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CORPORATE FIANANCE

DERIVATIVES,

FUTURES & OPTIONS

Presented by:

M. Fareed Mumtaz

M. Musharraf Kaleem

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The price of jet fuel can greatly affect the profitability of an airline. Withrising fuel costs during 2008, fuel became the largest expense for many airlines,accounting for 40 percent or so of operating costs. Southwest airline became aninnovator when it when it began to hedge its fuel costs by using variety ofsophisticated financial tools to deal with risks associated with volatile fuel costs,including heating oil futures contracts, jet fuel swaps, and call options. During

period of rising fuel costs, Southwest was often one of the few profitable airlines,saving millions of dollars through hedging.

During late 2008, the cost of jet fuel dropped dramatically, and Southwestshedges did not perform nearly as well. Until 2008, the company had neverannounced a quarterly loss in 16 years, but, in the fourth quarter it announced a

loss of $56 million, in large part due to a hedging loss of $117 million. ButSouthwest may have gotten off easy. For the same period, UAL Corp. , theparent of United Airlines, lost $933 million and Cathy Pacific lost $ 1 billion on itshedges. In the later discussion, we will explore broadly what derivatives are?Whats hedging and speculation? And what are futures and options?

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Why do firms use

derivatives?Derivatives are tools for changing the firms risk exposure.

When the firm reduces its risk exposure with the use of derivatives, it issaid to be hedging .

Derivatives can also be used to merely change or even increase the firmsrisk exposure, known as Speculation.

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DERIVATIVE

A derivative is a financial instrument whose payoffs and values arederived from, or depend on underlying variables.

Most derivatives are forward or futures agreements (i.e. swaps). Anoption is a complex form of derivative (i.e. The value of a call option

depends on the value of the underlying stock on which it is written.

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Forward ContractsA forward contract is customized contract between two entities, wheresettlementtakes place on a specific date in the future at todays pre-agreed price.

Futures Contracts A futures contract is a standardized contract between two parties toexchange a specified assetof standardized quantity and quality for a price agreed today (thefutures price or the strikeprice) with delivery occurring at a during specified future date, thedelivery date.OptionsAn option is a contract giving its owner the right to buy or sell an assetat a fixed price on orbefore a given date. Options are of two types calls and puts. Calls give the buyer the rightbut not theobli ation to bu a iven uantit of the underl in asset at a iven

TYPES OF DERIVATIVES

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Call Option Put Option

Option Buyer Buys the right to buy theunderlying asset at the

Strike Price

Buys the right to sell theunderlying asset at the

Strike Price

Option Seller Has the obligation to sellthe underlying asset to theoption holder at the StrikePrice

Has the obligation to buythe underlying asset fromthe option holder at theStrike Price

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An investor buys one European Call option on one share of PakistanPetroleum Ltd. at a premium of Rs.2 per share on 31 July. The strikeprice is Rs.60 and the contract matures on 30 September. It may beclear form the graph that even in the worst case scenario, the investorwould only lose a maximum of Rs.2 per share which he/she had paid

for the premium. The upside to it has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chartcompletely reverse of the call options buyer. The maximum loss that hecan have is unlimited though a profit of Rs.2 per share would be made

on the premium payment by the buyer.

Illustration on CallOption

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An investor buys one European Put Option on oneshare of Pakistan Petroleum Ltd. at a premium ofRs. 2 per share on 31 July. The strike price is

Rs.60 and the contract matures on 30 September.The adjoining graph shows the fluctuations of netprofit with a change in the spot price.

Il lustration on Put Options

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OPTION TERMINOLOGY (For The Equity Markets)Options

Options are instruments whereby the right is given by the option seller to the option buyer

to buy or sell a specific asset at a specific price on or before a specific date.

Option Seller - One who gives/writes the option. He has an obligation to perform, in case

option buyer desires to exercise his option.

Option Buyer - One who buys the option. He has the right to exercise the option but no

obligation.

Call Option - Option to buy.Put Option - Option to sell.

American Option - An option which can be exercised anytime on or before the expiry date.

Strike Price/ Exercise Price - Price at which the option is to be exercised.

Expiration Date - Date on which the option expires.

European Option - An option which can be exercised only on expiry date.

Exercise Date - Date on which the option gets exercised by the option holder/buyer.

Option Premium - The price paid by the option buyer to the option seller for granting the

option.

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M. Fareed Mumtaz MESM. Musharraf Kaleem KSEW

Thank

you