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A financial contract of pre-determined duration, whose value is derived from the value of an underlying asset
Securities commodities bullion precious metals currency livestock index such as interest rates, exchange rates
What is Risk?
The concept of risk is simple. It is the potential for change in the price or value of some asset or commodity. The meaning of risk is not restricted just to the potential for loss. There is upside risk and there is downside risk as well.
What is a Hedge
To Be cautious or to protect against loss. In financial parlance, hedging is the act of reducing uncertainty about future price movements in a commodity, financial security or foreign currency . Thus a hedge is a way of insuring an investment against risk.
Derivative Instruments.
Forward contracts Futures
Commodity Financial (Stock index, interest rate & currency )
Options
Put Call
Swaps.
Interest Rate Currency
Forward Contracts.
A one to one bipartite contract, which is to be performed in future at the terms decided today. Eg: Jay and Viru enter into a contract to trade in one stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties. Delivery and payments will take place as per the terms of this contract on the designated date and place. This is a simple example of forward contract.
Futures.
Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges. These markets are very liquid In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing corporation/house.
Illustration.
Let us once again take the earlier example where Jay and Viru entered into a contract to buy and sell Infosys shares. Now, assume that this contract is taking place through the exchange, traded on the exchange and clearing corporation/house is the counter-party to this, it would be called a futures contract.
Options
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.
Options Lingo
Underlying: This is the specific security / asset on which an options contract is based. Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of an option. It is the difference between the higher price paid for a security and the security's face amount at issue. The premium of an option is basically the sum of the option's intrinsic and time value.
Strike Price or Exercise Price :price of an option is the specified/ predetermined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Expiration date: The date on which the option expires is known as Expiration Date Exercise: An action by an option holder taking advantage of a favourable market situation .Trade in the option for stock.
Exercise Date: is the date on which the option is actually exercised. European style of options: The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that. American style of options: An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry.
Asian style of options: these are in-between European and American. An Asian option's payoff depends on the average price of the underlying asset over a certain period of time. Option Holder Option seller/ writer Call option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time. Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time
In-the-money: For a call option, inthe-money is when the option's strike price is below the market price of the underlying stock. For a put option, in the money is when the strike price is above the market price of the underlying stock. In other words, this is when the stock option is worth money and can be turned around and exercised for a profit.
Intrinsic Value: The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.
For a call option: Intrinsic Value = Spot Price - Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price
Positions
Long Position: The term used when a person owns a security or commodity and wants to sell. If a person is long in a security then he wants it to go up in price. Short position: The term used to describe the selling of a security, commodity, or currency. The investor's sales exceed holdings because they believe the price will fall.
0 100 -3 103
Loss
0 100 103
Loss
Initial price of the asset = Rs100 Option price= Rs3 Strike price = Rs100 Time to expiration = 1 month
0 98 100
-2
Loss
0 94 100
Price of the Asset XYZ at expiration Initial price of the asset XYZ = Rs100 Option Price = Rs2 Strike price = Rs100 Time to expiration = 1 month
Loss
Summary
The profit and loss profile for a short put option is the mirror image of the long put option. The maximum profit from this position is the option price. The theoritical maximum loss can be substantial should the price of the underlying asset fall. Buying calls or selling puts allows investor to gain if the price of the underlying asset rises; and selling calls and buying puts allows the investors to gain if the price of the underlying asset falls.
Long Call
Short Put
Price rises
Price Falls
For a stock option, the price at which the buyer of the option can buy or sell the stock is the strike price. For an index option, the strike index is the index value at which the buyer of the option can buy or sell the underlying stock index. For Eg: If the strike index is 700 for an S&P index option, the USD value is $70,000. If an investor purchases a call option on the S&P100 with a strike of 700, and exercises the option when the index is 720, then the investor has the right to purchase the index for $70,000 when the USD value of the index is $72000. The buyer of the call option then receive$2000 from the option writer.
Swaps
An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and currency swaps.
Counter Party B
A
Fixed Rate of 12%
The only Rupee exchanged between the parties are the net interest payment, not the notional principle amount. In the given eg A pays LIBOR/2*50crs to B once every six months. Say LIBOR=5% then A pays be 5%/2*50crs= 1.25crs B pays A 12%/2*50crs=3crs The value of the swap will fluctuate with market interest rates. If interest rates decline fixed rate payer is at a loss, If interest rates rise variable rate payer is at a loss. Conversely if rates rise fixed rate payer profits and floating rate payer looses.
Conclusion
Risk is an inherent part of business.