Financial Mkts and Products

Financial Markets and Products
Participants in Derivative Markets

 Dealers
 Clearing Houses
 Exchanges
Structural Hubs
Mechanisms to reduce Counterparty
risks…
 Setting Participant Standards
 Contract standardization
 Margining System
 Netting
 Collateral
 MTM, downgrade triggers, credit

surveillance etc.
Structural Hubs
Limitations of structural hubs
 Marking to Market
 Netting
 Standardisation
 Transparency in transactions
 Development of structural hub is
Expensive and time consuming
Structural Hubs
Introduction to Derivatives
 What is a Derivative :Derivative is a
product whose value is derived from
the value of one or more basic
variables, called bases (underlying
asset, index or interest rate), in a
contractual manner
Introduction (Options, Futures and Other

derivatives
Types of Derivatives
 Forwards
 Futures
 Options

derivatives
Forwards Contract
A forward contract is an agreement to
buy (or sell) an asset on a specified
date in future at today’s pre- agreed
price. These are not generally traded
on exchange.

derivatives
Futures contract
A future contract is same as forward
except that futures are normally traded
on exchanges and it can change
many hands before final settlement is
made and there are exchange specifies
certain standard features of the
contract.
derivatives
Difference Between Forwards and
Futures
FUTURES FORWARDS
Futures are traded on a stock Forwards are non tradable, negotiated

exchange instruments
Futures are contracts having standard Forwards are contracts customized by
terms and conditions the buyer and seller
No default risk as the exchange High risk of default by either party
provides a counter guarantee
Exit route is provided because of high No exit route for these contracts
liquidity on the stock exchange
Highly regulated with strong margining No such systems are present in a
and surveillance systems Forward market.

derivatives
Payoff profile for Forwards/Futures

derivatives
Payoff ….
 Long Forward/Futures Position Payoff
Payoff = ST – K
Where
ST – Spot rate at maturity

K – Strike/ Delivery Price
derivatives
Payoff…
 Short Forward/Futures Position Payoff
Payoff = K - ST
Where
ST – Spot rate at maturity

K – Strike/ Delivery Price
derivatives
Options OPTIONS
Buy (right) Sell ( somebody else’ right)

{Pay premium)
{Receive premium)
Call Put Call Put

(Buy the asset) (Sell the asset) (Buy the asset) (Sell the asset)

derivatives
Derivative terminologies
 Option holder : The buyer of the option
who gets the right
 Option writer : The seller of the option
who carries the obligation.
 Premium: The consideration paid by the
buyer for the right.

derivatives
Derivative terminologies…
 Exercise price: The price at which the
option holder has the right to buy or
sell. It is also called as the strike price
 Call option: The option that gives the
holder a right to buy.
 Put option : The option that gives the
holder a right to sell.
derivatives
 Tenure: The period for which the option
is issued.
 Market maker – One who makes a
market and is available to quote on any
side
 Spot Contract – agreement to buy or
sell today
derivatives
Derivative Terminologies…
 American Option – Can be exercised

anytime till maturity
 European Option – Can be exercised
only on maturity

derivatives
 In the money: An option is in the money if
the option holder is making a profit,the
option being exercised immediately.
 Out of money: An option is in the money if
the option holder is making a loss,the
option being exercised immediately.
 At the money: An option is in the money if
the option holder evens out, theoption
being exercised immediately.
derivatives
Options Payoff Profile
 CT = Max (0, ST – X )
 PT = Max (0, X – ST)
CT = Payoff on call Option

PT = Payoff on a Put Option
ST = Stock price on Maturity
X = Strike Price of the option

derivatives
Option Payoff charts
Long Call Long Put
Short Call Short Put

derivatives
Types of participants
 Hedgers
 Speculators
 Arbitrageurs

derivatives
Mechanics of Futures Markets
 Characteristics of a Futures Contracts
 Quality
 Contract Size
 Delivery Location
 Delivery Tenor
 Price quotations and Tick Size
 Daily Price Limits
 Position Limits
Mechanics of Futures markets

Convergence of Futures and Spot
prices.
Price
SPOT
Futures
Time BASIS = SPOT – FUTURES PRICE

Operation of Margins
 Initial margin
 Maintenance margin
 Variation Margin
Variation margin is the amt necessary

to bring back the margin a/c bal to
initial margin level

Normal & Inverted Futures Markets
 Settlement price is the average of
traded price in the closing period
 Increasing settlement prices over time
indicates Normal Market
 Decreasing settlement prices over time
indicates inverted Market

Types of Orders
 Market orders
 Discretionary orders
 Limit Orders
 Stop Loss Orders
 Market if touched orders
Validity of orders
Hedging Strategies Using futures
A Short Hedge occurs when a hedger
shorts a futures contract to hedge
against its losses
 A Long Hedge occurs when a hedger
longs a futures contract to hedge
against its losses
Hedging Strategies Using Futures

Advantages/Disadvantages of
hedging
 For
 Price risk is Hedged
 No Uncertainty thereafter
 Against
 Why should companies hedge if investors can hedge
 If competition doesn’t hedge, it leads to variability of
profitability

Sources of Basis Risk
 Interruptionin convergence
 Changes in Cost of Carry
 Imperfect match
 Maturity/Duration Mismatch
 Liquidity Mismatch
 Credit risk Mismatch

Basis risk…
 When spot price increases faster than
futures price over the hedging horizon,
basis increases and strengthening of
basis is said to occur
 When futures price increases faster than
spot price over the hedging horizon,
basis decreases and weakening of basis
is said to occur
Basis risk…
 Tominimize basis risk – Hedgers should
select an asset that is
 Highly correlated with the spot position
 Contract maturity is closest to hedging
horizon
 Contract liquidity is also good enough

The Optimal Hedge Ratio
 Theoptimal ratio which minimizes the
variance of the combined hedge
position is called the Hedge ratio

Hedge Ratio…
H.R = Þ S,F * (σS/ σF)
Where,
Þ S,F = correlation between spot and futures
price
σS – Standard Deviation of Spot Price
σF – Standard Deviation of Futures Price
Sample Question
 Giventhe correlation between the spot
and futures at 0.91, standard deviation
of spot to be 0.15 and standard
deviation of futures to be 0.10,
Compute the hedge Ratio.

Sample Question
The standard deviation of wheat futures contract is 0.6
While std deviation of wheat spot is 0.75
The covariance between the two is 0.3825
Which of the following is closest to optimal hedge ratio
1. O.478
2. 0.850
3. 1.063
4. 1.250

Understanding Beta
Beta = Covariance (S,F) / Covariance (F)

Where,
S – Spot / stock
F – Futures / Index

Beta…
Beta gives the relationship of stock with
respect to index.
 A beta of 1 represents that, if index rises (falls) by 2%,

the stock is likely to rise (fall) by 2 %
 A beta of -1 represents that, if index rises (falls) by
2%, the stock is likely to fall (rise) by 2 %

Hedging with Index Futures
Example:
Portfolio – 20 mio
Beta -1.4
Futures price – 1150
Multiplier – 250
How will you hedge the underlying
position given the above data?
Adjusting Portfolio Beta
Portfolio -100,000,000
Beta – 1.2
Index – 1080
lot size – 250
Completely Hedge the Portfolio

Adjusting Portfolio Beta…
Portfolio – 100 mio
Beta 1.2
Index 10000 (lot size -10)
To cut beta in half, the correct trade is
1. Long 600 contracts
2. Short 600 contracts
3. Long 1200 contracts
4. Short 1200 contracts
Determination of forward and Futures
prices
The pricing model used to compute
forward prices makes the following
assumptions:
 No transaction cost or short sale restriction
 Same tax rates on all net profits
 Borrowing and Lending at risk free rate
 Arbitrage opportunities are exploited as

they arise
Determination of forwards and
Futures Prices.
Cost of Carry Model
F0 = S0 erT
If F0 > S0 erT, then arbitrageurs will profit
by selling fwd and buying asset with
borrowed funds
If F0 < S0 erT, then arbitrageurs will profit
by selling the asset, lending out the
proceeds and buying the forward.
Futures Prices.
Forward Price with a carrying cost
 F0 = (S0 – I ) erT
 Example:
Compute price of 6m forward on a

coupon bearing bond that pays semi
annual coupon of 5%. A coupon is to be
paid in 3 months, assume risk free rate
of 4%, Spot 1000
Futures Prices.
Effect of known dividend
 F0 = S0 e(r-q)T
If an asset pays a continuous dividend of 2%,
which of the following is closest to the no
arbitrage price of 3 m forward contract, with
current spot at 500, and assuming risk free
rate at 3%
1. 494.24
2. 498.75
3. 501.25
4. 506.29 Determination of forwards and
Futures Prices.
Currency futures
F0 = S0 e(r-rf)T
Suppose we wish to compute the 10 month

futures contract on the USDINR quoted in
terms of dollar/peso. Assume risk free rate in
US (rf) at 2% and in India at 8%, and current
exchange rate at 48.20

Futures Prices.
Commodity Futures
F0 = (S0 + U) erT
If we express storage costs in terms of

a continuous yield
F0 = S0 e(r+u)T

Futures Prices.
commodity futures…
There is a benefit to owning the

underlying consumable asset
compared to owning the future.
F0eyT = (S0 + U) erT = S0 e(r+u)T

Futures Prices.
Commodity futures
 Contango
 Backwardation

Futures Prices.
Properties Of stock Options
 Factors that affect option prices
 Spot
 Strike
 Time to expiration
 Risk free int rate
 Volatility
Properties of Stock Options.

Factors affecting option price
Factor European Call European Put American call American Put
S + - + -
X - + - +
T ? ? + +
vol + + + +
r + - + -
D - + - +

Lower and Upper Bounds
Upper Bounds
C<= S0 and C<= S0
p<= X and P <= X
P<= X e –rT
(For european Option)
Upper and Lower Bounds …
Lower bounds
European Call
c>= max (S0 – Xe-rT,0)
European put
p>= max (Xe-rT –S0,0)
Upper and Lower Bounds…
 Lower Bounds
 American Call
C>= c>= max (S0 – Xe-rT ,0)
 AmericanPut
P>= max (X –S0,0)

Put Call Parity
 Stock + put = bond + call
S + P = C + Xe−rT

Put Call Parity…
European Option Example

Current Stock price is 52, risk free rate
is 5%, A 3m Put option with Strike 50 is
trading at 1.50, Calculate the price of
3m call option at strike 50.

Put call Parity…
American options Example:

Current price is 22, 1 yr risk free rate
6%, what is upper and lower bounds for
american put option at strike 20 if
american call at strike 20 is priced at 4
S0 – X <= C – P <= S0 – Xe-rT

Trading Strategies Involving Options
 Covered Calls
 Protective Puts
 Bull and Bear Spreads
 Butterfly Spreads
 Calendar Spreads
 Straddle
 Strangle
 Strips and Straps
 Collar
 Box Spread
Trading Strategies using Options.
Covered Call & Protective Put
Covered call
 Own a Stock + Short a OTM Call
Protective Put
 Own a Stock + Long ATM Put

Straddle
 BuyCall and Buy Put at the same strike
and expiration

Strangle
 Buy OTM Call And Buy OTM Put

Bull Call Spread / Bull Put Spread
Buy Call at Lower Strike and Sell Call at Higher strike
Sell Put at Higher Strike and Buy Put at Lower Strike
200
100

Bear Call Spread / Bear Put Spread
Buy Call at Higher Strike and Sell Call at Lower Strike
Sell Put at Lower Strike and Buy Put at Higher Strike
100
200

Butterfly
 Buy call at lower strike
 Sell 2 Calls at Higher Strike
 Buy Call at even higher Strike

Condor
 Buy call at lower strike
 Sell Call at Higher Strike
 Sell Call at even higher Strike
 Buy Call at even higher Strike

Calendar Spread
 Sell
Near term Put Options and Buy far
term Put options
 Sell
Near term Call Options and Buy Far
term call Options

Strips and straps
 Strip – Buy one call and two Puts
 Straps – Buy One put and two calls

Collar and Box Spread
 Collar = Protective Put + Covered call
 Boxspread = Bull call Spread + Bear

Put Spread

Fundamentals of commodity Spot and
futures Markets
 Majorrisk associated with commodity
Spot transactions
 Price risk
 Transportations risk (ordinary and
extraordinary)
 Delivery risk
 Credit Risk
Commodity Spot and Futures Market

Hedge Effectiveness
 Hedge effectiveness = 1 – variance of
basis
variance of spot
The number closer to 1 indicates a

effective hedge
Exchange for physicals & Alternative
Delivery Process
 Exchange for physicals
 A off the floor trade to unwind the deal
 Parties must inform the clearing house
 Alternative Delivery process

 New terms after it has been matched by the
exchange
 Parties must submit notice of intent to respective
exchanges

Commodity Forwards and Futures
 Pv of expected spot price E(ST) e-αT
 This is equivalent to cost of bond e-
rT
F0,T
 e-rT F0,T = E(ST) e-αT
 Therefore F0,T = E(ST) e(r-α)T

Commodity Arbitrage
 Cash and carry
 Borrow money for the term of the contract
 Buy underlying at spot
 Sell futures
 Reverse cash and carry

 Short sell the commodity
 Lend proceeds at mkt rate
 Buy futures

Lease Rates
 Leaserate is the amount of interest the
lender of the commodity requires
 F0,T = S0 e(r-s1)T
 Leaserates in commodity is similar to
dividend payment in equity

Commodity futures …
 StorageCost
 Convenience yield

Foreign Exchange Risk
 Sources
of profit and losses on foreign
exchange trading
 Mismatched foreign asset and liability
positions
 On Balance Sheet Hedging
 Off Balance Sheet Hedging

Interest rate Parity Theorem
T
 (1 + rDC ) 
Forward = Spot  
 (1 + rFC ) 

Relationship between nominal & real
interest rates
 N = r + E(i)
 Where
 N = Nominal int rates
 r = real interest rate
 E(i) = Expected Inflation
 (1+n) = (1+r) * (1 + E(i))

Mechanics of dealing with sovereign risk
exposure
 Ways to address sovereign Risk
 Debt for equity swaps
 Multilayer restructuring agreement
 Sale of less developed country loans
 Bond for Loan swaps
Mechanics of dealing with

sovereign risk exposure
Corporate Bonds
 Features
 Bond Indenture
 Corporate trustee
 Coupon
 Maturity date
 Face Value
 YTM
Corporate Bonds
Types of interest payment
 Straight coupon Bonds
 Participating Bonds
 Income Bonds
 Floating Rate bonds
 Zero Coupon Bonds
Corporate Bonds
Bond Types
 Mortgage Bonds
 Collateral trust Bonds
 Equipment trust Certificates
 Debentures
 Guaranteed Bonds
Corporate Bonds
Methods of retiring Bonds
 Calland refunding provisions
 Sinking fund
 Maintenance and replacement fund
 Tender Offer
Corporate Bonds
Corporate bonds…
 Credit risk
 Credit spread risk
 Event risk
 JunkBonds
 Default rate
Corporate Bonds
Interest Rates
 Compounding
m*n
 R
FV1 = A1 +  FV2 = Ae Rc*n
 m
 R
Rc = m ln1 +  (
R = m e Rc / m − 1 )
 m
Interest Rates
Bond pricing
 Spot (zero) rates
 Bond Yield
Interest Rates
Interest Rates and measures
 Bootstrapping spot rates
 Forward rates
 FRA
 Duration
 Convexity
Interest Rates
Theories of term structure of interest
rates
 Expectation Theory
 Market Segmentation Theory
 Liquidity Preference Theory
Interest Rates
Interest rate Futures
 Day Count Conventions
 Treasury Bonds (Actual/Actual)
 Corp and Municipal bonds (30/360)
 Money Market (Actual/360)
Interest Rate Futures

Quotations for T-Bonds
 Clean and Dirty Price
 Dirty= Clean + Accrued
 Cash price = Quoted price + Accrued

Quotation for T bills
 DiscountRate
 Per Annum Rate

Treasury Bond Futures
 Conversion factor
 Accrued Interest
 Cheap to Deliver
CTD = QBP – (QFP * CF)

 Where,
 QBP – quoted bond price
 QFP – Quoted futures price
 CF – Conversion Factor

Example
 Assume an investor with a short
position is about to deliver a bond and
has 4 bonds to choose ffrom, the last
settlement price is $95.75, determine
which bond is cheapest to deliver.
Bond QBP CF
1 99 1.01
2 125 1.24
3 103 1.06
4 115 1.14

Swaps
 Mechanics of Interest rate Swaps
 Comparative advantage
________________________________________
Company fixed Floating .
Y5.00% LIBOR + 10 bps
X 6.50% LIOR + 100 Bps
-----------------------------------------------------------------
-----------------
Swaps
Swap Example
Notional – USD 1 mio
Floating – Pay 6m Libor (last fixing was at
5%)
Fixed- Receive 6% s.a
The swap has remaining life of 15 months with pay dates
at 3, 9
and 15 months
SPOT Libor as follows
3m – 5.4%, 9m – 5.6%, 15m at 5.8%
Calculate value of swap using FRA methodology
Swap Example contd…
Steps to solve
 Lay down the fixed leg cash flows
 Calculate fwd rate for corresponding

periods
 Convert to semi annual frequency
 Lay down floating leg cash flows
 Difference of the PV of cash flows is the

value of the swap
Currency swap
 Pay fixed 6% on GBP notional (100 mio)
 Receive fixed 5% on USD Notional (175
mio)
 Suppose yield curves on USD and GBP
are flat at 2% and 4% respectively
 Spot exchange rate USD 1.50 = GBP 1
 Calculate the value of the swap if

remaining term to maturity is 3 yrs
That’s all for the day !

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Financial Markets and Products

Participants in Derivative Markets

 MTM, downgrade triggers, credit

Introduction (Options, Futures and Other

Introduction (Options, Futures and Other

Introduction (Options, Futures and Other

Futures are traded on a stock Forwards are non tradable, negotiated

Introduction (Options, Futures and Other

Introduction (Options, Futures and Other

ST – Spot rate at maturity

ST – Spot rate at maturity

Buy (right) Sell ( somebody else’ right)

Call Put Call Put

Introduction (Options, Futures and Other

Introduction (Options, Futures and Other

 American Option – Can be exercised

Introduction (Options, Futures and Other

CT = Payoff on call Option

Introduction (Options, Futures and Other

Long Call Long Put

Short Call Short Put

Introduction (Options, Futures and Other

Introduction (Options, Futures and Other

 Price quotations and Tick Size

 Daily Price Limits

Mechanics of Futures markets

Time BASIS = SPOT – FUTURES PRICE

Mechanics of Futures markets

Variation margin is the amt necessary

Mechanics of Futures markets

Mechanics of Futures markets

 Stop Loss Orders

 Market if touched orders

Hedging Strategies Using Futures

Hedging Strategies Using Futures

 Credit risk Mismatch

Hedging Strategies Using Futures

Hedging Strategies Using Futures

Hedging Strategies Using Futures

H.R = Þ S,F * (σS/ σF)

Hedging Strategies Using Futures

Hedging Strategies Using Futures

Beta = Covariance (S,F) / Covariance (F)

Hedging Strategies Using Futures

 A beta of 1 represents that, if index rises (falls) by 2%,

Hedging Strategies Using Futures

Hedging Strategies Using Futures

 Borrowing and Lending at risk free rate

 Arbitrage opportunities are exploited as

Compute price of 6m forward on a

Suppose we wish to compute the 10 month

Determination of forwards and

If we express storage costs in terms of

Determination of forwards and

There is a benefit to owning the

F0eyT = (S0 + U) erT = S0 e(r+u)T

Determination of forwards and

Determination of forwards and

Properties of Stock Options.

Properties of Stock Options.

C<= S0 and C<= S0

p<= X and P <= X