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What is in today’s lecture?
Introduction to Derivative
Options
Derivatives
In the last 20 years derivatives have become
increasingly important in the world of finance
In Pakistan derivative market was developed in
2001
Few banks like SCB, UBL and RBS are allowed by
the SBP to deal in derivative transactions
SBP regulates the OTC market for
◦ Foreign currency options
◦ Forward rate agreements
◦ Interest rate swaps
Derivatives
A derivative can be defined as a financial
instrument whose value depends on (or
derives from) the values of other, more
basic underlying variables or asset.
Types of Derivatives
Among many variations of derivative
contracts, following are the major types:
◦ Forward contracts
◦ Future Contract
◦ Options
Forward Contract
• Definition: an agreement to buy or sell
an asset at a certain future time for a
certain price
• A forward contract is traded in the over-
the-counter market
• A party assuming to buy the underlying
asset is said to have assumed a long-
position
• The other party assumes a short-position
and agrees to sell the asset
A Real life example
As you know next football world cup will be played in Brazil. Like
South Africa did, Brazil will need to construct football stadiums,
seating arrangements, parking areas etc which need heavy
consumption of cement. Brazil does not have the required
amount of cement, it will call many producers of cement to send
their quotations to Brazil. If from Pakistan, Lucky cement
company is short-listed and approved for export of cement to
Brazil at $10 a bag, 500,000 bags by December 2011, it will be an
example of forward contract
In the above contract, lucky cement has a short-position
(sold cement now deliverable in future) and Brazil government
has a long position
Example continued
The contract exposes lucky cement to
few risks.
◦ If the cost of raw material increases, it cannot
be passed on to the Brazil government
◦ If the value of rupee against dollar increases,
Lucky cement will receive fewer rupees per
dollar
To control these risks, lucky cement
should use forward/future contracts
(HOW?)
Solution
Lucky cement should buy raw material
(coal, oil, chemicals) in advance through
future contracts (i.e going long)
Lucky cement should sell dollars derivable
in December 2009 (when it will receive
them from Brazilian government)
Table
Example-2
Suppose on July 20,2007 a US
corporation knows that it will have to pay
£1 million in 6 months
Risk: exchange rate fluctuations
6 months long forward contract at an
exchange rate of $2.0489/£ (according to
the previous table)
The bank has a short forward contract
for selling £ at the rate of $2.0489/£ after
6 months
Payoffs from the forward contracts
However if at the end of 6 months the spot
rate becomes $1.9000/£
£1 million will be worth$1,900,000 in the open
market whereas under the contract the
company will be obligated to buy for
$2,048,900
Here the worth of the forward contract will be
($148,900)
The company will be paying $148,900 more for
£1 million pounds as compared to the open
market
Payoffs from the forward contracts
However if at the end of 6 months the spot
rate becomes $1.9000/£
£1 million will be worth$1,900,000 in the
open market whereas under the contract
the company will be obligated to buy for
$2,048,900
Here the worth of the forward contract will
be ($148,900)
The company will be paying $148,900 more
for £1 million pounds as compared to the
open market
Payoffs from the forward contracts
In general the payoff from the long
forward contract on one unit of an asset
is,