Introduction to derivatives

Risk
• Risk can be defined as deviations of the actual results from expected.

• Risk can be classified in two ways.

1)Risk of small losses with high probability- Like stock price,
commodity price change and exchange rate.
2)Risk of large losses with low probability- Earthquakes and other
natural clement.
• The impact or magnitude of risk is normally estimated from following
two factors
1)The probability of an adverse event happening, and
2)In case the event occurs the magnitude of the loss it can cause.
Managing risk
• The ways to manage risk include attempt to control potential damage,
diffuse it, diversify and/or transfer risk to those willing to accept it.

• One can manage risk by transferring it to another party who is

willing to assume risk. Risk cannot be eliminated but can be
transferred.
Derivatives
• Risks of price, exchange rate and interest rate can be managed through
products that are specially designed for hedging.

These products are classified as derivatives.

• Derivatives are the products that derive their value from some other
asset called underlying asset.
• But in other aspects they may remain distinctly different from and
independent of the underlying asset.
Example
• Indian exporter is expecting to realize $ 1000 in six months time from
now. The exporter had priced his product with a profit target of Rs
2000 based on the current market price of dollar at Rs 45. The actual
amount that will be realized by him in Indian rupees will depend upon
the exchange rate prevailing six months later. The exporter expects Rs
45000 but he might end up getting Rs 44000 or 46000.

• He can sell dollars to a party who needs them six months later and negotiate the
exchange rate today- Forward contract.
• Since the price of the forward contract is determined by or derived from the spot
price in the foreign currency markets, such a contract is classified as derivatives.
Types of derivatives
• Variety of derivatives are available; both standard products that are
traded on an exchange as well as tailor-made, to suit various
applications.
Four broad types of derivative instruments are
• Forwards,
• Futures,
• Options, and
• Swaps.

Prepared by Sumit Goyal- LPU

Forward contract
• A forward contract is an agreement to buy or sell an asset at a certain
future time for a certain price. It can be contrasted with a spot
contract, which is an agreement to buy or sell an asset today.
• Forward contracts ability to lock in a purchase or sale price without
incurring much direct cost makes it attractive for hedging as well as
speculation.
• The buyer of the forward contract is called the long and the seller of
forward contract is called the short.
• The only risk parties of contract faces is counterparty risk.
Example
• Suppose on January 1, 2015 an Indian textile exporter receives an order to supply
his product to a big retail chain in the US. Spot price of INR/US exchange rate
is Rs. 45/dollar.
• After six months, the exporter will receive $1 million (Rs 4.5 crore) for his
products. Since all his expenditure is in rupee term therefore he is exposed to
currency risk. Let’s assume that his cost of production is Rs. 4 crore. To avoid
uncertainty, the exporter enters into a six-month forward contract with a bank
(with some fees) at Rs. 45 to a dollar. So the exporter is hedged completely.
• If exchange rate appreciates to Rs. 35 after six months, then the exporter will
receive Rs. 3.5 crore after converting his $1 million and the rest Rs. 1 crore will
be provided by the bank. If exchange rate depreciates to Rs. 60/dollar then the
exporter will receive Rs. 6 crore after conversion, but has to pay Rs. 1.5 crore to
the bank. So no matter what the situation, the exporter will end up with Rs. 4.5
crore.
Futures
• It has the same concept and pricing mechanism, but some additional
characteristics clearly differentiate it from a forward contract.
• Futures are traded on the exchange.
• The features of the futures contracts are standardized in terms of
quality, delivery, dates, delivery places, quality of the product etc.
• Counterparty risk is also reduced, since both the parties have to
provide margin to the exchange in which the trade has been done.
 Marking to Market
• Marking to Market (MTM) means valuing the security at the current
trading price. Therefore, it results in the traders’ daily settlement of
profits and losses due to the changes in its market value.

Prepared by Sumit Goyal- LPU

Mark to Margin
• Let us assume you have purchased one lot of reliance in the futures
market at rupees 1000. The lot size of reliance futures is of 500 shares
hence the contract value is equal to lot size into share price that is 500
into thousand that is rupees 5 lakhs

• Suppose the initial margin is 10 percent of the contract value then the
initial margin you paid is 10 percent of 5 lakhs that is rupees 50 000.

Prepared by Sumit Goyal- LPU

• At the end of the trading session around 3 p.m that is just before the
market is closing if the price of reliance is trading at Rs 920 the broker
may ask you to pay the difference between the price you bought and
the closing price that is rupees thousand minus rupees 920 which will
be rupees 80 into 500 shares that is rupees 40,000 to carry the position
to the next day

• This difference of rupees 40,000 due to closing price and the trade
price is marked to market.

Prepared by Sumit Goyal- LPU

Option
• A financial derivative that represents a contract sold by one party
(option writer) to another party (option holder). The contract offers the
buyer the right, but not the obligation, to buy (call) or sell (put) a
security or other financial asset at an agreed-upon price (the strike
price) during a certain period of time or on a specific date (exercise
date).
• European Style Options: can be exercised only at expiration.
• American Style Options: can be exercised at any time prior to
expiration.
Call Option
• A call option gives you the right to buy a stock from the investor who sold you the call option at a
specific price on or before a specified date

• For instance,
• If you bought a 35 next month call option on General Electric , the option would come with terms telling
you that you could buy the stock for 35 (the strike price) any time before the the expiration date.

• What this means is, if GE rises anywhere above 35 before the expiration date, you can buy the stock for
less than its market value.

• Or if you don't want to buy the stock yourself or exercise the option, you can sell your option to someone
else for a profit.
 Put Option
• A put option gives you the right to sell a stock to the investor who sold you the put option at a
specific price, on or before a specified date.

• For instance,
• If you bought a 25 next month put option on Pfizer , the option would come with terms telling you that
you could sell the stock for 25 (the strike price) any time before the expiration date.

• What this means is, if Pfizer falls anywhere below 25 before the expiration date, you can sell the stock for
more than its market value.

• And if you don't want to sell the stock yourself, you can sell your option to someone else for a profit.
Example (Call Option)/ Bullish

• Profit from stock price gains with limited risk and lower cost than buying the stock outright

• Example:

• You buy one Reliance Communication (RCOM) 25 call with the stock at 25, and you pay Rs.1 as
premium

• Rcom moves up to 28 and so your option is Rs. 3 in value

• Returns?
Example (Put Option)/ Bearish

• Strategy:

• Profit from stock price drops with limited risk and lower cost than shorting the stock

• Example:

• You buy one Reliance Communication (RCOM) 20 put with the stock at 21, and you pay Rs.0.8 as
premium

• Rcom drops to 18 and so your option is Rs. 2 in value

• Returns?
Swaps
• A swap is an agreement between two parties to exchange a series of
future cash flows.
 EXAMPLE

Interest Rate Swap

• In an interest rate swap, one firm pays a fixed interest rate
on a sum of money and receives from some other firm a
floating interest rate on the same sum

 Popular with corporate treasurers as risk management

tools and as a convenient means of lowering corporate
borrowing costs

21
• Assume that Charlie owns a $1,000,000 investment that pays him LIBOR + 1%
every month. As LIBOR goes up and down, the payment Charlie receives
changes.

• Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every
month. The payment she receives never changes.

• Charlie decides that that he would rather lock in a constant payment and Sandy
decides that she'd rather take a chance on receiving higher payments. So Charlie
and Sandy agree to enter into an interest rate swap contract.

• Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per
month on a $1,000,000 principal amount (called the "notional principal" or
"notional amount").

• Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.
Why SWAP?

• Interest rate swaps provide a way for businesses to hedge their exposure to
changes in interest rates.

• If a company believes long-term interest rates are likely to rise, it can hedge
its exposure to interest rate changes by exchanging its floating rate
payments for fixed rate payments.
Example
• Company XYZ issues $10 million in 15-year corporate bonds with a variable
interest rate of LIBOR + 150 basis points. LIBOR is currently 3%, so Company
XYZ pays bondholders 4.5%.

• After selling the bonds, an analyst at Company XYZ decides there's reason to
believe LIBOR will increase in the near term. Company XYZ doesn't want to be
exposed to an increase in LIBOR, so it enters into a swap agreement with Investor
ABC.

• Company XYZ agrees to pay Investor ABC 4.58% on $10,000,000 each year for
15 years. Investor ABC agrees to pay Company XYZ LIBOR + 1.5% on
$10,000,000 per year for 15 years. Note that the floating rate payments that XYZ
receives from ABC will always match the payments they need to make to their
bondholders.
OTC Derivatives
• The contracts that are directly entered into between two mutually
consenting parties known to each other with matching needs are called
OTC products/contracts. These contracts are customized to the
requirements of the counterparties.

• Forward contracts are OTC products that dominate the foreign

exchange market. Swaps are also OTC products.
Exchange traded contracts
• Is traded on the organized exchanges where the buyer and seller need
not know each other. The exchange serves as counterparty for both
buyer and seller.
 Participants in Derivative Markets
• Hedgers: are those who use derivatives for hedging i.e. reduce or eliminate
risk.
• Speculators: are those take positions in derivatives to increase returns by
assuming increased risk. They provide much needed liquidity to markets.
• Arbitrageurs: are those who exploit mispricing in different markets; They
assume riskless and profitable positions.
• Margin trader:Margin trading is when you buy and sell stocks or other types
of investments with borrowed money. That means you are going into debt to
invest. Margin trading is built on this thing called leverage, which is the idea
that you can use borrowed money to buy more stocks and potentially make
more money on your investment
All 4 participants are essential for efficient functioning.
 Uses of Derivatives

– Risk management
o Hedging (e.g. farmer with corn forward)
– Speculation
o Essentially making bets on the price of something
– Reduced transaction costs
o Sometimes cheaper than manipulating cash portfolios
– Regulatory arbitrage
o Tax loopholes, etc
Features of Forward contract
• Forward commitment created in the over-the counter
market.
• It is not conditional - both the buyer and the seller are
obliged to perform the contract as agreed.
• Negotiated in the present and will be settled in the future.
• Private and largely unregulated market.
• Customized
• Counterparty default risk
 Terminology
Long position - Buyer

Short position - seller

Spot price – Price of the asset in the spot market.(market price)

Delivery/forward price – Price of the asset at the delivery date.

Features of Futures Contract

• Organized Exchange

• Highly Standardized

Highly standardized with specified underlying goods, quantity (contract size),

delivery date, trading hours and trading area

• Active Secondary Market

• No Default Risk

• Daily Settlement
Options Terminology
Terminologies

• Open interest refers to the total number of outstanding

derivative contracts that have not been settled.
• Strike Price Intervals are the various levels of strike prices for
each Index and Stock option. The exchange authorities
determine the strike prices and the strike intervals are also
defined from time to time and modified based on the
movement in prices.
•

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 Example
On November 3, 2010 a person decided to enter into a
futures contract. He expects the market to go up so he
takes a long Nifty Futures position for November expiry.
Assume that, on November 3, 2010 Nifty November month
futures closes at 8000.
Lot Size = 75, Expiry:November 26, 2010, 10% as initial
margin
Calculate the contract value and Initial margin

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• On the next trading day i.e., on November 4, 2010 Nifty
futures contract closes at 8100
• Calculate Margin due/paid
•

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