Welcome to the Welcome to the World of derivativesWorld of derivatives

Just common sense is sufficient

to have the working knowledge

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Terminology for call optionsTerminology for call options

16-Jul-2015

CALL OPTIONS contract is entered b/w 2 parties ◦ Infosys shares are the underlying asset

◦ 31-Aug-2015 call option contract is defined on it performance of obligations happens on 31-Aug-15

◦ One party holds long position i.e. right to BUY ( Receive)

◦ Other party holds short i.e. Obligation to DELIVER

31-Aug-2015

The SHORT shall be ready to deliver the UA◦ However, the long decides today whether to take delivery

To get this privilege, Krishnan paid ____________ on 15-Jul-2015

◦ If exercised, Long pays _______ to receive ______ shares

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American vs European OptionsAmerican vs European Options

An American option can be exercised at any time during its life

A European option can be exercised only at maturity

Payoff (benefit) of Put optionPayoff (benefit) of Put option

Long will exercise when beneficial◦ The stock prices shall remain below K

◦Beneficial to exercise (deliver) if ST < K

◦Not beneficial to exercise if ST > K

Payoff of a Put option◦ For long Max (K - ST , 0)

◦ For short -Max (K - ST , 0)

Terminology of Forward contractTerminology of Forward contract

Underlying EquityDelivery price (Forward price) F

◦ The price that would make the contract worth exactly zero)

◦ This may be different for contracts of different maturities

Spot price STrade date tDelivery date TDelivery instructions

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Payoff function: LONG SHORTForward ST – F -(ST – F)

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Is it naked or covered optionIs it naked or covered option

Covered optionOOM optionLong Term Equity AnticiPation Security

◦ Options on long term until expiry than others◦ Available on approximately 2,500 equities and 20

indices◦ LEAPS were created relatively recently and

typically extend for terms of 2 years out. ◦ Equity LEAPS always expire in January.◦ When LEAPS were first introduced in 1990, they

were derivative instruments solely for equities

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Are S and F related?Are S and F related?

If the spot price of gold is S and the forward price 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.

FT = S0 [(1+rINR)/(1+r$)]T

What is a derivative?

A financial instrument (contract) whose value depends on value of other, more basic, underlying variables◦ underlying (UA) shall be price of a traded asset.

For example, price of a call option depends on◦ Price of UA (S), delivery price (K), delivery date (T), interest

rate for period T, volatility of S, dividend yield of S

Derivative can be dependent on almost any variable!

Introduction

Derivatives are everywhere◦ traded by institutions, fund managers and corporate

treasurers in OTC market.

◦ Derivatives are added to bond issues, used in compensation plans, embedded in capital investment proposals

Understanding derivatives is important! ◦ Mechanics of forwards, options and swaps

◦ How to use them in hedging, speculation, arbitrage

◦ How to value these derivative contracts

Asset classes

CurrenciesCommodities◦Metals and minerals◦Bullion◦Agricultural products◦Animal products

Equity shares and indicesBond issues and their indicesEnergy and other underlyings

RECAP!RECAP!

Futures/forward contracts are obligations that must be fulfilled at maturity.

Options contracts are rights, not obligations, to either buy (call) or sell (put the underlying financial instrument.

Swaps are the multi-period contractsDerivatives are traded in auction markets

◦ Institutions make spot and derivative markets◦ Develops new instruments to fill the gaps◦ Trading volumes in OTC are much higher

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Options: Rights & ObligationsOptions: Rights & Obligations

Holder (long position) Writer (Short position) Right to receive UA Obligation to deliver UA Obligation to pay K Right to receive K

Obligation to deliver UA Receive K Obligation to receive UA Pay K

ForwardExercises it only when

beneficialCall

optionPut

optionExercises it only when

beneficial

ON maturity date or expiration rate, do the following:

RECAP!RECAP!

Payoff in Forward/futures contractsPayoff in options contractsArbitrage and the law of one priceHedging with Forward/futures and optionsSpeculation with futures and options

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Users of Derivatives Users of Derivatives

Banks and Financial InstitutionsFund managers (Asset management cos.)Treasurers of manufacturing and service companies

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Any one who works in finance needs to understand how derivatives work, how they are used, and how they are priced.

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 15

1.6 Types of Traders1.6 Types of Traders

• Hedgers : offset the exposure to price of UA.

• Speculators: No exposure to offset.

• Arbitrageurs: To lock in a arbitrage profit

Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators (See for example Barings Bank, Business Snapshot 1.2, page 15)

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 16

Ways Derivatives are UsedWays Derivatives are Used

To lock in an arbitrage profit

To hedge risks (to lock into price)

To speculate (take a view on the future direction of the market)

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

Ways Derivatives are UsedWays Derivatives are Used

To embed into securities to alter their payoffs (an application in corporate finance!)◦ Convertible securities

Management compensation contracts with variable pay linked to the market◦ ESOPs

Embedded in capital investment opportunities◦ Option to expand

◦ Option to delay

◦ Option to abandon

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 17

Some questions

Long Forward vs. Long callShort Call @ K vs. Long Put @ KWhy do we use F for forward delivery price

and K for delivery price on option contracts?Suppose you have 500 shares of YES bank.

How to obtain insurance against a decline in share value over 4 months?

Payoff for [Long forward + long put]Exercise 1.24

Role of Derivative InstrumentsRole of Derivative Instruments

Protect against different types of investment risks, ◦ Purchasing power risk, interest rate risk, currency risk.

Advantages:

◦ Lower transactions costs

◦ Faster to carry out transaction

◦ Greater liquidity

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 20

Futures ContractsFutures Contracts

Agreement to buy or sell an asset for a certain price at a certain time

Similar to forward contractWhereas a forward contract is traded OTC, a

futures contract is traded on an exchange◦ Tick size◦ Delivery date◦ Contract size◦ Margining

Forward vs. Futures contracts

Forward Contract Futures contract

Private contract between two parties

Traded on an exchange

Contract terms not standardized

Standardized contract

Usually one specific delivery date

Range of delivery dates

Settled at the end of contract period

Settled daily

Delivery or final cash settlement usually happens

Contract is usually closed out prior to maturity

Some credit risk Virtually no credit risk

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 22

Exchanges Trading FuturesExchanges Trading Futures

Chicago Board of TradeChicago Mercantile ExchangeLIFFE (London)Eurex (Europe)BM&F (Sao Paulo, Brazil)TIFFE (Tokyo)and many more (see list at end of book)

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 23

Exchanges Trading FuturesExchanges Trading Futures

Bombay Stock ExchangeNational Stock ExchangeMCX Stock ExchangeMCXNCDEXUnited Stock ExchangeCCIL

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 24

Examples of Futures ContractsExamples of Futures Contracts

Agreement to:

◦ Buy 100 oz. of gold @ US$1,280/oz. in Oct (NYMEX)

◦ Sell £62,500 @ 1.6500 US$/£ in June (CME)

◦ Sell 1,000 bbl. of oil @ US$114/bbl. in April (NYMEX)

◦ Buy 100 shares of Infosys Limited at Rs.3,973 in 25-Sep-2014 (NSE)

Infosys Option Prices (March 01, 2013; S =2925)Infosys Option Prices (March 01, 2013; S =2925)

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 25

Strike Price

28-Mar Call

25-Apr Call

30-May Call

28-Mar Put

25-Apr Put 30-May Put

2,850 107.30 200.00 - 30.65 - -

2,900 78.50 150.00 - 48.00 120.00 -

2,950 53.00 - - 70.70 128.65 -

3,000 34.20 - - 103.00 - -

3,050 21.00 - - 151.40 - -

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 26

Options vs Futures/ForwardsOptions 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

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 27

Hedge Funds Hedge Funds (see Business Snapshot 1.1, page 9)(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, ◦ makes 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

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 28

Hedge Funds strategiesHedge Funds strategies

Convertible Arbitrage Distressed Securities Emerging Markets Macro or global Market neutral

SUMMARY

5 broad asset classes. Active spot markets exist for these assets and had evolved over time.

Investment in any of these assets expose the investor to investment risks such as price risk or interest rate risks. They cover it in the derivatives market.

A forward/futures contract involves an obligation to buy or sell an asset at maturity for certain price ◦ Forward are privately negotiated and tailor-made ◦ Futures contracts are standardized & well-defined: UA, delivery price,

delivery date, locations, quality

◦ The payoff function for long position is (ST – F) while that of short position is –(ST – F).

There are 2 types of options: call option and put option ◦ Call option gives the holder the right to buy the UA by a certain date

for certain price. Its payoff function is max(ST – F,0).◦ Put option gives the holder the right to sell the UA by a certain date

for certain price. Its payoff function is max(F– ST,0).

Summary contd.

3 main types of traders can be identified in derivatives market. ◦ Hedgers have exposure to UA from their regular line of business.

They take opposite exposure in derivative markets to reduce or eliminate this risk thereby lock into price.

◦ Speculators does not have exposure to UA. They wish to bet on future movements in price of UA. They use derivatives to get extra leverage and hence adds liquidity to the market.

◦ Arbitrager looks at price of the asset in spot market and derivative market along with interest rate in money market. If they see the futures price get out of line with cash price, they will take offsetting positions in the two markets to lock into arbitrage profit.

Both hedgers and speculators find it attractive to trade a derivative than to trade the asset itself.

IN the next chapter, we look at some technical aspects of futures contracts.