Derivatives Management

UNIT 1 INTRODUCTION

Derivatives definition types forward contracts Options swaps difference between cash and future markets types of traders OTC and Exchange Traders Securities types of Settlement Uses and Advantages of derivatives - Risks in Derivatives.

Definition A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Derivatives
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 do derivatives do?

Derivatives

attempt either to minimize the loss arising from adverse price movements of the underlying asset Or maximize the profits arising out of favorable price fluctuation. Since derivatives derive their value from the underlying asset they are called as derivatives.

Types of Derivatives (UA: Underlying Asset)

Based

on the underlying assets derivatives are classified into. Financial Derivatives (UA: Fin asset) Commodity Derivatives (UA: gold etc) Index Derivative (BSE sensex)

How are derivatives used?

Derivatives are basically risk shifting instruments. Hedging is the most important aspect of derivatives and also their basic economic purpose Derivatives can be compared to an insurance policy. As one pays premium in advance to an insurance company in protection against a specific event, the derivative products have a payoff contingent upon the occurrence of some event for which he pays premium in advance.

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.

What is derivatives in stock market, how it is different from equity shares? In derivatives u can buy a future stock by paying 20% amount of the stock. its always in lot sizes, and there are 3 way available for trading in derivative 1)current month 2) next month 3)next to next month.

It expires on the last Thursday of every month. where in equity u can by a stock by paying the price at spot. and u can hold the stock for as much time as much u want. long term investments are done in equity shares we can do short term trading also but in derivatives we can do only short term trading which can last for maximum 3 months. There are other options also in derivatives like call , put ,forward options

Growth of Derivatives Market

Analytical techniques Technology Globalization

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importance of derivatives There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks.

. The fundamental risks involved in derivative business includes: Credit Risk This is the risk of failure of a counterparty to perform its obligation as per the contract. Also known as default or counterparty risk, it differs with different instruments. Market Risk Market risk is a risk of financial loss as a result of adverse movements of prices of the underlying asset/instrument.

Liquidity Risk The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk. A firm faces two types of liquidity risks Related to liquidity of separate products Related to the funding of activities of the firm including derivatives. Legal Risk Derivatives cut across judicial boundaries, therefore the legal aspects associated with the deal should be looked into carefully.

Who are the operators in the derivatives market? Hedgers - Operators, who want to transfer a risk component of their portfolio. Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit. Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate misspricing.

Derivative Instruments.
Forward contracts Futures

Commodity Financial (Stock index, interest rate & currency )

Options
Put Call

Swaps.
Interest Rate Currency

Forward Contracts
An agreement where one party agrees to buy (or sell) the underlying asset at a specific future date and a price is set at the time the contract is entered into. Characteristics

Positions in Forwards
Long position Short position

Flexibility Default risk Liquidity risk

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Hedging with Futures

Hedging:

Generally conducted where a price change could negatively affect a firms profits.

Long hedge: Involves the purchase of a futures contract to guard against a price increase. Short hedge: Involves the sale of a futures contract to protect against a price decline in commodities or financial securities. Perfect hedge: Occurs when gain/loss on hedge transaction exactly offsets loss/gain on unhedged position.

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Option Contracts
The right, but not the obligation, to buy or sell a specified asset at a specified price within a specified period of time. Option Terminology

Market Arrangements

Call option versus put option Holder versus writer or grantor Exercise or strike price Option premium American versus European option

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Swap Contracts

Financial contracts obligating one party to exchange a set of payments it owns for another set of payments owed by another party.
Currency swaps Interest rate swaps

Usually used because each party prefers the terms of the others debt contract. Reduces interest rate risk or currency risk for both parties involved.

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Commodity Price Exposure

Security Price Exposure

The purchase of a commodity futures contract will allow a firm to make a future purchase of the input at todays price, even if the market price on the item has risen substantially in the interim. The purchase of a financial futures contract will allow a firm to make a future purchase of the security at todays price, even if the market price on the asset has risen substantially in the interim.

Using Derivatives to Reduce Risk

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Foreign Exchange Exposure

The purchase of a currency futures or options contract will allow a firm to make a future purchase of the currency at todays price, even if the market price on the currency has risen substantially in the interim.

Using Derivatives to Reduce Risk

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Increases financial leverage

Derivative instruments are too complex Risk of financial distress

Risks to Corporations from Financial Derivatives

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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.

The key elements of a futures contract are:

Futures price Settlement or Delivery Date Underlying (infosys stock)

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 counterparty to this, it would be called a futures contract.

Positions in a futures contract

Long - this is when a person buys a futures contract, and agrees to receive delivery at a future date. Eg: Virus position Short - this is when a person sells a futures contract, and agrees to make delivery. Eg: Jays Position

How does one make money in a futures contract?

The long makes money when the underlying assets price rises above the futures price. The short makes money when the underlying assets price falls below the futures price. Concept of initial margin Degree of Leverage = 1/margin rate.

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/ pre-determined 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, in-themoney 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-themoney, 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

Example of an Option

Elvis and crocodiles.

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.

Profit/Loss Profile of a Long call Position Profit

0 100 -3 103

Loss

Option Price = Rs3 Strike Price = Rs100

Price of Asset XYZ at expira tion

Time to expiration = 1month

Profit /Loss Profile for a Short Call Position

Profit
+3

0 100 103

Price of the Asset XYZ at expiration

Loss

Initial price of the asset = Rs100 Option price= Rs3 Strike price = Rs100 Time to expiration = 1 month

Profit/Loss Profile for a Long Put Position

Profit

0 98 100

Price of the Asset XYZ at expiration

-2

Initial price of the asset XYZ = Rs100

Option Price = Rs2 Strike price = Rs100

Loss

Time to expiration = 1 month

Profit/Loss Profile for a Short Put Position

Profit
+2

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

Long Put Short Call

Stock Index Option

Trading in options whose underlying instrument is the stock index. Here if the option is exercised, the exchange assigned option writer pays cash to the options buyer. There is no delivery of any stock. Dollar Value of the underlying index = Cash index value * Contract multiple. The contract multiple for the S&P100 is $100. So, for eg, if the cash index value for the S&P is 720,then dollar value will be $72,000

 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.

Binomial Model for Option Valuation

Current Price of the stock = S Two possible values it can take next year :- uS or dS ( uS> dS) Amount B can be borrowed or lent at a rate of r. The interest factor (1+r) may be represented , for sake of simplicity , as R. d<R<u. Exercise price is E.

 Value

of a call option, just before expiration, if the stock price goes up to uS is Cu = Max(uS-E,0) Value of a call option, just before expiration, if the stock price goes down to dS is Cd = Max(dS-E,0) The value of the call option is C=^S+B ^ = (Cu-Cd)/ S (u-d) B = uCd-dCu/(u-d)R

Illustration: S=200, u=1.4, d=.9 E=220 r=0.15 R=1.15 Cu = Max(uS-E,0) = Max(280-220,0)=60 Cd = Max(dS-E,0) = Max(180-220,0)=0 ^=Cu-Cd/(u-d)S = 60/(1.4-.9)200=0.6 B=uCd-dCu/(u-d)R = -0.9(60)/0.5(1.15) = -93.91 (A negative value for B means that funds are borrowed). Thus the portfolio consists of 0.6 of a share plus a borrowing of 93.91( requiring a payment of 93.91(1.15) = 108 after one year. C=^S+B= 0.6*200-93.91 = 26.09

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

LIBOR

Counter Party B

A
Fixed Rate of 12%

Rs50,00,00,000.00 Notional Principle

Interest Rate Swap

A is the fixed rate receiver and variable rate payer. B is the variable rate receiver and fixed rate payer.

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.