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DERIVATIVES Notes
DERIVATIVES Notes
DERIVATIVES Notes
DERIVATIVES
As per SCRA,derivative instruments means
(ii)A contract that derives its value from prices/index of prices of underlying securities.
Usefulness:
(i) The prices of derivatives converge with the prices of the underlying at the expiration of
the contract. This helps in discovery of future & current prices.
(ii) Facilitates transfer of risk from those who carry them (but do not like to carry them) to
those with risk appetite.
(iii) Derivatives, by their very nature, are linked to the underlying cash markets.They
therefore facilitate higher trading volumes as more players take part due to available facility
for risk transfer.
In the 12th century, European traders offered futures contracts promising future delivery of
items .
In the 13th century, English Cistercian monasteries sold wool 20 years in advance to foreign
parties.
1634-37: Period of “Tulip Mania” in which huge speculative bets were placed on Tulip
flower & fortunes were lost.
17th Century: Rice futures market was developed in Japan, near Osaka.
1848 ; Central Board of Trade (CBOT) developed forward contracts on several commodities.
In 1865, CBOT extended these contracts to exchanges called “Exchange Traded
Contracts”thereby introducing future contracts in the US.
Thereafter CBOT was “spun off “ into a separate Chicago Butter & Egg Board .
This was reorganized for futures trading & name changed to Chicago Mercantile Exchange.
(CME)
In 1972, the CME constituted the International Monetary Market (IMM) for trading in
currency futures.
In 1973, the Chicago Board Options Exchange (CBOE) was formed & became the first
market place for trading in listed options.
In 1975, CBOT introduced interest rate futures using treasury bills derivative contracts, the
first pure interest rate futures market.
In 1983, Chicago Board Options Exchange (CBOE) introduced options on index contracts
using S & P 100 & S & P 500 indices.
TULIP MANIA
Tulip Mania, a speculative frenzy in 17th-century Holland over the sale of tulip bulbs.
Tulips were introduced into Europe from Turkey shortly after 1550.
These delicately formed, vividly coloured flowers became a popular if costly item.
The demand for differently coloured varieties of tulips soon exceeded the supply.
Prices for individual bulbs of rare types began to rise to unwarranted heights in northern
Europe.
By about 1610 a single bulb of a new variety was acceptable as dowry for a bride, and a
flourishing brewery in France was exchanged for one bulb of the variety Tulipe Brasserie.
But the steadily rising prices tempted many ordinary middle-class and poor families
to speculate in the tulip market.
Homes, estates, and industries were mortgaged so that bulbs could be bought for
resale at higher prices.
Sales and resales were made many times over without the bulbs ever leaving the
ground.
Rare varieties of bulbs sold for the equivalent of hundreds of dollars each.
The crash came early in 1637, when doubts arose as to whether prices would
continue to increase.
Almost overnight the price structure for tulips collapsed, sweeping away fortunes and
leaving behind financial ruin for many ordinary Dutch families.
DERIVATIVE MARKETS IN INDIA
In 1999, the Securities Contract Regulations Act (SCRA) was amended to include
“derivatives” within the domain of “securities”. Regulatory framework was developed
for governing derivatives trading.
In March 2000, a three decade old notification ,which prohibited forward trading in
securities, was repealed.
In June 2000, SEBI pemitted both BSE & NSE to introduce derivatives trading.
First , index futures was introduced based on BSE Sensex & CNX Nifty .
In February 2013, MCX (renamed MSEI) started trading in all these products.
MSEI index derivatives was based on the index of that exchange SX-40 .
FORWARD CONTRACTS
One of the parties assumes a long position i.e. he agrees to buy the asset
o a specified future date for a certain specified price.
The other party assumes a short position i.e. he agrees to sell the asset
on the same date for the same price.
Other contract details like delivery date,price & quantity are negotiated
bilaterally between the parties.
(i) They are bilateral contracts & hence exposed to counterparty risk.
(ii) Each contract is customer designed & hence unique in terms of contract
size,expiration date & asset type & quality.
(v) If a party wants to reverse the contract,it has to necessarily approach the
counterparty which results in charging of higher price.
(vi) They are used in hedging & speculation.(Exporter can sell expected forex forward &
importer can buy forex forward.
(vii) Useful for a speculator who uses forward market instead of a cash market –he would
go long,wait for the prices to rise & reverse the transaction (sell) to make quick
profits.
(iii) Liquidity
FUTURES
Very much like a forward contract-two parties agree to buy/sell an asset to each other
at a future date at a predetermined price.
Exchange specifies certain standard features for the contract to facilitate liquidity.
A futures contract can be offset prior to maturity by entering into an equal & opposite
transaction.
(i) Futures price: The price at which futures contract trades in market.
(ii) Contract Cycle: Period over which the contract trades.Eg.index futures typically have one
month,two month & three months expiry cycles that expire on the last Thursday of the
month.
(iii) Expiry Date: The date specified in the futures contract. The last day of trading of this
contract which will ceast to exist at the end of the day.
(iv) Contract size: Size of asset to be delivered under one contract. (contract size of NIFTY
futures is 50).
(v) Basis : Futures price minus spot price.For each contract,there will be a different basis for
each delivery month.In normal markets,basis will be +ve indicating future prices normally
> spot prices.
(vi) Cost of Carry:Measures storage cost plus interest cost for financing the asset minus
income earned on the asset.
Maintenance Margin :Lower than the initial margin.It is to ensure that the balance
in the margin a/c does not become –ve.If the balance in the margin a/c falls below
the maintenance margin,investor receives a margin call & is expected to top up the
margin account to the initial margin level before trading commences the next day.
Pay Offs :It is the likely profit/loss that would accrue to the market participant with
the change in price of underlying asset.
Pay off for BUYER : Pay off for buyer of future contract is akin to pay off for a
person holding the asset. He a potential unlimited upside/downside.
Eg: A person who buys a NIFTY futures contract when nifty is 22300. underlying
asset in this case is the NIFTY portfolio. When the NIFTY moves up,the long futures
starts making profit & when it moves down, it starts making losses .
Pay off for SELLER : Pay off for seller of future contract is akin to pay off for a
person shorting the asset. He a potential unlimited upside/downside.
Eg: In the above example,in this case,the position is opposite. When the NIFTY
moves down,short futures starts making profit & when it moves up, losses start.
MARGIN ACCOUNT CALCULATIONS
day price gain/loss cum gain/loss margin a/c balance margin call IM 12000
(i) COST OF CARRY MODEL: It explains the dynamics of pricing that constitute
estimation of fair vale of futures.
(ii) Fair value calculation is used to decide the no arbitrage limits on the price of futures.
(iii) Using discrete compounding,where interest rates are compounded at discrete
intervals(e.g. semi annually/annually),price of contract is defined as :
F=S + C
where F=futures price,S=spot price & C= carry or holding cost.
In case of equity,the holding cost is the cost of financing minus dividend income.
F=Se ^rT
Stock index Futures are cash settled ,there is no delivery of underlying stocks.
Thus crucial aspect of dealing with equity futures is the accurate forecasting of dividends.
The better the forecast of dividend offered by a stock, the better is the estimate of
its futures price.
Pricing of equity index can be done w.r.t. (i) Expected dividend amount
(ii) Expected dividend yield.
PRICING OF FUTURES GIVEN EXPECTED DIVIDEND AMOUNT
the cost of financing the financing the portfolio underlying the index minus present value
of the dividends obtained from the stocks comprising the portfolio.
If the dividend flow throughout the year is generally uniform (there are few cases of
clustering of dividend in any particular month) ,it is used to calculate the annual dividend
yield
F=S(1+r-q)^T
OR
S*e^[(r-q)*t)
,where
F=Futures price
S=spot index value
r=Cost of financing
q=expected dividend yield
T=holding period
PRICING STOCK FUTURES
If no dividends are expected during life of stock ,pricing futures on the stock simply involves
multiplying the spot price by cost of carry
F =S(1+r)^T or F= S*e(rt)
1.On Nov 1st, X bought one month January Nifty futures for Rs.5,38,000. Initial margin
of Rs. 43040 was paid to broker. (1 NIFTY contract or lot=200 NIFTY futures). In
February , NIFTY closed at Rs.2720 on expiry. What was his pay off?
OR
F= S*e^(rt) + C
If the spot price of silver=Rs.50,000/kg & cost of financing =15% , find out the
price of three months’ silver futures contract of 100 gms
F= S* e^rt = 50000 * e^ (0.15*0.25) = 51910 for 1kg or 1000 gms
F = S* e^(rt) – D* e^(rt)
F = S* e^(rt) – D * e(rt) = 390* e^(.08*0.25 ) – 30 * e^(.08*.25) = 367.17
If share of ABC Ltd has a spot price of Rs700 & if it declares a dividend of 3% , the
interest rate being 7% p.a., find out the value of 4 months’ futures of ABC Ltd
F = S*e^ (r-D) * t = 700 * e^[(.07-.03) * 4/12] = 709.39
Spot price of XYZ Ltd is Rs. 900 . An investor buys a 3 months’ future contract on
XYZ Ltd. If the company declares a dividend of 80 two months after the
purchase of the contract, find out the price of the three month futures. Interest
rate is 7.5%.
Here t will change while discounting dividend since it is carried forward only for
one month during the contract.
F = S* e^(rt1) – D* e^(rt2)
F = S*e^(rt) – D * e^ (rt) = 900 * e^ (.075
* 3/12) – 80* e^ (.075* 1/12)
= 837.20
1.On January 1st, an investor buys 10,000 shares of Rs.1000 each.He hedged with stock
futures on the same date . Risk free rate=6%. The company expects to pay a dividend of
Rs.90 per share on January 31st.The contract expires on March 28th & the company’s
closing price on that date is 976. If the investor sells the share on March 28 th, what will be
his pay off?
2.Suppose the company had not paid dividend, calculate his pay off.
Spot price =1000 , dividend =6% p.a.
no of days of contract= 31+28+27 =86
No of days of dividend= 1+28 +27 =56
In the cash segment, he bought at 1000 & sold at 976 . He received dividend of Rs.90
-1000+ 976 +90 =+66
He short sold the futures at 923.17 & squared off on the expiry at 976
Gain= 38
Net gain/share = 38 – 24 = 14
(We are dividing by 200 because we are the calculating the dividend value per NIFTY )
NUMERICAL
The customer requested for cancellation of the contract & the bank agreed.
You borrow $2,00,000 for 3 months from a bank at the US rate of interest of 5%
. Tthe Indian rate of interest is 9%. If the spot $/INR rate is Rs.75 , calculate
Invest thuis amount in a bank for 3 months @ rupee interest rate of 9%.p.a.
3 month INR interest rate= 9%*3/12 = 2.25% =0.0225
No arbitrage three months INR/$ forward rate = the fair forward rate of
Rs.75.74
OPTIMAL HEDGE RATIO
It shows the strength of relationship between two assets which can be exploited to
achieve the minimum portfolio variance.
It shows how the variance value of the hedger’s position depends on the hedge ratio
chosen. The optimal hedge ratio is a risk management ratio that helps you work
out the percentage of a hedging instrument, or in other words, the percentage of
your portfolio that you should hedge.
CROSS HEDGE:It is used to manage price risk of an asset by hedging it with derivative
product of another asset ,both of which are positively correlated. Investor takes
opposite position in the derivative position for reducing the price risk of the asset held.
An airlines intends to buy 1 m gallons jet fuel. . It desires to hedge using jet fuel
futures.But this product is not available on the exchanges. So it chooses heating oil
futures to hedge as it has a strong correlation in price with jet fuel. This is called Cross
hedge . 1 contract of heating oil futures =42000 gallons.
Jet fuel Heating oil
SD 2.83% 3.38%
MV ratio/opt.
hedge ratio
=0.814* 0.0283/0.0338
= 0.6815
No of contracts of heating oil futures (N)= h * size of the exposure/ size of hedging
instrument
If spot price of jet fuel rises by $1 per gallon, gain in futures price = 1/ ρ^2
= 1/ (0.814)^2 = 1.51
= 0.0338^2/0.0283^2*0.6815^2
=0.6625 or 66.25%
A Cocoa merchant has inventory of cocoa of $ 10m @ $1250 /metric ton. He considers
miminisation of risk strategy using cocoa futures contracts on the cocoa exchange.
SD of cocoa = 27% , SD of cocoa futures = 33%, contract size cocoa futures =10 metric
tons
Estimate:
Since the merchant is holding cocoa inventory, he will hedge to mitigate the price
fall.So he will go short on cocoa futures.
An option contract gives its holder an option i.e.a right but not an obligation to buy or sell
an asset at a predetermined price on a specified future date.
Thus the holder of an option contract does not have to necessarily exercise this right.
OPTION TERMINOLOGY
INDEX OPTION:
Two types of option: American options can be exercised anytime upto the expiration
date.
Like index Futures contracts, index option contracts are cash settled.
STOCK OPTIONS:
They are options on individual stocks.
The stock option contract gives the holder the right to buy or sell shares at a specified price
on a predetermined date.
BUYER OF OPTION
He buys the right but not the obligation to exercise his option to buy/sell the asset on the
seller/writer of the option by payment of an option premium.
WRITER OF AN OPTION
He is the seller of the option & is obliged to buy/sell the asset if the buyer of the option
exercises his right by receipt of an option premium.
CALL OPTION
It gives the holder of the option the right but not the obligation to buy an asset on a
certain date for a certain price.
PUT OPTION
It gives the holder of the option the right but not the obligation to buy an asset on a
certain date for a certain price.
OPTION PRICE/PREMIUM
Option price is the price that the option buyer pays to the option seller.Also referred to as
Option premium.
EXPIRATION DATE
The date specified in the option contract is called the Expiration Date.
STRIKE PRICE
The price specified in the options contract is called the Strike Price or the Exercise price.
It is an option which would lead to a positive cash flow if the option was exercised
immediately.
A call option on the index is said to be in the money when the current index stands at a
higher level than the strike price.i.e spot price> strike price.
If the index is much higher than the strike price,the call is said to be deep ITM.
In the case of a put option, the put is ITM if the index is below the strike price.
At the Money Option (ATM)
It is the option that would lead to zero cash flow if exercised immediately.
An option on the index is at the money when the current index=strike ot price. i.e the spot
price=strike price.
It is the option that would lead to a negative cash flow if exercised immediately.
A call option on the index is out the money when the current index < strike ot price. i.e the
spot price < strike price.
PRICING OPTIONS
An option buyer has the right but not the obligation to exercise his right on the seller.
The worst thing that can happen to the option buyer is the loss of premium paid by him.
It is the supply & demand in the secondary markets that decides option price.
CALL OPTION BUYER
100 110
120
BE
90 100
0 70 B
E
70
0 90 100
BE
100 110 120
Invstor buys 200 three month call option contracts (I contract – 100 options) , premium
= Rs. 8 per option & X =200 . Compute pay off to the investor for both cash & option if
(i) expiry price = 210 (ii) 180
Scenario 2
In CASH, the investor had cash equal to the option premium = 1,60,000