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7/28/2019 Derivatives - Session 01
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DERIVATIVES
PROF KAUSHIK DESARKAR
FULLTIME PGDM PROGRAM
GOA INSTITUTE OF MANAGEMENT
7/28/2019 Derivatives - Session 01
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DERIVATIVES
•What are derivatives
•Taxonomy & Terminologies
•Basic Introduction
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FINANCIAL DERIVATIVES•Last 35 years have seen Derivatives move to the forefront of finance.
•Most Exchanges today have active trading units in Futures & Options
•Derivatives are found in Bond Issues (Convertibles) and Executive
Compensation (ESOPS)
•They are also found in Capital Investment Opportunities – can you
guess what
they
are
called
?
•Answer : REAL OPTIONS – Options embedded in CapEx Decisions
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DERIVATIVES
•A Derivative can be defined as a financial instrument whose valuedepends on (or derives from) the values of other, more basic,underlying variables.
•Very often the variables underlying the derivatives are prices of traded assets.
•There are however exceptions to the above – like WeatherDerivatives.
•Nevertheless, whatever the underlying, there must be an agreementto its measure for writing derivative contracts on it.
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DERIVATIVES
•Derivatives can be classified in various ways but 2 basic classifications are based on
•Exchange Traded (ET) Vs. Over The Counter (OTC).
•Linear Payoffs
Vs.
Non
‐Linear
Payoffs.
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DERIVATIVES
•Exchange Traded (ET) Vs. Over The Counter (OTC)
•Derivatives traded
on
the
exchange
have
the
following
features
•Standardized Contracts
•Standardized Dates
•The Exchange stands as the counterparty (negligible counterpartycredit risk)
•Price transparency and discovery
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DERIVATIVES•Exchange Traded (ET) Vs. Over The Counter (OTC)
• However the
OTC
market
is
larger
is
terms
of
volume.
• OTC market allows non‐standardization of contracts to suit client needs.
• Buyers and sellers can create mutually attractive and acceptable deals.
• Let us strike a deal whereby based on tomorrow’s price of Tata Steel > Rs.270/‐, the loserwill compensate the winner Re.1/‐. (There is a name for such a product – guess?)
• However issue of counterparty credit risk (Lehman Brothers 2008).
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DERIVATIVES
•Payoffs
• Let us take a simple example.
•You bought 1 share of Tata Motors on 1st May 2012 @ Rs.232 per share. On 18th
July 2012, Rs.4/‐ dividend per share was paid to you. On 1st May 2013 you soldthe share for Rs.313.45.
•What is the Payoff ?
•Answer : Payoff is the amount you received = 313.45 + 4 = Rs.317.45
•What is the Profit ?
•Answer : Profit = Payoff – Investment = 317.45 – 232 = Rs.85.45
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DERIVATIVES
•Payoffs
•Certain Derivatives’
payoffs
mimic
the
underlying
price
movements
–
thus they have linear payoffs – Forwards and Futures
•Others have a discontinuity in their payoffs, hence termed as non‐
linear payoffs ‐ Options
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DERIVATIVES•Use
•Risk Management
– allows
transfer
of
risk
•Speculation – Highly leveraged bets
•Reduced Transaction Costs – managing a large portfolio and hedgingusing derivatives
•Arbitrage – bypassing rules while participating in deals like InterestSwaps
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DERIVATIVES• FORWARD CONTRACTS
• Relatively simple Derivative
• Agreement to buy or sell an asset at a certain future time for a certain price. Theagreement is binding and both parties are obliged to complete the deal.
•Forward
contracts
are
traded
in
the
OTC
Market.
• 2 parties involved – one assumes a Long Position and agrees to buy the underlying asseton a certain specified future date for a certain agreed specified price. The other partyassumes a Short Position and agrees to sell the asset for the same terms and conditions.
• Very popular in the Foreign Exchange market and in short term Interest rate hedging.Also prevalent in commodities and used by corporates to secure long‐term agreements.
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DERIVATIVES•FORWARD CONTRACTS
• As the treasurer of your company, you know that on July 1st 20XX you will be paying outUS$ 5 million to settle an imported item bill. Since your business is based in India,unsettled forex rates may force you to pay more Indian Rupees than originally plannedfor.
• One strategy you may pursue to hedge against the forex risk is by entering into a ForwardContract to buy on July 1st 20XX, US$ 5 Million at a agreed exchange rate of Rs.62 perUS$1.
• You have entered into a Long Forward to buy and the bank/counterparty has enteredinto a Short Forward to sell. Both parties are obliged to complete the deal.
• Entering into Forwards usually cost nothing !!! All you require is a good relationship withthe counterparty and a good credit rating.
• The cost comes up when the contract is completed – if the USDINR rate is 64, you got agood deal but if the USDINR rate is 60, you lost Rs2 per USD.
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DERIVATIVES
•FUTURES
• Close relative
of
the
Forward
Contract.
• Exchange based and marked to market.
• They are standardized – in terms of size, quality of underlying (commodities and FIS
products), maturity dates.
• Popular underlying includes Financial assets, commodities.
• One can reverse a trade by entering into an offsetting trade thus allowing loss mitigation.
• Zero cost to enter.
•But
Exchanges
impose
margin
requirements
– initial
and
maintenance
margins.
• Risk : LIQUIDITY (remember 2008).
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DERIVATIVES•OPTIONS
• Traded on
both
the
Exchange
as
well
as
the
OTC
market.
• Comes in 2 flavors : Vanilla and Exotics
• Basically 2 types of Vanilla Options
• Call
•Put
• A Call Option is the right to buy a particular asset for an agreed amount at a specifiedtime in the future.
•
A Put Option is the right to sell a particular asset for an agreed amount at a specifiedtime in the future.
• The keyword is Right to Buy/Sell – not an obligation from the holder’s perspective.
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DERIVATIVES
•OPTIONS
• The Call
Option
focusses
on
the
upside
with
a capped
loss
risk.
• The Put Option focusses on the downside with a capped loss risk.
•
3
important
players
• Buyer (Long) – the person who buys the right of the option
• Seller (Short) – the person who sells the right of the option
• Writer (Short) – the person who is responsible to fulfill (obliged) if the option rights are
exercised.• Hence Options involve a right‐and‐obligation relationship.
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DERIVATIVES
•OPTIONS
• Important terminologies
related
to
Options
• Options are not Costless : Unlike Forwards and Futures, you have to pay a Premium tobuy the contract – hence the capped loss risk. Option Pricing and valuation is all aboutestablishing the ‘true’ Premium.
• Exercise Price : the agreed amount/price the holder of the option will pay to the writerof the option if she/he chooses to exercise the right. Also called the Strike Price.
• Exercise Dates : Can be at the end of the Option’s life (European Option). Can at any timeof the Option’s life (American Option). Can be at selective (agreed) dates (Bermudan
Option).• Payoffs/Profits : Can have a binary outcome (Binary Options), can be based on a singular
value of the underlying or the average price during a selected interval (Asian Options).
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DERIVATIVES•What does the payoff profiles of Forwards and Options look like ???
•Returning back
to
the
treasury
example
we
have
the
following
2 choices
to
hedge
the US$5 Million purchase price on July 1st 20XX :
1. Using Forward – quoted rate Rs.62.00
2. Using a European Call Option – Strike (Exercise Price) Rs. 62.00 – premium
Rs.1.50
•
Outcomes – next
slide
7/28/2019 Derivatives - Session 01
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DERIVATIVES•The profiles of your choice:
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DERIVATIVES•Another example – this time with Short Forward & Put Option.
•You will
be
receiving
US$
5 Million
on
1st July
2013
– you
are
not
sure
of
the
exchange rates and have the following quotes from your bank:
1. Using Forward – quoted rate Rs.62/‐
2. Using a European Put Option – Strike (Exercise Price) Rs. 62.00 – premium Rs.
1.25. ( We will see later that usually Puts are cheaper than Calls – BUT NOTALWAYS)
•Outcomes – next slide
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DERIVATIVES•Profit Profile of your choice
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DERIVATIVES•To round up
•If S(T)
is
the
Spot
Price
on
date
T and
K is
the
agreed/Strike
Price
•Profit from Long Forward = S(T) – K
•Profit from Short Forward = K – S(T)
•Profit from Long Call = Max(S(T) – K, 0) – Premium
•Profit from Long Put = Max(K – S(T),0) ‐ Premium
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DERIVATIVES
•Next Session
– The
world
of
Forwards
•Please read Chapter 1 of JC Hull (6th/7th/8th edition)