1.Fundamentals of Derivatives Lecture

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Introductionto

Derivatives

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The Nature of Derivatives

A derivative is an instrument whose value depends on the values of other more basic underlying variables called bases (underlying asset, index, or reference rate), in a contractual manner

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Derivatives

The underlying asset can be equity, forex, commodity or any other asset.

• For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date.

• Such a transaction is an example of a derivative.

• The price of this derivative is driven by the spot price of wheat which is the “underlying”.

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Examples of Derivatives

• Futures Contracts

• Forward Contracts

• Swaps

• Options

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Categories of Derivatives

FuturesListed, OTC futuresForward contracts

OptionsCallsPuts

SwapsInterest rate swapForeign currency swap

Derivatives

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Players in the Derivative Market

• The following three broad categories of participants

• Hedgers• Speculators• Arbitrageurs

Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

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Ways Derivatives are Used• To discover price• To hedge risks• To speculate (take a view on the

future direction of the market)• To lock in an arbitrage profit• To change the nature of a liability• To change the nature of an investment

without incurring the costs of selling one portfolio and buying another

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Uses of Derivatives

• Risk management

• Income generation

• Financial engineering

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Risk Management

• The hedger’s primary motivation is risk management– “Banks appears to have effectively used

such instruments to shift a significant part of the risk from their corporate loan portfolios”

• Alan Greenspan, 2002

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Risk Management (cont’d)• Someone who is bullish believes prices are

going to rise

• Someone who is bearish believes prices are going to fall

• We can tailor our risk exposure to any points we wish along a bullish/bearish continuum

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Risk Management (cont’d)

– FALLING PRICES FLAT MARKET RISING PRICES EXPECTED EXPECTED EXPECTED

BEARISH NEUTRAL BULLISH

Increasing bearishness Increasing bullishness

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Income Generation• Writing a covered call is a way to generate

income– Involves giving someone the right to purchase

your stock at a set price in exchange for an up-front fee (the option premium) that is yours to keep no matter what happens

• Writing calls is especially popular during a flat period in the market or when prices are trending downward

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Financial Engineering• Financial engineering refers to the practice of

using derivatives as building blocks in the creation of some specialized product

• Financial engineers:– Select from a wide array of puts, calls futures, and

other derivatives– Know that derivatives are neutral products (neither

inherently risky nor safe)

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Effective Study of Derivatives

• The study of derivatives involves a vocabulary that essentially becomes a new language– Implied volatility

– Delta hedging

– Short straddle

– Near-the-money

– Gamma neutrality

– Etc.

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• In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines

“derivative” to include –1. A security derived from a debt instrument,

share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.

2. A contract which derives its value from the prices, or index of prices, of underlying securities.

Derivatives in India

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Derivatives in India

• Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

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Derivatives Markets• Exchange traded

– Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading

– Contracts are standard there is virtually no credit risk

• Over-the-counter (OTC)– A computer- and telephone-linked network of

dealers at financial institutions, corporations, and fund managers

– Contracts can be non-standard and there is some small amount of credit risk

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Size of OTC and Exchange Markets

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

020406080

100120140160180200220240

Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04

Size of Market ($ trillion)

OTC

Exchange

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Forward Contracts

• Forward contracts are similar to futures except that they trade in the over-the-counter market

• Forward contracts are particularly popular on currencies and interest rates

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Foreign Exchange Quotes for GBP June 3, 2008 (example)

Bid Offer

Spot 1.6281 1.6285

1-month forward 1.6248 1.6253



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Forward Price

• The forward price for a contract is the delivery price that would be applicable to the contract if it were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)

• The forward price may be different for contracts of different maturities

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Terminology

• The party that has agreed to buy has what is termed a long position

• The party that has agreed to sell has what is termed a short position

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Example (page 4 of text)

• On June 3, 2003 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.6100

• This obligates the corporation to pay $1,610,000 for £1 million on December 3, 2003

• What are the possible outcomes?

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Profit from aLong Forward Position

Profit

Price of Underlying at Maturity, STK

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Profit from a Short Forward Position

Profit

Price of Underlying at Maturity, STK

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Futures Contracts• A futures contract is an agreement to

buy or sell an asset at a certain time in the future for a certain price

• By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)

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Exchanges Trading Futures

• Chicago Board of Trade• Chicago Mercantile Exchange• LIFFE (London)• Eurex (Europe)• BM&F (Sao Paulo, Brazil)• TIFFE (Tokyo)• NSE & BSE• NCDEX, NBOT, MCX and other commodity

exchanges in India

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Futures Price

• The futures prices for a particular contract is the price at which you agree to buy or sell

• It is determined by supply and demand in the same way as a spot price

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Electronic Trading

• Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange

• Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers

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Terminology

• The party that has agreed to buy has a long position

• The party that has agreed to sell has a short position

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Over-the Counter Markets

• The over-the counter market is an important alternative to exchanges

• It is a telephone and computer-linked network of dealers who do not physically meet

• Trades are usually between financial institutions, corporate treasurers, and fund managers

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OTC Markets- Limitations• The following features of OTC derivatives markets

can give rise to instability in institutions markets, and the international financial system:

(i) the dynamic nature of gross credit exposures;(ii) information asymmetries(iii) the effects of OTC derivative activities on available

aggregate credit(iv) the high concentration of OTC derivative activities in

major institutions(v) The central role of OTC derivatives markets in the

global financial system.

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OTC Markets- Limitations

• Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie

derivative contracts occur, which significantly alter the perceptions of current and potential future credit exposures.

• When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions.

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OTC Markets- Limitations

• The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures.

• Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives.

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Forward Contracts

• Forward contract are similar to futures except that they trade in the over-the-counter market

• Forward contracts are popular on currencies and interest rates

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Foreign Exchange Quotes for GBP (Example in Rs)

Bid Offer

Spot 75.51 76.51




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Options

• A call option is an option to buy a certain asset by a certain date for a certain price (the strike price)

• A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

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American vs European Options

• An American options can be exercised at any time during its life

• A European option can be exercised only at maturity

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WIPRO Options (Jun 1, 2008; Stock Price=62.75);

Strike Price

July Call

Oct Call

July Put

Oct Put

50 16.87 18.87 2.69 4.62

65 7.00 10.87 8.25 10.62

80 2.00 5.00 17.50 19.50

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Exchanges Trading Options

• Chicago Board Options Exchange

• American Stock Exchange

• Philadelphia Stock Exchange

• Pacific Exchange

• LIFFE (London)

• Eurex (Europe)

• NSE & BSE in India

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Options vs Futures/Forwards

• A futures/forward contract gives the holder the obligation to buy or sell at a certain price

• An option gives the holder the right to buy or sell at a certain price

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Types of Traders

• Hedgers

• Speculators

• Arbitrageurs

Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

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Hedging- Examples

• An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

• A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract

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Value of Microsoft Shares with and without Hedging

20,000

25,000

30,000

35,000

40,000

20 25 30 35 40

Stock Price ($)

Value of Holding ($)

No Hedging

Hedging

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Speculation Example

• An investor with Rs4,000 to invest feels that RIL’s stock price will increase over the next 2 months. The current stock price is Rs40 and the price of a 2-month call option with a strike of 45 is Rs2

• What are the alternative strategies?

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Speculation Example

• An investor with Rs4,000 to invest feels that WIPRO’s stock price will increase over the next 2 months. The current stock price is Rs400 and the price of a 2-month call option with a strike of 450 is Rs20.

• What are the alternative strategies?

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Arbitrage Example

• A stock price is quoted as £100 in London and $172 in New York

• The current exchange rate is 1.7500

• What is the arbitrage opportunity?

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Arbitrage Example

• A stock price is quoted as £100 in London and $172 in New York

• The current exchange rate is 1.7500

• What is the arbitrage opportunity?

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1. Gold: An Arbitrage Opportunity?

• Suppose that:– The spot price of gold is US$390– The quoted 1-year futures price of gold

is US$425– The 1-year US$ interest rate is 5% per

annum• Is there an arbitrage opportunity?

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2. Gold: Another Arbitrage Opportunity?

• Suppose that:– The spot price of gold is US$390– The quoted 1-year futures price

of gold is US$390– The 1-year US$ interest rate is

5% per annum• Is there an arbitrage opportunity?

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The Futures Price of Gold If the spot price of gold is S & the futures price is

for a contract deliverable in T years is F, then

F = S (1+r )T

where r is the 1-year (domestic currency) risk-free rate of interest.

In our examples, S=390, T=1, and r=0.05 so that

F = 390(1+0.05) = 409.50

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1. Oil: An Arbitrage Opportunity?

Suppose that:– The spot price of oil is US$49– The quoted 1-year futures price of

oil is US$55– The 1-year US$ interest rate is 5%

per annum– The storage costs of oil are 2% per


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2. Oil: Another Arbitrage Opportunity?

• Suppose that:– The spot price of oil is US$49– The quoted 1-year futures price of

oil is US$46– The 1-year US$ interest rate is 5%

per annum– The storage costs of oil are 2% per


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Hedge Funds (see Business Snapshot 1.1,

page 9) • Hedge funds are not subject to the same rules as

mutual funds and cannot offer their securities publicly.

• Mutual funds must – disclose investment policies, – make shares redeemable at any time,– limit use of leverage– take no short positions.

• Hedge funds are not subject to these constraints.• Hedge funds use complex trading strategies are big

users of derivatives for hedging, speculation and arbitrage

Documents

1.Fundamentals of Derivatives Lecture