INTRODUCTION TO DERIVATIVES

Himanshu Puri Faculty DIAS

INTRODUCTION
Derivatives are financial instruments whose value is derived from the value of underlying assets. These underlying assets can be equities, commodities, currency, etc. The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. A Brief Story

PARTICIPANTS

Hedgers They use derivatives to reduce the risk Speculators They wish to bet on future movements in the price of an asset

Arbitrageurs They take advantage of a discrepancy between prices in two different markets

TYPES OF DERIVATIVES
DERIVATIVES

FORWARD

FUTURE

OPTIONS

SWAPS

CALL

PUT

CURR ENY

INTE RST RATE

OVER THE COUNTER

FORWARDS

FUTURES
A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price Similar to forward contract, except that forward contract is traded OTC and futures contract is traded on an exchange. Standardized (Terms are not negotiable)

Quantity (Contract size) Expiration Date Underlying Asset and its Quality (Basis Grade) Trading Hours Tick Size

PURPOSES OF FUTURES MARKETS

Meets
1.

the needs of four groups of futures market users:

Those who wish to discover information about future prices of underlying (suppliers) 2. Those who wish to speculate (speculators) 3. Those who wish to transfer risk to some other party (hedgers) 4. Those who wish to make riskless profit (arbitragers)

FUTURES PRICE

The futures prices for a particular contract is the price at which you agree to buy or sell
It is determined by supply and demand in the same way as a spot price

EXAMPLES OF FUTURES CONTRACTS

Agreement to:
buy

100 oz. of gold @ US$600/oz. in December 1,000 bbl. of oil @ US$65/bbl. in January

sell

TYPES OF FUTURES

Commodity Futures Index and Stock Futures Interest Rate Futures

Currency Futures

PROFIT FROM A LONG FORWARD/FUTURES POSITION

Profit

Price of Underlying at Maturity

PROFIT FROM A SHORT FORWARD/FUTURES POSITION

Profit

Price of Underlying at Maturity

DIFFERENCE IN FORWARDS AND FUTURES

Futures Exchange Traded. Terms highly standardized.

Forwards OTC. Terms structured to suit both contracting parties. Counterparty risk. No Clearing Clearing House guarantees the House. performance of the contract. No compulsion to make Initial Margin to be deposited. deposits. No such provision. Daily Settlement. Quite difficult to do so. Easy to close positions. Regulation not as tight. Monitored and regulated. Marking to market is done at the No such adjustments carried out. end of every trading day.

An Option is a contract in which the seller grants the buyer :

A Right but not an Obligation To Buy or Sell ( Call or Put) An Underlying Asset On Some Future Date ( Exercise Date) At a Price Fixed today (Exercise Price).

But if the Buyer wants to exercise his option,

Seller has the Obligation.

Seller of the option is also called the Writer of the Option.

Risk management

Expiration (Last Thursday in May)

Type of option

Reliance May 580 Call

Underlying asset (Reliance common stock)

Strike price (580 per share)

Type of Right
Call

Exercise Style
American

Put

European

Exercise Date The Date at which the contract Matures Strike Price The predetermined price at which the option is to be exercised regardless of market price of the asset at the time of exercising. Expiration Period At the time of introducing an option contract, the exchange specifies the period (not more than 9 months) during which the option can be exercised or traded. Beyond this the contract expires. Option Premium or Option Price Amount which the buyer of the option pays to the writer of the option to induce him to accept the risk associated with the contract. It can also be regarded as price paid to buy the option. Intrinsic Value It is the value of the profits that are likely from the option. It is the profit that will accrue if the option is exercised today (in case of American Option) or the present value of the profit (in case of European Option).

Money-ness
Out-of-the-Money In-the-Money At-the-Money

Put Options
Spot Price > Exercise Price

Call Options
Spot Price < Exercise Price

Spot Price < Exercise Price

Spot Price = Exercise Price

Spot Price > Exercise Price

Spot Price = Exercise Price

If the Difference between Spot Price and Exercise price is considerably high, it is considered as Deep Out-of-theMoney / Deep In-the-Money.

Exercise Price
Price of underlying asset Time to maturity Price volatility of underlying stock Risk free interest rate

Buyer Right to buy at a future date at a price determined today. Seller Obliged to deliver if asked.

Buyer of Call :

Payoff = Max ( 0, Stock Price at Expiration Strike Price) Profit = Payoff Option Premium

Writer of Call :

Payoff = - Max ( 0, Stock Price at Expiration Strike Price) Profit = Payoff + Option Premium

Buyer Right to Sell at a future date at a price determined today. Seller Obliged to Buy if asked.

Buyer of Put:

Payoff = Max ( 0, Strike Price - Stock Price at Expiration) Profit = Payoff Option Premium

Writer of Put :

Payoff = - Max ( 0, Strike Price - Stock Price at Expiration) Profit = Payoff + Option Premium

TRADING

Done via dealer Options clearing corporation-A clearing organization that acts as both the issuer and guarantor for option and futures contracts. Margins- to keep a check in case of writers default Initial margin Maintenance margin

MARGINS

A margin is cash or marketable securities deposited by an investor with his or her broker

The balance in the margin account is adjusted to reflect daily settlement

Margins minimize the possibility of a loss through a default on a contract

TYPES OF MARGIN
1.

Initial Margin Deposit that a trader must make before trading any futures.

2.

Maintenance Margin When margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level. The maintenance margin is generally about 75% of the initial margin.

Problem
Day Settlement Price

1
2 3 4 5

4700
4500 4650 4750 4700

The initial margin is set at Rs. 10,000 per contract, while the maintenance margin is Set at Rs. 8000 per contract. The multiple of each contract is 50. Calculate the mark-to-market cash flows and the daily closing balances in Accounts of. A) An investor who has gone long at 4600 on day 0. B) Calculate the net profit/loss on each of the contracts.

Investor Who has gone long at 4600 (initial margin =10,000 and Maintenance margin = 8,000)

Day 0 1 2 3 4 5 Total Profit/Loss

Settlement Price Bought 50 @ 4600 4700 4500 4650 4750 4700

Opening Balance
10000 10000 15000 10000 17500 22500

Mark-toMarket
5000 -10000 7500 5000 -2500 5000

Is the balance < 8000

NO YES NO NO NO

Margin Call
-

Closing Balance
10000 15000

5000

10000 17500 22500 20000

THE BASIS
...is

the Spot price of a particular stock minus the price of a futures contract for the same stock.
BASIS = SPOT PRICE FUTURES PRICE

THE BASIS (CONTINUED)

Prices
Cash Basis Futures

Present

Time Maturity

CONTANGO & BACKWARDATION

Contango is the term for the market where the futures are at a premium to the spot price.
Backwardation is the term for the market where the spot price is at a premium to the futures.