Welcome to the

World of derivatives

Just common sense is sufficient

to have the working knowledge

Terminology 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

2

American 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 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
For short

Max (K - ST , 0)
-Max (K - ST , 0)

Terminology of Forward contract

Underlying
Delivery

price (Forward price)

Equity
F

The price that would make the contract worth exactly zero)

This may be different for contracts of different maturities

Spot

price
Trade date
Delivery date
Delivery instructions
Payoff function:
Forward

S
t
T

LONG
ST F

SHORT
-(ST F)
5

Is it naked or covered option

Covered

option
OOM option
Long 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
6

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
7

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
Currencies
Commodities

Metals and minerals

Bullion
Agricultural products
Animal products

Equity

shares and indices

Bond issues and their indices
Energy and other underlyings

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 contracts
Derivatives 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

Options: Rights & Obligations

ON maturity date or expiration rate, do the following:

Holder (long position)

Right to receive UA
Forward Obligation to pay K
Call Exercises it only when
option
beneficial
Put Exercises it only when
option
beneficial

Writer (Short position)

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

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RECAP!
Payoff

in Forward/futures contracts
Payoff in options contracts
Arbitrage and the law of one price
Hedging with Forward/futures and options
Speculation with futures and options

13

Users of Derivatives
Banks

and Financial Institutions

Fund managers (Asset management cos.)
Treasurers of manufacturing and service companies

Any one who works in finance needs to understand how derivatives

work, how they are used, and how they are priced.

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1.6 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

15

Ways 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
Options, Futures, and Other
Derivatives, 7th Edition, Copyright

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Ways 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

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Some questions
Long

Forward vs. Long call

Short Call @ K vs. Long Put @ K
Why 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 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

Futures Contracts
Agreement

to buy or sell an asset for a

certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC, a
futures contract is traded on an exchange

Tick size
Delivery date
Contract size
Margining
Options, Futures, and Other
Derivatives, 7th Edition, Copyright

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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

Exchanges Trading Futures

Chicago

Board of Trade
Chicago Mercantile Exchange
LIFFE (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

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Exchanges Trading Futures

Bombay

Stock Exchange
National Stock Exchange
MCX Stock Exchange
MCX
NCDEX
United Stock Exchange
CCIL

Options, Futures, and Other

Derivatives, 7th Edition, Copyright

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Examples 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)

Options, Futures, and Other

Derivatives, 7th Edition, Copyright

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

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

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Options 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

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Hedge Funds (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

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Hedge Funds strategies

Convertible Arbitrage
Distressed Securities
Emerging Markets
Macro or global
Market neutral

Options, Futures, and Other

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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 (S T 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(S T 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 S T,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.