=quarter t=.25
Required
Calculate the value of above call option
 Black-Scholes Valuation Cont.…
Put call parity
Step 1: Value the corresponding call option using -rt
the Black-Scholes model. P= c – Pa+ Pee
Step 2: Then calculate the value the put option
using the put call parity equation.
Example of B Co, where the current share price is
$100, exercise price is $95, the risk-free rate of
interest is 10%, the standard deviation of shares
return is 50% and the time to expiry is three
months,
calculate the value of a put option.
 Black-Scholes Valuation Cont.…
The figure N(d1) is known as delta.
Delta -measures the change in option value which would result from a $1 change in the value of
the underlying asset.
Sensitivities to other factors in the Black Scholes formula are denoted by other Greek letters as
follows:
Gamma -measures the rate of change of delta as the underlying asset’s price changes
Vega – measures the sensitivity of an option’s value to a change in the implied volatility of the
underlying asset.
Rho – measures the sensitivity of the option value to changes in the risk free rate of interest.
Theta – measures the rate of decline in the value of the option caused by the passage of time.
 6.Interest Rate Swaps and related topics
A swap is an exchange of cash flows between two counterparties over a number of periods of time.
An interest rate swap is an agreement in which two counterparties agree to periodically exchange fixed and
floating rates of interest over a number of periods of time.
One of the swap counterparties, known as the long interest rate swap position, agrees to periodically
receive a floating rate and pay a fixed rate.
The other swap counterparty, known as the short interest rate swap position, agrees to periodically
receive a fixed rate and pay a floating rate.
The fixed rate is agreed-upon at the initiation of the interest rate swap. The fixed rate does not change
during the life of the swap.
The floating rate fluctuates over time. The most commonly used floating rate is the London Interbank
Offered Rate (LIBOR).
LIBOR is a benchmark rate that is formed through a survey of the rates at which banks borrow from
each other.
Interest Rate Swaps and related topics
Other organizations provide alternatives to LIBOR, examples of which are EURIBOR (Euro Interbank
Offered Rate) and TIBOR(Tokyo Interbank Offered Rate).
The maturity of the swap is referred to as its “tenor.”
The tenor is determined by agreement between the two counterparties.
Common interest rate swap tenors are 5- and 10-year tenors.
To ensure that an interest rate swap has zero value at initiation, a fixed rate is set such that it is
perceived as “fair” to both counterparties. i.e., an asset nor a liability at initiation.
There is only one fixed rate that is fair to both counterparties: a fixed rate equal to the counterparties’
expectations of the floating rate
After initiation, LIBOR will, inevitably, either increase or decrease.
Asset: The interest rate swap value for the counterparty that benefits from the LIBOR change will be
positive (an asset).
Liability: The interest rate swap value for the counterparty that is harmed by the asset price change
will be negative (a liability).
Frequency of payments
The exchange of cash flows in an interest rate swap may take place more than once
per year. Further, the frequency of the payments may be different.

Interest Rate Swaps for the fixed leg is different than it is for the floating leg.
In the United States, the typical convention for the frequency of payments is as
follows:
Fixed leg: Semi-annual (i.e., twice per year)

Floating leg: Quarterly (i.e., four times per year)

 7.Credit Derivatives

A credit derivative is a financial contract that allows parties to minimize their exposure to
credit risk.
Credit derivatives consist of a privately held, negotiable bilateral contract traded over-the-
counter (OTC) between two parties in a creditor/debtor relationship.
These allow the creditor to effectively transfer some or all of the risk of a debtor defaulting to
a third party. This third party accepts the risk in return for payment, known as the premium.
Several types of credit derivatives exist,
including:
• Credit default swaps (CDS)
• Collateralized debt obligations (CDO)
• Total return swaps
• Credit spread options/forwards
 Credit Derivatives Cont..

A credit default swap is an agreement between two counterparties to

exchange periodic payments of spread in return for a payment contingent
on a credit event. The two counterparties are known as the “protection
buyer” and the “protection seller.”

The payments made by the protection buyer to the protection seller are
known as the credit default swap “spread.”
While the expression “spread” is used, the payments made by the
protection buyer do not include any rate other than the spread.
 Credit Derivatives Cont..
Example
Spread of 1%
Five-year tenor
Notional principal of $10 million
Day count convention is A/360
Number of days in given quarter is 92
The accrual factor is 92∕360 = 0.2556,

Quarterly spread payment = credit default spread × accrual factor × notional principal
= 1% × 0.2556 × $10, 000, 000
= $25, 556.56
 Cross Currency Swaps

A cross-currency swap is an agreement similar to an interest rate swap with one key
difference.
Unlike an interest rate swap in which the notional principal is in the same currency for both
legs, in a cross-currency swap the notional principal for each of the swap legs is in a different
currency.
Three types of cross-currency swaps are as follows:
Fixed rate in one currency for floating rate in the other currency
Floating rate in one currency for floating rate in the other currency
Fixed rate in one currency for fixed rate in the other currency
 Other Swap Varieties
• An equity swap is an agreement in which two counterparties agree to swap equity returns for an
interest rate.
• One of the counter parties receives equity returns and pays an interest rate while the other
counterparty receives the interest rate and pays equity returns.
• Some equity swaps, known as “equity-for-equity” swaps, each of the counterparties receives one
equity return and pays another equity return
• A commodity swap is an agreement in which two counterparties agree to swap commodity returns
for an interest rate. Hence one of the counterparties receives commodity returns and pays an
interest rate, while the other counterparty receives the interest rate and pays commodity returns
8.Trading Volatility

A core purpose of forwards, calls, and puts is to allow an investor to turn a view about the future into
profits.
Investors have many views.
The two key types of views are price views and volatility views.
Price views
A price view is a view about whether the underlying asset price will increase or decrease in the future.
Price views can be one of the following:
Price bullish: The view that the underlying asset price will increase

Price bearish: The view that the underlying asset price will decrease

Price neutral: Neither price bullish nor price bearish

 Trading volatility Cont…

Volatility views
is a view about whether the underlying asset volatility will increase or decrease in the
future.
Volatility views can be

Volatility bullish: The view that the underlying asset volatility will increase

Volatility bearish: The view that the underlying asset volatility will decrease

Volatility neutral: Neither volatility bullish nor volatility bearish

Example
A stock’s current volatility is 25%. An investor believes that the stock’s volatility will
increase to 26%.
The investor is volatility bullish.
A Treasury bond’s current volatility is 10%. An investor is unsure as to whether the
bond’s volatility will increase or decrease.
The investor is volatility neutral.
Gold’s current volatility is 80%. An investor believes that gold’s volatility will decrease
to 65%.
The investor is volatility bearish.
 Five strategies of trading volatility

1.Buy (or Go Long) Puts

When volatility is high, both in terms of the broad market and in relative terms for a specific stock,
traders who are bearish on the stock may buy puts on it based on the twin premises of “buy high, sell
higher,” and “the trend is your friend.”
This strategy is a simple but relatively expensive one, so traders who want to reduce the cost of their
long put position can either buy a further out-of-the-money put or can defray the cost of the long put
position by adding a short put position at a lower price, a strategy known as a bear put spread.
2. Write (or Short) Calls
A trader who was also bearish on the stock but thought the level of implied volatility for the options
could recede might have considered writing naked calls
Note that writing or shorting a naked call is a risky strategy, because of the theoretically unlimited risk
if the underlying stock or asset surges in price
In order to mitigate this risk, traders will often combine the short call position with a long call position
at a higher price in a strategy known as a bear call spread.
 Five strategies of trading volatility
3. Short Straddles or Strangles
The trader writes or sells a call and put at the same strike price in order to receive the premiums on both the
short call and short put positions.
The rationale for this strategy is that the trader expects IV to abate significantly by option expiry, allowing most
if not all of the premium received on the short put and short call positions to be retained.
Writing a short put imparts on the trader the obligation to buy the underlying at the strike price even if it
plunges to zero while writing a short call has theoretically unlimited risk as noted earlier. However, the trader
has some margin of safety based on the level of the premium received
4.Iron Condors
The trader combines a bear call spread with a bull put spread of the same expiration, hoping to capitalize on a
retreat in volatility that will result in the stock trading in a narrow range during the life of the options
It is constructed by selling an out-of-the-money (OTM) call and buying another call with a higher strike price
While selling an in-the-money (ITM) put and buying another put with a lower strike price. Generally, the
difference between the strike prices of the calls and puts is the same, and they are equidistant from the
underlying
Five strategies of trading volatility

5. The Bottom Line

These five strategies are used by traders to capitalize on stocks or securities that exhibit
high volatility.
Since most of these strategies involve potentially unlimited losses or are quite
complicated (like the iron condor strategy), they should only be used by expert options
traders who are well versed with the risks of options trading.
Beginners should stick to buying plain-vanilla calls or puts.
 9.Exotic Derivatives
The term Exotic Derivatives usually refers to more complex, unusual and specific derivative
contracts that depend on the value of some underlying asset or defined set of assets.
This term contrasts with the use of Vanilla Derivatives to denote more standard derivative
contracts.
The more advanced and complex features of exotic options allow their holders to realize
substantial returns. Also, the exotic options’ various features make them perfect for
hedging and risk management.
Exotic options are products of financial engineering, which is concerned with the creation of
new securities and developing suitable pricing techniques.

Finance professionals who work on the development of new types of securities are called
financial engineers.
 Types of Exotic Options
The most common types of exotic options include the following:
1. Asian options
The Asian option is one of the most commonly encountered types of exotic options. They are option
contracts whose payoffs are determined by the average price of the underlying security over several
predetermined periods of time.
2. Barrier options
The main feature of barrier exotic options is that the contracts become activated only if the price of
the underlying asset reaches a predetermined level.
3. Basket options
Basket options are based on several underlying assets. The payoff of a basket option is essentially the
weighted average of all underlying assets. Note that the weights of the underlying assets are not
always equal.
4. Bermuda options
These are a combination of American and European options. Similar to European options, Bermuda
options can be exercised at the date of their expiration. At the same time, these exotic options are
also exercisable at predetermined dates between the purchase and expiration dates.
 Types of Exotic Options Cont..
5. Binary options
Binary options are also known as digital options. The options guarantee the payoff based on the
occurrence of a certain event. If the event has occurred, the payoff is a fixed amount or a
predetermined asset. Conversely, if the event has not occurred, the payoff is nothing. In other
words, binary options provide only all-or-nothing payoffs.

6. Chooser options
Chooser exotic options provide the holder with the right to decide whether the purchased
options are calls or puts. Note that the decision can be made only at a fixed date prior to the
expiration of the contracts.

7. Compound options
Compound options (also known as split-fee options) are essentially an option on an option. The
final payoff of this option depends on the payoff of another option. Due to this reason,
compound options have two expiration dates and two strike prices.
Types of Exotic Options Cont..
8. Extendible options
Extendible option contracts provide the right to postpone their expiration dates.
For example, the holder-extendible options allow a purchaser extending their options by a
predetermined amount of time if the options are out-of-money. Conversely, the writer-
extendible options provide similar rights to a writer (issuer) of options.
9. Lookback options
Unlike other types of options, lookback options initially do not have a specified exercise price.
However, on the maturity date, the holder of lookback options has the right to select the most
favorable strike price among the prices that have occurred during the lifetime of the options.
10. Spread options
The payoff of a spread option depends on the difference between the prices of two underlying
assets.
11. Range options
Range options are also distinguished by their final payoff. The final payoff of range exotic options
is determined as the spread between maximum and minimum prices of the underlying asset