Financial Derivatives

1
Financial Derivatives

 Main Text
 Options, Futures and Other Derivative by John C. Hull (preferably latest edition)

2
Introduction

 Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.

3
Introduction

 Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.
 Similarly, shares and bonds also have price risk.

4
Introduction

 Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.
 Similarly, shares and bonds also have price risk.
 Consider the case of a farmer of wheat crop and manufacturer of bread. Do they
face any risk?

5
Introduction

 Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.
 Similarly, shares and bonds also have price risk.
 Consider the case of a farmer of wheat crop and manufacturer of bread. Do they
face any risk?
 It is desirable to have some mechanism which can help eliminate or at least
reduce the price risk.

6
Introduction

 Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.
 Similarly, shares and bonds also have price risk.
 Consider the case of a farmer of wheat crop and manufacturer of bread. Do they
face any risk?
 It is desirable to have some mechanism which can help eliminate or at least
reduce the price risk.
 Derivatives have been evolved as an instrument for hedging the price risk
involved in dealing with financial and non-financial assets.

7
Derivatives

 A derivative is a financial contract whose payoff structure is determined by the

value of an underlying asset.

8
Derivatives

 A derivative is a financial contract whose payoff structure is determined by the

value of an underlying asset.
 The underlying asset may be real asset or financial assets.

9
Derivatives

 A derivative is a financial contract whose payoff structure is determined by the

value of an underlying asset.
 The underlying asset may be real asset or financial assets.
 Types of financial derivatives
 Forward
 Futures
 Options
 Swaps

10
Forward Contract

 A forward contract is an agreement between two parties to buy or sell an asset at a

certain future time for a certain future price.

11
Forward Contract

 A forward contract is an agreement between two parties to buy or sell an asset at a

certain future time for a certain future price.
 These contracts are customized: delivery date, price and quantity are negotiated
bilaterally.

12
Forward Contract

 A forward contract is an agreement between two parties to buy or sell an asset at a

certain future time for a certain future price.
 These contracts are customized: delivery date, price and quantity are negotiated
bilaterally.
 The buyer of the underlying asset is said to have a long position in the forward contract
whereas the seller of the underlying assets has a short position in forward contract.

13
Long Forward Contract

 Suppose a manufacturer has taken a long position in a forward contract to

purchase one quintal of wheat at INR 1000 three months from now.

14
Long Forward Contract

 Suppose a manufacturer has taken a long position in a forward contract to

purchase one quintal of wheat at INR 1000 three months from now.

Profit

Price of Underlying at Maturity, ST

K

15
Short Forward Contract

Profit

Price of Underlying at Maturity, ST

K

16
Advantages of Forward Contracts

 An ideal instrument for hedging the risk arising from price fluctuations of
underlying asset.

17
Advantages of Forward Contracts

 An ideal instrument for hedging the risk arising from price fluctuations of
underlying asset.
 Tailor-made products to meet the requirements of the two counter parties to the
contract.

18
Disadvantages of Forward Contracts

 Credit risk or default risk

19
Disadvantages of Forward Contracts

 Credit risk or default risk

 There is a possibility that one of the parties to the contract may default or fail to
fulfill his or her obligations under the contract.
 Also called counter party risk.

 Illiquidity

20
Disadvantages of Forward Contracts

 Credit risk or default risk

 There is a possibility that one of the parties to the contract may default or fail to
fulfill his or her obligations under the contract.
 Also called counter party risk.

 Illiquidity
 A forward contract cannot be cancelled other than the consent of both the parties.
 Very difficult, if not impossible, to exit the forward contracts.

21
Futures Contracts

 Futures contracts are standardized forward contracts.

22
Futures Contracts

 Futures contracts are standardized forward contracts.

 These are traded at organized stock exchanges.

23
Futures Contracts

 Futures contracts are standardized forward contracts.

 These are traded at organized stock exchanges.
 It is the respective stock exchange which introduces these contracts.

24
Futures Contracts-Standardized

 Standardization means that the terms and conditions, popularly called

specifications, are decided in advance and these are same for all the participants
in futures market.

25
NSE Derivative Segment

26
Clearing Corporation

 It eliminates the counter party risks

27
Margin System

 Initial margin

28
Margin System

 Initial margin
 At the time of entering into the contract
 Generally 5%-30%

 Maintenance margin

29
Margin System

 Initial margin
 At the time of entering into the contract
 Generally 5%-30%

 Maintenance margin
 It is the minimum balance which buyers and sellers are expected to maintain
 Generally 75% of the initial margin.

 Variation margin

30
Margin System

 Initial margin
 At the time of entering into the contract
 Generally 5%-30%
 Maintenance margin
 It is the minimum balance which buyers and sellers are expected to maintain
 Generally 75% of the initial margin.
 Variation margin
 When the balance in margin account falls below the maintenance margin level
 A margin call is made
 Additional funds to be deposited on the basis of the margin call are known as
variation margin.

31
Closing out the Futures Contract

 Two Ways
 Taking the delivery of the assets and making payment
 Taking offsetting position in contacts

32
Benefits of Futures Contract

 No counterparty risk

33
Benefits of Futures Contract

 No counterparty risk
 Liquidity

34
Benefits of Futures Contract

 No counterparty risk
 Liquidity
 Risk hedging

35
Benefits of Futures Contract

 No counterparty risk
 Liquidity
 Risk hedging
 Price discovery

36
Benefits of Futures Contract

 No counterparty risk
 Liquidity
 Risk hedging
 Price discovery
 Market efficiency

37
Benefits of Futures Contract

 No counterparty risk
 Liquidity
 Risk hedging
 Price discovery
 Market efficiency
 Leveraging

38
 Leverage

 Suppose the current price of stock

and its futures is INR 100.
 An investor anticipates its price to
rise to INR 120. He has INR 1000.
 He has two alternative to take
position in the stock .
 First, purchase 10 shares @ INR 100
each and the net payoff if his
expectation materializes

39
 Leverage

 Suppose the current price of stock Particular Amount

and its futures is INR 100.
Revenue ( 10*120) 1200
 An investor anticipates its price to
rise to INR 120. He has INR 1000. Cost (10*1000) 1000
 He has two alternative to take
Profit 200
position in the stock .
 First, purchase 10 shares @ INR 100 Percentage return 20%
each and the net payoff if his
expectation materializes

40
 Leverage

 Suppose the margin requirement is 20%. With INR 1000, he can take long a
position in 50 futures contracts.

Spot Market Futures Market

Particular Amount

Revenue ( 10*120) 1200

Cost (10*1000) 1000

Profit 200

Percentage return 20%

41
 Leverage

 Suppose the margin requirement is 20%. With INR 1000, he can take long a
position in 50 futures contracts.

Spot Market Futures Market

Particular Amount Particular Amount

Revenue ( 10*120) 1200 Revenue ( 50*120) 6000

Cost (10*1000) 1000 Cost (50*1000) 5000

Profit 200 Profit 1000

Percentage return 20% Percentage return 100%

42
 Leverage

 Suppose price of stock and futures declines to INR 80

Spot Market Futures Market

Particular Amount

Revenue ( 10*80) 800

Cost (10*1000) 1000

Profit -200

Percentage return -20%

43
 Leverage

 Suppose price of stock and futures declines to INR 80

Spot Market Futures Market

Particular Amount Particular Amount

Revenue ( 10*80) 800 Revenue ( 50*80) 4000

Cost (10*1000) 1000 Cost (50*1000) 5000

Profit -200 Profit -1000

Percentage return -20% Percentage return -100%

44
Options

 An option contract gives the holder the right-but not the

obligation-to conduct a transaction involving an underlying
security or commodity at a predetermined future date and
at a predetermined price

45
Options

 Buyer (option holder) has the long position in the contract

 Seller (option writer) has the short position in the contract
 Buyer and seller are counterparties in the transaction

46
Options - Terminology

 Call option

47
Options - Terminology

 Call option
 The buyer or holder of the option has the right to purchase the underlying asset at a
predetermined price.

 Put option

48
Options - Terminology

 Call option
 The buyer or holder of the option has the right to purchase the underlying asset at a
predetermined price.

 Put option
 The buyer or the holder of the put option has the right to sell the underlying asset at
a predetermined price.

 Exercise Price or Strike Price

49
Options - Terminology

 Call option
 The buyer or holder of the option has the right to purchase the underlying asset at a
predetermined price.

 Put option
 The buyer or the holder of the put option has the right to sell the underlying asset at
a predetermined price.

 Exercise Price or Strike Price

 The exercise price is the price the call buyer will pay to-or the put buyer will receive
from-the option seller if the option is exercised.

50
Options - Terminology

 Expiration time
 European options
 American options

51
Options - Terminology

 Expiration time
 European options
 American options

 Option Trading Markets

 Options trade both in over-the-counter markets and on exchanges

52
Option Premium

 The amount which the buyer of the option (whether call or put) has to pay to the
option writer to avail the corresponding right.
 At the money:
 stock price equals exercise price
 In-the-money
 option has intrinsic value
 Out-of-the-money
 option has no intrinsic value

53
Intrinsic Value

 Intrinsic value is the worth of the option contract

 It is the minimum option price.
 The difference between option price (premium) and intrinsic value is the time
value of money.

54
 Intrinsic Value: Call Option [max(0, S – K)]

Strike Price Current Price IV

100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
100 150
100 160
100 170
55
 Intrinsic Value: Call Option [max(0, S – K)]

Intrinsic Value
Strike Price Current Price IV
80
100 70 0
70
100 80 0
60
100 90 0

Intrinsic Value
50
100 100 0
40
100 110 10
30
100 120 20
20
100 130 30
10
100 140 40
0
100 150 50 60 80 100 120 140 160 180
100 160 60 Stock Price
100 170 70
56
 Intrinsic Value: Put Option

Strike Price Current Price IV

100 40
100 50
100 60
100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
57
 Intrinsic Value: Put Option

IV
Strike Price Current Price IV
100 40 60 70

100 50 50 60

100 60 40

Intrinsic Value
50

100 70 30 40
100 80 20 30
100 90 10 20
100 100 0 10
100 110 0 0
100 120 0 20 40 60 80 100 120 140 160

100 130 0 Stock Price

100 140 0
58
 Payoff: Call Option Holder [ Call Premium INR 10]

Strike Price Current Price IV Payoff

100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
100 150
100 160
100 170
100 180
59
 Payoff: Call Option Holder [ Call Premium INR 10]

Strike Price Current Price IV Payoff Call Option Holder

80
100 70 0 -10
70
100 80 0 -10
60
100 90 0 -10
50
100 100 0 -10
100 110 10 0 40

Payoff
100 120 20 10 30

100 130 30 20 20

100 140 40 30 10

100 150 50 40 0
60 80 100 120 140 160 180 200
100 160 60 50 -10
100 170 70 60 -20
Stock Price
100 180 80 70
60
 Call Option Writer [ Call Premium INR 10]

Strike Price Current Price IV Payoff

100 70 IV = - Max [ 0, S – K] or Min [ K – S, 0]
100 80
100 90
100 100
100 110
100 120
100 130
100 140
100 150
100 160
100 170
100 180
61
 Call Option Writer [ Call Premium INR 10]

Strike Price Current Price IV Payoff

100 70 0 10
100 80 0 10
100 90 0 10
100 100 0 10
100 110 -10 0
100 120 -20 -10
100 130 -30 -20
100 140 -40 -30
100 150 -50 -40
100 160 -60 -50
100 170 -70 -60
100 180 -80 -70
62
 Call Option Writer [ Call Premium INR 10]

Strike Price Current Price IV Payoff Call Option Writer

20
100 70 0 10
10
100 80 0 10
0
100 90 0 10 60 80 100 120 140 160 180 200
-10
100 100 0 10
100 110 10 0 -20

Payoff
100 120 20 -10 -30

100 130 30 -20 -40

100 140 40 -30 -50

100 150 50 -40 -60

100 160 60 -50 -70
100 170 70 -60 -80
Stock Price
100 180 80 -70
63
 Put Option Holder

Strike Price Current Price IV Payoff

100 40
100 50
100 60
100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
64
 Put Option Holder

Strike Price Current Price IV Payoff

100 40 60 50
100 50 50 40
100 60 40 30
100 70 30 20
100 80 20 10
100 90 10 0
100 100 0 -10
100 110 0 -10
100 120 0 -10
100 130 0 -10
100 140 0 -10
65
 Put Option Holder

Strike Price Current Price IV Payoff Put Option Holder

60
100 40 60 50
100 50 50 40 50

100 60 40 30 40

100 70 30 20 30
100 80 20 10

Payoff
20
100 90 10 0
10
100 100 0 -10
100 110 0 -10 0
30 50 70 90 110 130 150
100 120 0 -10 -10

100 130 0 -10 -20

Stock Price
100 140 0 -10
66
 Put Option Writer

Strike Price Current Price IV Payoff

100 40
IV = - Max[ K – S, 0 ] or Min [S – K, 0]
100 50
100 60
100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
67
 Put Option Writer

Strike Price Current Price IV Payoff

100 40 -60 -50
100 50 -50 -40
100 60 -40 -30
100 70 -30 -20
100 80 -20 -10
100 90 -10 0
100 100 0 10
100 110 0 10
100 120 0 10
100 130 0 10
100 140 0 10
68
 Put Option Writer

Strike Price Current Price IV Payoff Put Option Holder

20
100 40 60 -50
10
100 50 50 -40
100 60 40 -30 0
30 50 70 90 110 130 150
100 70 30 -20 -10
100 80 20 -10

Payoff
-20
100 90 10 0
-30
100 100 0 10
100 110 0 10 -40

100 120 0 10 -50

100 130 0 10 -60

Stock Price
100 140 0 10
69
Title

70
Title

71