INDEX

Introduction
Derivatives permitted by SEBI
History of derivatives
Ancient and recent derivatives
Need for financial derivatives
Development of derivatives market in India
Functions of derivatives in Indian market
Derivatives permitted by SEBI
Taxation
Forward, futures, swap, option, warrants
Difference in forwards and futures
Participants in the market
Hedgers
Short hedge
Hedging and shareholders
Basis risk
Long hedgers
Arguments for and against hedging
Hedge ratio
Speculators
Arbitragers
Types of derivatives
Over the counter
Exchange traded
Common derivative types
Comparison of derivatives trading with other exchanges of countries
Flow of cash and zero sum game
Valuation
Market and arbitrage free prices
Determining market price
Determining arbitrage free price
Criticism
Futures
Currency futures
Bond futures
Stock index futures
Specification of future contract
Convergence of future price to spot price
Operation of margins
 Keynes and hicks
Delivery
Cash settlement
Forwards
Valuation
Cost of carry
Short selling
Risk and return
Options
Options strategy
Bullish strategy
Bearish strategy
Straddle
Strangle
Box spread
Butterfly spread
Swaps

Fixed-for-floating rate swap, same currency

Fixed-for-floating rate swap, different currencies

Floating-for-floating rate swap, same currency

Floating-for-floating rate swap, different currencies

Fixed-for-fixed rate swap, different currencies

Valuation and pricing

Interest rate swaps

Valuation of options price
Black scholes model
Assumptions
Binary model
Risk management tools
Counter party risk
Benefits of trading in derivatives
Glossary

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Introduction
In the last 20 years derivatives have become increasingly important in the world of finance.
Futures and options are now traded actively on many exchanges throughout the world.
Forward contracts, swaps, and many different types of options are regularly traded outside
exchanges by financial institutions, fund managers, and corporate treasurers in what is
termed the over-the-counter market. Derivatives are also sometimes added to a bond or
stock issue.

Derivatives are the most complex of financial instruments. The word ‘derivative’ comes
from the verb ‘derive’. A derivative is a contract whose value is derived from the value
of another asset, known as underlying , which could be a share, a stock market index,
an interest rate, a commodity, or a currency.

For example, a derivative of the shares of Infosys (underlying), will derive its value from
the share price (value) of Infosys. Similarly, a derivative contract on soybean depends on
the price of soybean.
Derivatives are specialized contracts which signify an agreement or an option to buy or sell
the underlying asset of the derivate up to a certain time in the future at a prearranged price,
the exercise price.
The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the
date of commencement of the contract. The value of the contract depends on the expiry
period and also on the price of the underlying asset.
For example, a farmer fears that the price of soybean (underlying), when his crop is ready
for delivery will be lower than his cost of production.
Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in
the selling price of his crop, he enters into a contract (derivative) with a merchant, who
agrees to buy the crop at a certain price (exercise price), when the crop is ready in three
months time (expiry period).
In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of
this derivative contract will increase as the price of soybean decreases and vice-a-versa.
If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will
be more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the
contract becomes even more valuable.
This is because the farmer can sell the soybean he has produced at Rs .9000 per tonne even
though the market price is much less. Thus, the value of the derivative is dependent on the
value of the underlying.
If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold,
silver, precious stone or for that matter even weather, then the derivative is known as a
commodity derivative.

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If the underlying is a financial asset like debt instruments, currency, share price index,
equity shares, etc, the derivative is known as a financial derivative.

History of Derivatives
The history of derivatives is surprisingly longer than what most people think. Some texts
even find the existence of the characteristics of derivative contracts in incidents of
Mahabharata. Traces of derivative contracts can even be found in incidents that date back
to the ages before Jesus Christ. However, the advent of modern day derivative contracts is
attributed to the need for farmers to protect themselves from any decline in the
price of their crops due to delayed monsoon, or overproduction. The first 'futures' contracts
can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were
evidently standardized contracts, which made them much like today's futures. The Chicago
Board of Trade (CBOT), the largest derivative exchange in the world, was established in
1848 where forward contracts on various commodities were standardized around 1865.
From then on, futures contracts have remained more or less in the same form, as we know
them today.
Derivatives have had a long presence in India. The commodity derivative market
has been functioning in India since the nineteenth century with organized trading in cotton
through the establishment of Cotton Trade Association in 1875. Since then contracts on
various other commodities have been introduced as well. Exchange traded financial
derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE
and BSE. There are various contracts currently traded on these exchanges. National
Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December
2003, to provide a platform for commodities trading. The derivatives market in India has
grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts
on NSE accounting for around 55% of the total turnover of derivatives at NSE, as on April
13, 2005.

Derivatives have the characteristic of leverage or gearing. With a small initial outlay of
funds one can deal large volumes. Derivatives are financial contracts, or financial
instruments, whose values are derived from the value of something else (known as the
underlying). The underlying on which a derivative is based can be an asset (e.g.,
commodities, equities (stocks), residential mortgages, commercial real estate, loans,
bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer
price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions,
or other derivatives). Credit derivatives are based on loans, bonds or other forms of
credit.There is a huge variety of derivative products that are traded on organized
exchanges or OTC markets.

The ancient derivatives

1400’s Japanese rice futures

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1600’s dutch tulip bulb options

1800’s puts and call options

The recent: financial derivatives listed markets

1972 Financial Currency Futures

1973 Stock Options
1977 Treasury Bond Futures
1981 Euro Dollars Futures
1982 Index Futures
1983 Stock Index Options
1990 Foreign Index Warrants And Leaps
1991 Swap Futures
1992 Insurance Futures
1993 Flex Options

OTC Markets
1981 Currency Swaps
1982 Interest Rate Swaps
1983 Currency And Bond Options

Need for financial derivatives

There are several risks inherent in financial transactions and asset liability positions.
Derivatives are risk shifting devices, they shift risk from those ‘who have it but may not
want it’ to ‘those who have the appetite and are willing to take it’. The three broad types of
price risks are as follows
• Market risk: market risk arises when security prices go up due to reasons
affecting the sentiments of the whole market. Market risk is also referred to as
‘systematic risk’ since it can not be diversified away because the stock market as a
whole may go up or down from time to time.
• Interest rate risk: this risk arises in the case of fixed income securities such as
treasury bills, government securities, and bonds, whose market price could
fluctuate heavily if interest rates change. For example the market price of fixed
income securities could fall if the interest rate shot up.
• Exchange rate risk: in case of imports, exports, foreign loans or investments,
foreign currency is involved which gives rise to exchange rate risk.
To hedge these risks, equity derivatives, interest rate derivatives, and currency
derivatives have emerged.

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Development of derivatives market in India
The first step towards introduction of derivatives trading in India was the promulgation of
the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on
options in securities. The market for derivatives, however, did not take off, as there was no
regulatory framework to govern trading of derivatives. SEBI set up a 24–member
committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop
appropriate regulatory framework for derivatives trading in India. The committee submitted
its report on March 17, 1998 prescribing necessary pre–conditions for introduction of
derivatives trading in India. The committee recommended that derivatives should be
declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’
could also govern trading of securities. SEBI also set up a group in June 1998 under the
Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in
derivatives market in India. The report, which was submitted in October 1998, worked out
the operational details of margining system, methodology for charging initial margins,
broker net worth, deposit requirement and real–time monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in December 1999 to
include derivatives within the ambit of ‘securities’ and the regulatory framework was
developed for governing derivatives trading. The act also made it clear that derivatives
shall be legal and valid only if such contracts are traded on a recognized stock exchange,
thus precluding OTC derivatives. The government also rescinded in March 2000, the three–
decade old notification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2001. SEBI permitted the derivative segments of two stock
exchanges, NSE and BSE, and their clearing house/corporation to commence trading and
settlement in approved derivatives contracts. To begin with, SEBI approved trading in
index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was
followed by approval for trading in options based on these two indexes and options on
individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in
options on individual securities commenced in July 2001. Futures contracts on individual
stocks were launched in November 2001. The derivatives trading on NSE commenced with
S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced
on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001.
Single stock futures were launched on November 9, 2001. The index futures and options
contract on NSE are based on S&P CNX
Trading and settlement in derivative contracts is done in accordance with the rules,
byelaws, and regulations of the respective exchanges and their clearing house/corporation
duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors
(FIIs) are permitted to trade in all Exchange traded derivative products.
The following are some observations based on the trading statistics provided in the NSE
report on the futures and options (F&O):
• Single-stock futures continue to account for a sizable proportion of the F&O
segment. It constituted 70 per cent of the total turnover during June 2002. A
primary reason attributed to this phenomenon is that traders are comfortable with
single-stock futures than equity options, as the former closely resembles the

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erstwhile badla system.
• On relative terms, volumes in the index options segment continues to remain poor.
This may be due to the low volatility of the spot index. Typically, options are
considered more valuable when the volatility of the underlying (in this case, the
index) is high. A related issue is that brokers do not earn high commissions by
recommending index options to their clients, because low volatility leads to higher
waiting time for round-trips.
• Put volumes in the index options and equity options segment have increased since
January 2002. The call-put volumes in index options have decreased from 2.86 in
January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the
traders are increasingly becoming pessimistic on the market.
• Farther month futures contracts are still not actively traded. Trading in equity
options on most stocks for even the next month was non-existent.
• Daily option price variations suggest that traders use the F&O segment as a less
risky alternative (read substitute) to generate profits from the stock price
movements. The fact that the option premiums tail intra-day stock prices is
evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day.
If calls and puts are not looked as just substitutes for spot trading, the intra-day
stock price variations should not have a one-to-one impact on the option premiums.

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Functions of derivatives in Indian market

• Derivatives enable price discovery, improve the liquidity of the underlying asset,
serve as effective hedging instruments and offer better ways of raising money.
• They contribute substantially in to increasing the depth of markets.
• Derivatives shift the risk from the buyer of the derivative product to the seller and
as such are very effective risk management tools.
• They provide better avenues for raising money.
• Derivatives improve the liquidity of the underlying instrument.

Derivatives permitted by SEBI

Derivative products have been introduced in a phased manner starting with Index Futures
Contracts in June 2000. Index Options and Stock Options were introduced in June
2001 and July 2001 followed by Stock Futures in November 2001. Sectoral indices
were permitted for derivatives trading in December 2002. Interest Rate Futures on a
notional bond and T-bill priced off ZCYC have been introduced in June 2003 and
exchange traded interest rate futures on a notional bond priced off a basket of
Government Securities were permitted for trading in January 2004. During December
2007 SEBI permitted mini derivative (F&O) contract on Index (Sensex and Nifty).
Further, in January 2008, longer tenure Index options contracts and Volatility Index
and in April 2008, Bond Index was introduced. In addition to the above, during August
2008, SEBI permitted Exchange traded Currency Derivatives.

A stock on which stock option and single stock future contracts are proposed to be
introduced is required to fulfill the following broad eligibility criteria:-

o The stock shall be chosen from amongst the top 500 stock in terms of
average daily market capitalisation and average daily traded value in the
previous six month on a rolling basis.
o The stock’s median quarter-sigma order size over the last six months shall
be not less than Rs.1 Lakh. A stock’s quarter-sigma order size is the mean
order size (in value terms) required to cause a change in the stock price
equal to one-quarter of a standard deviation.
o The market wide position limit in the stock shall not be less than Rs.50
crores.

A stock can be included for derivatives trading as soon as it becomes eligible. However, if
the stock does not fulfill the eligibility criteria for 3 consecutive months after being
admitted to derivatives trading, then derivative contracts on such a stock would be
discontinued.

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Taxation
The income-tax Act does not have any specific provision regarding taxability from
derivatives.The only provisions which have an indirect bearing on derivative transactions
are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a
speculative business carried on by the assessee, shall not be set off except against profits
and gains, if any, of speculative business. In the absence of a specific provision, it is
apprehended that the derivatives contracts, particularly the index futures which are
essentially cash-settled, may be construed as speculative transactions and therefore the
losses, if any, will not be eligible for set off against other income of the assessee and will
be carried forward and set off against speculative income only up to a maximum of eight
years .As a result an investor’s losses or profits out of derivatives even though they are of
hedging nature in real sense, are treated as speculative and can be set off only against
speculative income.

Most derivatives can be summarized in the following categories:

Forwards: A forward contract is a particularly simple derivative, a contract between two

parties. It 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. A forward contract is traded in the over-the-counter market—usually between two
financial institutions or between a financial institution and one of its clients.
One of the parties to a forward contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset on the same date for the same
price.
Forward contracts on foreign exchange are very popular. Most large banks have a "forward
desk" within their foreign exchange trading room that is devoted to the trading of forward
contracts.
Both sides are obligated to complete the deal, however there is a risk one side might default
on its obligations.
These are not traded on exchanges because they are negotiated directly between two
parties.
Features of Forward Contracts:
• Over the Counter Trading (OTC).
• No down Payment
• Settlement at Maturity.
• Linearity (Loss of a forward buyer is the gain of the forward seller)
• No Secondary Market
• Necessity of a third party
• Delivery.
Forward Rate contracts for commodities.
Forward Rate contracts for currency.
Forward Rate contracts for Interest Rates.

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Futures: A contract essentially the same as a forward except the deal is struck via an
organized and regulated exchange. There are three key differences between forwards and
futures. A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future for a certain price. Unlike forward contracts, futures contracts are
normally traded on an exchange. To make trading possible, the exchange specifies certain
standardized features of the contract. As the two parties to the contract do not necessarily
know each other, the exchange also provides a mechanism that gives the two parties a
guarantee that the contract will be honored. The largest exchanges on which futures
contracts are traded are the Chicago Board of Trade (CBOT) and the Chicago Mercantile
Exchange (CME). On these and other exchanges throughout the world, a very wide range
of commodities and financial assets form the underlying assets in the various contracts. The
commodities include pork bellies, live cattle, sugar, wool, lumber, copper, aluminum, gold,
and tin. The financial assets include stock indices, currencies, and Treasury bonds.

1. Futures contract is guaranteed against default.

2. They are standardized.
3. They are settled on a daily basis.
Short Position: This commits the seller to deliver an item at the contracted price on
maturity.
Long Position: This commits the buyer to purchase.
Key features of Futures contracts:
• Standardization.
• Intermediation by the Exchange.
• Price Limits.
• Margin requirements.
• Marking to market.
Standardization: It is standardized, so that it can be traded in the stock exchange.
Intermediation by the exchange:

Marking to market: while the forward contracts are settled down the maturity date futures
contracts are ‘marked to market’ on a periodic basis. This means that profits and losses on
future
contracts are settled on a periodic basis.
Types of Future Contracts – (The Global scene types of Futures)
1. Commodity Futures
2. Financial Futures.
Commodity Futures: A commodity futures is a future contract in commodities like
agricultural products, metals and mineral etc. Some of the will established commodity
exchanges are as follows.

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 • London Metal Exchange (LME) – to deal in gold.
• Chicago Board of Trade (CBT) – to deal in Soya bean oil.
• New York cotton Exchange – to deal in cotton.
• Commodity exchange in New York (COMEX) – to deal in agricultural products.
• International Petroleum Exchange of London (IPE) – to deal in crude oil.

Swaps: A swap is an agreement made between two parties to exchange payments on

regular future dates. Swaps are OTC products and there is a risk for default. Swaps are
used to manage or hedge risk associated with volatile interest rates, currency exchange
rates, commodity prices, and share prices. It can be considered a series of forward
contracts.

Options: Options are traded both on exchanges and in the over-the-counter market. There
are two basic types of options. A call option gives the holder the right to buy the
underlying asset by a certain date for a certain price. A put option gives the holder the right
to sell the underlying asset by a certain date for a certain price. The price in the contract is
known as the exercise price or strike price; the date in the contract is known as the
expiration date or maturity. American options can be exercised at any time up to the
expiration date. European options can be exercised only on the expiration date itself.4 Most
of the options that are traded on exchanges are American. In the exchange-traded equity
options market, one contract is usually an agreement to buy or sell 100 shares. European
options are generally easier to analyze than American options, and some of the properties
of an American option are frequently deduced from those of its European counterpart.
It should be emphasized that an option gives the holder the right to do something. The
holder does not have to exercise this right. This is what distinguishes options from forwards
and futures, where the holder is obligated to buy or sell the underlying asset. Note that
whereas it costs nothing to enter into a forward or futures contract, there is a cost to
acquiring an option.
An Option is a contract which gives the right, but not an obligation, to buy or sell the
underlying at a stated date and at a stated price. While a buyer of an option pays the
premium and buys the right to exercise his option, the writer of an option is the one who
receives the option premium and therefore obliged to sell/buy the asset if the buyer
exercises it on him. The buyer pays a premium to the writer of the contract because the
option provides flexibility as the buyer can choose whether or not to exercises it. Options
are OTC and exchange products. It may be classified into two categories Options are of
two types - Calls and Puts options:
‘Calls’ give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a given future date.
‘Puts’ give the buyer the right, but not the obligation to sell a given quantity of underlying
asset at a given price on or before a given future date.
Presently, at NSE futures and options are traded on the Nifty, CNX IT, BANK Nifty and
116 single stocks.

Warrants: Options generally have lives of up to one year. The majority of

options traded on exchanges have maximum maturity of nine months.
Longer dated options are called Warrants and are generally traded over-the counter.

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Difference among Forwards and Futures contract
Sno. Forwards Futures
1. Essentially OTC contracts involving A contract traded through an exchange
only the buyer and the seller. Buyer, Seller and exchanges are involved.
2. Both the parties have necessarily to The contract need not necessarily culminate
perform the contract. in delivery of the underlying.
3. There is no payment of initial To trade in futures contract, one has to
margins. become a member of the exchange by
paying the initial margin and maintain a
variable margin account too with the
Futures Exchange.
4. The maturity and size of the contract The maturity and size of contracts are
may be customized. standardized.
5. Settlements take place only on the Settlement is on a daily basis on all the
date of maturity. outstanding contracts(marking to market on
a daily basis).
6. Credit or counter-party risk is The futures exchange takes care of credit or
higher. counter-party risk.
7. Markets for forward contracts are Futures contracts are highly liquid and can
not very liquid. be closed out easily.
8. Physical delivery takes place on the Hardly 2% of the total contracts are
maturity date. delivered and taken delivery of.

Participants in the Derivatives Market:

Hedger: Reduces / eliminates his risk.
Speculator: Bets on future movements in the price of an asset.
Arbitrageur: Takes advantage of a discrepancy between prices in two different markets.

Dealers work for major banks and securities houses. Hedgers consists of corporations,
investment institutions, banks and governments that want to reduce exposure to market
variables such as interest rates, share values, bond prices, currency exchange rates
and commodity prices. Speculators are those such as hedge funds that want to bet on
the prices of commodities and financial assets and on key market variables such as
interest, indices, and exchange rates. It is usually much cheaper to speculate using
derivatives than on the underlying. As a result, the risks and returns are much greater.
Arbitrageurs exploit mispricing in the market to create risk-free profits. Those that are
not members of a future and options exchange have to employ a broker to fill their
orders.
Trading in these markets are regulated by Commodity Futures Trading Commission

13
(CFTC) and International Swaps and Derivatives Association (ISDA) and the National
Futures Association (NFA).

Derivatives can be used to mitigate the risk of economic loss arising from changes in the
value of the underlying. This activity is known as hedging. Alternatively, derivatives can
be used by investors to increase the profit arising if the value of the underlying moves in
the direction they expect. This activity is known as speculation.

Because the value of a derivative is contingent on the value of the underlying, the notional
value of derivatives is recorded off the balance sheet of an institution, although the market
value of derivatives is recorded on the balance sheet. The market for financial derivatives
has grown tremendously both in terms of variety of instruments and turnover. The
explosive growth of derivatives in the developed centuries is fuelled by the following.

• The increased volatility in global financial markets.

• The technological changes enabling cheaper communication and computing power.
• Breakthrough in modern financial theory, providing economic agents a wider
choice of risk management strategies and instruments that optimally combine the
risk and returns over a large number of financial assets.
• Political developments wherein the role of government in economic arena has
become more of a facilitator and less of a prime mover. Thus the move towards
market oriented policies and the deregulation in financial markets has lead to
increase in financial risk at the individual participant’s level.
• Increased integration of domestic financial markets with international markets.

Hedging
Many of the participants in futures markets are hedgers. Their aim is to use futures markets
to reduce a particular risk that they face. This risk might relate to the price of oil, a foreign
exchange rate, the level of the stock market, or some other variable. A perfect hedge is one
that completely eliminates the risk. In practice, perfect hedges are rare. To quote one trader:
"The only perfect hedge is in a Japanese garden." For the most part, therefore, a study of
hedging using futures contracts is a study of the ways in which hedges can be constructed
so that they perform as close to perfect as possible.
The hedger simply takes a futures position at the beginning of the life of the hedge and
closes out the position at the end of the life of the hedge. In Chapter 14 we will examine
dynamic hedging strategies in which the hedge is monitored closely and frequent
adjustments are made. Throughout this chapter we will treat futures contracts as forward
contracts, that is, we will ignore daily settlement. This means that we can ignore the time
value of money in most situations because all cash flows occur at the time the hedge is
closed out.

Derivatives allow risk about the value of the underlying asset to be transferred from one
party to another. For example, a wheat farmer and a miller could sign a futures contract to
exchange a specified amount of cash for a specified amount of wheat in the future. Both

14
parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for
the miller, the availability of wheat. However, there is still the risk that no wheat will be
available due to causes unspecified by the contract, like the weather, or that one party will
renege on the contract. Although a third party, called a clearing house, insures a futures
contract, not all derivatives are insured against counterparty risk.

From another perspective, the farmer and the miller both reduce a risk and acquire a risk
when they sign the futures contract: The farmer reduces the risk that the price of wheat will
fall below the price specified in the contract and acquires the risk that the price of wheat
will rise above the price specified in the contract (thereby losing additional income that he
could have earned). The miller, on the other hand, acquires the risk that the price of wheat
will fall below the price specified in the contract (thereby paying more in the future than he
otherwise would) and reduces the risk that the price of wheat will rise above the price
specified in the contract. In this sense, one party is the insurer (risk taker) for one type of
risk, and the counterparty is the insurer (risk taker) for another type of risk.

Hedging also occurs when an individual or institution buys an asset (like a commodity, a
bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a
futures contract. The individual or institution has access to the asset for a specified amount
of time, and then can sell it in the future at a specified price according to the futures
contract. Of course, this allows the individual or institution the benefit of holding the asset
while reducing the risk that the future selling price will deviate unexpectedly from the
market's current assessment of the future value of the asset.

Short hedge
An investment strategy that is focused on mitigating a risk that has already been taken. The
"short" portion of the term refers to the act of shorting a security, usually a derivatives
contract, that hedges against potential losses in an investment that is held long (i.e., the risk
that was already taken). If a short hedge is executed well, gains from the long position will
be offset by losses in the derivatives position, and vise versa.
An investment transaction that is intended to provide protection against a decline in the
value of an asset. For example, an investor who holds shares of Nextel and expects the
stock to decline may enter into a short hedge by purchasing a put option on Nextel stock. If
Nextel does subsequently decline, the value of the put option should increase.

Hedging and Shareholders

One argument sometimes put forward is that the shareholders can, if they wish, do the
hedging themselves. They do not need the company to do it for them. This argument is,
however, open to question. It assumes that shareholders have as much information about
the risks faced by a company as does the company's management. In most instances, this is
not the case. The argument also ignores commissions and other transactions costs. These
are less expensive per dollar of hedging for large transactions than for small transactions.
Hedging is therefore likely to be less expensive when carried out by the company than by
individual shareholders. Indeed, the size of futures contracts makes hedging by individual
shareholders impossible in many situations. One thing that shareholders can do far more
easily than a corporation is diversify risk. A shareholder with a well-diversified portfolio

15
may be immune to many of the risks faced by a corporation. For example, in addition to
holding shares in a company that uses copper, a well diversified shareholder may hold
shares in a copper producer, so that there is very little overall exposure to the price of
copper. If companies are acting in the best interests of well-diversified shareholders, it can
be argued that hedging is unnecessary in many situations. However, the extent to which
managements are in practice influenced by this type of argument is open to question.

BASIS RISK
The hedges in the examples considered so far have been almost too good to be true. The
hedger was able to identify the precise date in the future when an asset would be bought or
sold. The hedger was then able to use futures contracts to remove almost all the risk arising
from the price of the asset on that date. In practice, hedging is often not quite as
straightforward. Some of the reasons are as follows:
1. The asset whose price is to be hedged may not be exactly the same as the asset
underlying the futures contract.
2. The hedger may be uncertain as to the exact date when the asset will be bought or sold.
3. The hedge may require the futures contract to be closed out well before its expiration
date.
These problems give rise to what is termed basis risk. This concept will now be explained.
The Basis
The basis in a hedging situation is as follows:
Basis — Spot price of asset to be hedged - Futures price of contract used
If the asset to be hedged and the asset underlying the futures contract are the same, the
basis should be zero at the expiration of the futures contract. Prior to expiration, the basis
may be positive or negative. When the underlying asset is a low-interestrate currency or
gold or silver, the futures price is greater than the spot price. This means that the basis is
negative. For high-interest-rate currencies and many commodities, the reverse is true, and
the basis is positive. When the spot price increases by more than the futures price, the basis
increases. This is referred to as a strengthening of the basis. When the futures price
increases by more than the spot price, the basis declines. This is referred to as a weakening
of the basis

Long hedgers

A situation where an investor has to take a long position in futures contracts in order to
hedge against future price volatility. A long hedge is beneficial for a company that knows it
has to purchase an asset in the future and wants to lock in the purchase price. A long hedge
can also be used to hedge against a short position that has already been taken by the
investor.
For example, assume it is January and an aluminum manufacturer needs 25,000 pounds of
copper to manufacture aluminum and fulfill a contract in May. The current spot price is
$1.50 per pound, but the May futures price is $1.40 per pound. In January the aluminum
manufacturer would take a long position in 1 May futures contract on copper. This locks in
the price the manufacturer will pay.
If in May the spot price of copper is $1.45 per pound the manufacturer has benefited from
taking the long position, because the hedger is actually paying $0.05/pound of copper
compared to the current market price. However if the price of copper was anywhere below

16
$1.40 per pound the manufacturer would be in a worse position than where they would
have been if they did not enter into the futures contract.

ARGUMENTS FOR AND AGAINST HEDGING

The arguments in favor of hedging are so obvious that they hardly need to be stated. Most
companies are in the business of manufacturing or retailing or wholesaling or providing a
service. They have no particular skills or expertise in predicting variables such as interest
rates, exchange rates, and commodity prices. It makes sense for them to hedge the risks
associated with these variables as they arise. The companies can then focus on their main
activities—in which presumably they do have particular skills and expertise. By hedging,
they avoid unpleasant surprises such as sharp rises in the price of a commodity.

HEDGE RATIO

The hedge ratio is the ratio of the size of the position taken in futures contracts to the size
of the exposure.

1. A ratio comparing the value of a position protected via a hedge with the size of the entire
position itself.

2. A ratio comparing the value of futures contracts purchased or sold to the value of the
cash commodity being hedged.

1. Say you are holding $10,000 in foreign equity, which exposes you to currency risk.
If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5
(50 / 100). This means that 50% of your equity position is sheltered from exchange rate
risk.

2. The hedge ratio is important for investors in futures contracts, as it will help to identify
and minimize basis risk.

Derivatives traders at the Chicago Board of Trade.

Speculation and arbitrage

17
Commercial speculation, i.e. speculation by buyers and sellers of commodities, has been
used since the 19th century to enable commodity traders and processors to protect
themselves against short term price volatility. Buyers are protected against sudden price
increases, sellers against sudden price falls. For commodity buyers and sellers, commercial
speculation is a form of price insurance. Noncommercial speculation takes place not to
protect against or “hedge” price risk, but to benefit by anticipating and “betting long” for
prices to go up or “short” for prices to go down. Non-commercial speculators provide
capital to enable the ongoing function of the market as commercial speculators liquidate
their contract positions by paying for the contracted commodity or selling the contract to
offset the risk of other contract positions held. Non-commercial speculation is an
investment, but one that can overlap with the interests of agriculture when appropriately
regulated. However, today’s speculation has become excessive relative to the value of the
commodity as determined by supply and demand and other fundamental factors. For
example, according to the FAO, as of April 2008 corn volatility was 30 percent and
soybean volatility 40 percent beyond what could be accounted for by market fundamentals.
Price volatility has become so extreme that by July some commercial or “traditional”
speculators could no longer afford to use the market to hedge risks effectively.
Prices are particularly vulnerable to being moved by big speculative “bets” when a
commodity’s supply and demand relationship is “tight” due to production failures, high
demand and/or lack of supply management mechanisms.

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus,
some individuals and institutions will enter into a derivative contract to speculate on the
value of the underlying asset, betting that the party seeking insurance will be wrong about
the future value of the underlying asset. Speculators will want to be able to buy an asset in
the future at a low price according to a derivative contract when the future market price is
high, or to sell an asset in the future at a high price according to a derivative contract when
the future market price is low.

Individuals and institutions may also look for arbitrage opportunities, as when the current
buying price of an asset falls below the price specified in a futures contract to sell the asset.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick
Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures
contracts. Through a combination of poor judgment, lack of oversight by the bank's
management and by regulators, and unfortunate events like the Kobe earthquake, Leeson
incurred a $1.3 billion loss that bankrupted the centuries-old institution.

Types of derivatives
OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are
distinguished by the way they are traded in market:

18
 • Over-the-counter (OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or
other intermediary. Products such as swaps, forward rate agreements, and exotic
options are almost always traded in this way. The OTC derivative market is the
largest market for derivatives, and is largely unregulated with respect to disclosure
of information between the parties, since the OTC market is made up of banks and
other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts
are difficult because trades can occur in private, without activity being visible on
any exchange. According to the Bank for International Settlements, the total
outstanding notional amount is $684 trillion (as of June 2008). Of this total notional
amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are
foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts,
and 12% are other. Because OTC derivatives are not traded on an exchange, there is
no central counterparty. Therefore, they are subject to counterparty risk, like an
ordinary contract, since each counterparty relies on the other to perform.

• Exchange-traded derivatives (ETD) are those derivatives products that are traded
via specialized derivatives exchanges or other exchanges. A derivatives exchange
acts as an intermediary to all related transactions, and takes Initial margin from both
sides of the trade to act as a guarantee. The world's largest derivatives exchanges
(by number of transactions) are the Korea Exchange (which lists KOSPI Index
Futures & Options), Eurex (which lists a wide range of European products such as
interest rate & index products), and CME Group (made up of the 2007 merger of
the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008
acquisition of the New York Mercantile Exchange). According to BIS, the
combined turnover in the world's derivatives exchanges totalled USD 344 trillion
during Q4 2005. Some types of derivative instruments also may trade on traditional
exchanges. For instance, hybrid instruments such as convertible bonds and/or
convertible preferred may be listed on stock or bond exchanges. Also, warrants (or
"rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and
various other instruments that essentially consist of a complex set of options
bundled into a simple package are routinely listed on equity exchanges. Like other
derivatives, these publicly traded derivatives provide investors access to risk/reward
and volatility characteristics that, while related to an underlying commodity,
nonetheless are distinctive.

Common derivative contract types

There are three major classes of derivatives:

1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a

price specified today. A futures contract differs from a forward contract in that the
futures contract is a standardized contract written by a clearing house that operates
an exchange where the contract can be bought and sold, while a forward contract is
a non-standardized contract written by the parties themselves.

19
 2. Options are contracts that give the owner the right, but not the obligation, to buy (in
the case of a call option) or sell (in the case of a put option) an asset. The price at
which the sale takes place is known as the strike price, and is specified at the time
the parties enter into the option. The option contract also specifies a maturity date.
In the case of a European option, the owner has the right to require the sale to take
place on (but not before) the maturity date; in the case of an American option, the
owner can require the sale to take place at any time up to the maturity date. If the
owner of the contract exercises this right, the counterparty has the obligation to
carry out the transaction.
3. Swaps are contracts to exchange cash (flows) on or before a specified future date
based on the underlying value of currencies/exchange rates, bonds/interest rates,
commodities, stocks or other assets.

More complex derivatives can be created by combining the elements of these basic types.
For example, the holder of a swaption has the right, but not the obligation, to enter into a
swap on or before a specified future date.

Examples

Some common examples of these derivatives are:

CONTRACT TYPES

UNDERLYING Exchange-
Exchange- OTC OTC
traded OTC option
traded options swap forward
futures

Option on DJIA
DJIA Index
Index future
future Equity
Equity Index Option on Back-to-back n/a
NASDAQ swap
NASDAQ
Index future
Index future

Option on
Interest rate
Eurodollar Eurodollar
Interest Forward rate cap and floor
Money market future future
rate swap agreement Swaption
Euribor future Option on
Basis swap
Euribor future

Total
Option on Bond Repurchase
Bonds Bond future return Bond option
future agreement
swap

Single Stocks Single-stock Single-share Equity Repurchase Stock option

future option swap agreement Warrant
Turbo

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 warrant

Credit Credit
Credit n/a n/a default n/a default
swap option

Other examples of underlying exchangeables are:

• Property (mortgage) derivatives

• Economic derivatives that pay off according to economic reports as measured and
reported by national statistical agencies
• Energy derivatives that pay off according to a wide variety of indexed energy
prices. Usually classified as either physical or financial, where physical means the
contract includes actual delivery of the underlying energy commodity (oil, gas,
power, etc.)
• Commodities
• Freight derivatives
• Inflation derivatives
• Insurance derivatives
• Weather derivatives
• Credit derivatives

Cash flow
The payments between the parties may be determined by:

• the price of some other, independently traded asset in the future (e.g., a common
stock);
• the level of an independently determined index (e.g., a stock market index or
heating-degree-days);
• the occurrence of some well-specified event (e.g., a company defaulting);
• an interest rate;
• an exchange rate;
• or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at some
point in the future for a predetermined price. If the price of the underlying security or
commodity moves into the right direction, the owner of the derivative makes money;
otherwise, they lose money or the derivative becomes worthless. Depending on the terms of
the contract, the potential gain or loss on a derivative can be much higher than if they had
traded the underlying security or commodity directly.

Valuation

21
Total world derivatives from 1998-2007 compared to total world wealth in the year 2000

Market and arbitrage-free prices

Two common measures of value are:

• Market price, i.e. the price at which traders are willing to buy or sell the contract.
• Arbitrage-free price, meaning that no risk-free profits can be made by trading in
these contracts.

Determining the market price

For exchange-traded derivatives, market price is usually transparent (often published in real
time by the exchange, based on all the current bids and offers placed on that particular
contract at any one time). Complications can arise with OTC or floor-traded contracts
though, as trading is handled manually, making it difficult to automatically broadcast
prices. In particular with OTC contracts, there is no central exchange to collate and
disseminate prices.

Determining the arbitrage-free price

The arbitrage-free price for a derivatives contract is complex, and there are many different
variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. The
stochastic process of the price of the underlying asset is often crucial. A key equation for
the theoretical valuation of options is the Black–Scholes formula, which is based on the
assumption that the cash flows from a European stock option can be replicated by a
continuous buying and selling strategy using only the stock. A simplified version of this
valuation technique is the binomial options model.

22
Criticisms
Derivatives are often subject to the following criticisms:

Possible large losses

The use of derivatives can result in large losses due to the use of leverage, or borrowing.
Derivatives allow investors to earn large returns from small movements in the underlying
asset's price. However, investors could lose large amounts if the price of the underlying
moves against them significantly. There have been several instances of massive losses in
derivative markets, such as:

• The need to recapitalize insurer American International Group (AIG)

with $85 billion of debt provided by the US federal government. An AIG
subsidiary had lost more than $18 billion over the preceding three quarters
on Credit Default Swaps (CDS) it had written. It was reported that the
recapitalization was necessary because further losses were foreseeable over
the next few quarters.
• The loss of $7.2 Billion by Société Générale in January 2008
through mis-use of futures contracts.
• The loss of US$6.4 billion in the failed fund Amaranth Advisors,
which was long natural gas in September 2006 when the price plummeted.
• The loss of US$4.6 billion in the failed fund Long-Term Capital
Management in 1998.
• The bankruptcy of Orange County, CA in 1994, the largest
municipal bankruptcy in U.S. history. On December 6, 1994, Orange
County declared Chapter 9 bankruptcy, from which it emerged in June 1995.
The county lost about $1.6 billion through derivatives trading. Orange
County was neither bankrupt nor insolvent at the time; however, because of
the strategy the county employed it was unable to generate the cash flows
needed to maintain services. Orange County is a good example of what
happens when derivatives are used incorrectly and positions liquidated in an
unplanned manner; had they not liquidated they would not have lost any
money as their positions rebounded. Potentially problematic use of interest-
rate derivatives by US municipalities has continued in recent years.

Futures
A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset),
such as a physical commodity or a financial instrument, at a predetermined future date and
price. Futures contracts detail the quality and quantity of the underlying asset; they are
standardized to facilitate trading on a futures exchange. Some futures contracts may call for
physical delivery of the asset, while others are settled in cash. The futures markets are
characterized by the ability to use very high leverage relative to stock markets.

Futures can be used either to hedge or to speculate on the price movement of the

23
underlying asset. For example, a producer of corn could use futures to lock in a certain
price and reduce risk (hedge). On the other hand, anybody could speculate on the price
movement of corn by going long or short using futures. The primary difference between
options and futures is that options give the holder the right to buy or sell the underlying
asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of
his/her contract.

Currency Futures
Currency futures were first introduced in the international money market in Chicago, USA
in the year 1972. In real life, the actual delivery rate of the underlying goods specified in
futures contracts is very low. This is a result of the fact that the hedging or
speculating benefits of the contracts can be had largely without actually holding the
contract until expiry and delivering the good(s). For example, if you were long in a futures
contract, you could go short in the same type of contract to offset your position. This serves
to exit your position, much like selling a stock in the equity markets would close a trade.

Currency futures are futures markets where the underlying commodity is a currency
exchange rate, such as the Euro to US Dollar exchange rate, or the British Pound to US
Dollar exchange rate. Currency futures are essentially the same as all other futures markets
(index and commodity futures markets), and are traded in exactly the same way.

Futures based upon currencies are similar to the actual currency markets (often known as
Forex), but there are some significant differences. For example, currency futures are traded
via exchanges, such as the CME (Chicago Mercantile Exchange), but the currency markets
are traded via currency brokers, and are therefore not as controlled as the currency futures.
Some day traders prefer the currency markets, and some day traders prefer the currency
futures. I recommend the currency futures as they do not suffer from some of the problems
that currency markets suffer from, such as currency brokers trading against their clients,
and non centralized pricing.

Bond futures

Stock index futures

Settlement and Delivery

As currency futures are based upon the exchange rates of two currencies, they are settled in
cash, in the underlying currency. For example, the EUR futures market is based upon the
Euro to US Dollar exchange rate, and has the Euro as its underlying currency. When a EUR
futures contract expires, the holder receives delivery of $125,000 worth of Euros in cash.
Note that this only happens when the contract expires, and as day traders do not usually
hold futures contracts until they expire, they should not be involved in the settlement, and
will not receive delivery of the underlying currency.

Popular Currency Futures

24
Many of the most popular futures markets that are based upon currencies are offered by the
CME (Chicago Mercantile Exchange), including the following :

• EUR - The Euro to US Dollar currency future

• GBP - The British Pound to US Dollar currency future
• CHF - The Swiss Franc to US Dollar currency future
• AUD - The Australian Dollar to US Dollar currency future
• CAD - The Canadian Dollar to US Dollar currency future
• RP - The Euro to British Pound currency future
• RF - The Euro to Swiss Franc currency future

Futures contracts are now traded very actively all over the world. The two largest futures
exchanges in the United States are the Chicago Board of Trade (CBOT) and the Chicago
Mercantile Exchange (CME). The two largest exchanges in Europe are the London
International Financial Futures and Options Exchange and Eurex.

Example:-We examine how a futures contract comes into existence by considering the
corn futures contract traded on the Chicago Board of Trade (CBOT). On March 5, an
investor in New York might call a broker with instructions to buy 5,000 bushels of corn for
delivery in July of the same year. The broker would immediately pass these instructions on
to a trader on the floor of the CBOT. The broker would request a long position in one
contract because each corn contract on the CBOT is for the delivery of exactly 5,000
bushels. At about the same time, another investor in Kansas might instruct a broker to sell
5,000 bushels of corn for July delivery. This broker would then pass instructions to short
one contract to a trader on the floor of the CBOT. The two floor traders would meet, agree
on a price to be paid for the corn in July, and the deal would be done.
The investor in New York who agreed to buy has a long futures position in one contract;
the investor in Kansas who agreed to sell has a short futures position in one contract. The
price agreed to on the floor of the exchange is the current futures price for July corn. We
will suppose the price is 170 cents per bushel. This price, like any other price, is
determined by the laws of supply and demand. If at a particular time more traders wish to
sell July corn than buy July corn, the price will go down. New buyers then enter the market
so that a balance between buyers and sellers is maintained. If more traders wish to buy July
corn than to sell July corn, the price goes up. New sellers then enter the market and a
balance between buyers and sellers is maintained.

THE SPECIFICATION OF THE FUTURES CONTRACT

When developing a new contract, the exchange must specify in some detail the exact nature
of the agreement between the two parties. In particular, it must specify the asset, the
contract size (exactly how much of the asset will be delivered under one contract), where
delivery will be made, and when delivery will be made. Sometimes alternatives are
specified for the grade of the asset that will be delivered or for the delivery locations. As a
general rule, it is the party with the short position (the party that has agreed to sell the asset)

25
that chooses what will happen when alternatives are specified by the exchange. When the
party with the short position is ready to deliver, it files a notice of intention to deliver with
the exchange. This notice indicates selections it has made with respect to the grade of asset
that will be delivered and the delivery location.

The Contract Size

The contract size specifies the amount of the asset that has to be delivered under one
contract. This is an important decision for the exchange. If the contract size is too large,
many investors who wish to hedge relatively small exposures or who wish to take relatively
small speculative positions will be unable to use the exchange. On the other hand, if the
contract size is too small, trading may be expensive as there is a cost associated with each
contract traded.

Delivery Arrangements
The place where delivery will be made must be specified by the exchange. This is
particularly important for commodities that involve significant transportation costs.

Delivery Months
A futures contract is referred to by its delivery month. The exchange must specify the
precise period during the month when delivery can be made. For many futures contracts,
the delivery period is the whole month. The delivery months vary from contract to contract
and are chosen by the exchange to meet the needs of market participants. For example, the
main delivery months for currency futures on the Chicago Mercantile Exchange are March,
June, September, and December; corn futures traded on the Chicago Board of Trade have
delivery months of January, March, May, July, September, November, and December. At
any given time, contracts trade for the closest delivery month and a number of subsequent
delivery months. The exchange specifies when trading in a particular month's contract will
begin. The exchange also specifies the last day on which trading can take place for a given
contract. Trading generally ceases a few days before the last day on which delivery can be
made.

Daily Price Movement Limits

For most contracts, daily price movement limits are specified by the exchange. If the price
moves down by an amount equal to the daily price limit, the contract is said to be limit
down. If it moves up by the limit, it is said to be limit up. A limit move is a move in either
direction equal to the daily price limit. Normally, trading ceases for the day once the
contract is limit up or limit down. However, in some instances the exchange has the
authority to step in and change the limits. The purpose of daily price limits is to prevent
large price movements from occurring because of speculative excesses. However, limits
can become an artificial barrier to trading when the price of the underlying commodity is
increasing or decreasing rapidly. Whether price limits are, on balance, good for futures
markets is controversial.

Position Limits
Position limits are the maximum number of contracts that a speculator may hold. The
purpose of the limits is to prevent speculators from exercising undue influence on the
market.

26
CONVERGENCE OF FUTURES PRICE TO SPOT PRICE
As the delivery month of a futures contract is approached, the futures price converges to
the spot price of the underlying asset. When the delivery period is reached, the futures price
equals—or is very close to—the spot price. To see why this is so, we first suppose that the
futures price is above the spot price during the delivery period. Traders then have a clear
arbitrage opportunity:
1. Short a futures contract.
2. Buy the asset.
3. Make delivery.
These steps are certain to lead to a profit equal to the amount by which the futures price
exceeds the spot price. As traders exploit this arbitrage opportunity, the futures price will
fall. Suppose next that the futures price is below the spot price during the delivery period.
Companies interested in acquiring the asset will find it attractive to enter into a long futures
contract and then wait for delivery to be made. As they do so, the futures price will tend to
rise. The result is that the futures price is very close to the spot price during the delivery
period. The figure illustrates the convergence of the futures price to the spot price. The first
curve, futures price is above the spot price prior to the delivery month, and in the second
curve the futures price is below the spot price prior to the delivery month.

OPERATION OF MARGINS
If two investors get in touch with each other directly and agree to trade an asset in the
future for a certain price, there are obvious risks. One of the investors may regret the deal
and try to back out. Alternatively, the investor simply may not have the financial resources
to honor the agreement. One of the key roles of the exchange is to organize trading so that
contract defaults are avoided. This is where margins come in. The investor is entitled to
withdraw any balance in the margin account in excess of the initial margin. To ensure that
the balance in the margin account never becomes negative a maintenance margin, which is
somewhat lower than the initial margin, is set. If the balance in the margin account falls
below the maintenance margin, the investor receives a margin call and is expected to top
up the margin account to the initial margin level the next day. The extra funds deposited are
known as a variation margin. If the investor does not provide the variation margin, the
broker closes out the position by selling the contract.

KEYNES AND HICKS

27
We refer to the market's average opinion about what the future price of an asset will be at a
certain future time as the expected future price of the asset at that time. Suppose that it is
now June and the September futures price of corn is Rs. 200 It is interesting to ask what the
expected future price of corn is in September. Is it less that Rs. 200 , greater than Rs. 200,
or exactly equal to Rs. 200 ? If the expected future spot price is less than Rs. 200, the
market must be expecting the September futures price to decline so that traders with short
positions gain and traders with long positions lose. If the expected future price is greater
than Rs. 200 the reverse must be true. The market must be expecting the September futures
price to increase so that traders with long positions gain while those with short positions
lose. Economists John Maynard Keynes and John Hicks argued that if hedgers tend to hold
short positions and speculators tend to hold long positions, the futures price of an asset will
be below its expected future spot price. This is because speculators require compensation
for the risks they are bearing. They will trade only if they can expect to make money on
average. Hedgers will lose money on average, but they are likely to be prepared to accept
this because the futures contract reduces their risks. If hedgers tend to hold long positions
while speculators hold short positions, Keynes and Hicks argued that the futures price will
be above the expected future spot price for a similar reason.
When the futures price is below the expected future spot price, the situation is known as
normal backwardation; when the futures price is above the expected future spot price, the
situation is known as contango.

DELIVERY
Very few of the futures contracts that are entered into lead to delivery of the underlying
asset. Most are closed out early. Nevertheless, it is the possibility of eventual delivery that
determines the futures price. An understanding of delivery procedures is therefore
important. The period during which delivery can be made is defined by the exchange and
varies from contract to contract. The decision on when to deliver is made by the party with
the short position, whom we shall refer to as investor A. When investor A decides to
deliver, investor A's broker issues a notice of intention to deliver to the exchange
clearinghouse. This notice states how many contracts will be delivered and, in the case of
commodities, also specifies where delivery will be made and what grade will be delivered.
The exchange then chooses a party with a long position to accept delivery.

Cash Settlement
Some financial futures, such as those on stock indices, are settled in cash because it is
inconvenient or impossible to deliver the underlying asset. In the case of the futures
contract on the S&P 500, for example, delivering the underlying asset would involve
delivering a portfolio of 500 stocks. When a contract is settled in cash, it is simply marked
to market on the last trading day, and all positions are declared closed. To ensure that the
futures price converges to the spot price, the settlement price on the last trading day is set
equal to the spot price of the underlying asset at either the opening or close of trading on
that day. For example, in the S&P 500 futures contract trading on the Chicago Mercantile
Exchange final settlement is based on the opening price of the index on the third Friday of
the delivery month.

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Forwards
VALUING FORWARD CONTRACTS
The value of a forward contract at the time it is first entered into is zero. At a later stage it
may prove to have a positive or negative value. Using the notation introduced earlier, we
suppose Fo is the current forward price for contract that was negotiated some time ago, the
delivery date is in T years, and r is the 7-year risk-free interest rate. We also define:

K: Delivery price in the contract

/: Value of a long forward contract today
A general result, applicable to all forward contracts (both those on investment assets and
those on consumption assets), is

f = (F0- K)e~rT

COST OF CARRY
The relationship between futures prices and spot prices can be summarized in terms of the
cost of carry. This measures the storage cost plus the interest that is paid to finance the
asset less the income earned on the asset. For a non-dividend-paying stock, the cost of carry
is r, because there are no storage costs and no income is earned; for a stock index, it is r —
q, because income is earned at rate q on the asset. For a currency, it is r — rf\ for a
commodity with storage costs that are a proportion u of the price, it is r + u; and so on.
Define the cost of carry as c. For an investment asset, the futures price is
Fo = SoecT
For a consumption asset, it is
Fo = Soe{c-y)T
where y is the convenience yield.

SHORT SELLING
Some of the arbitrage strategies presented in this chapter involve short selling. This trade,
usually simply referred to as "shorting", involves selling an asset that is not owned. It is
something that is possible for some—but not all—investment assets. We will illustrate how
it works by considering a short sale of shares of a stock. Suppose an investor instructs a
broker to short 500 IBM shares. The broker will carry out the instructions by borrowing the
shares from another client and selling them in the market in the usual way. The investor can
maintain the short position for as long as desired, provided there are always shares for the
broker to borrow. At some stage, however, the investor will close out the position by
purchasing 500 IBM shares. These are then replaced in the account of the client from
whom the shares were borrowed. The investor takes a profit if the stock price has declined
and a loss if it has risen. If, at any time while the contract is open, the broker runs out of
shares to borrow, the investor is short-squeezed and is forced to close out the position
immediately even if not ready to do so. An investor with a short position must pay to the
broker any income, such as dividends or interest, that would normally be received on the
securities that have been shorted. The broker will transfer this to the account of the client
from whom the securities have been borrowed.

29
Risk and Return
Another explanation of the relationship between futures prices and expected future spot
prices can be obtained by considering the relationship between risk and expected return in
the economy. In general, the higher the risk of an investment, the higher the expected
return demanded by an investor. Readers familiar with the capital asset pricing model will
know that there are two types of risk in the economy: systematic and nonsystematic.
Nonsystematic risk should not be important to an investor. It can be almost completely
eliminated by holding a well-diversified portfolio. An investor should not therefore require
a higher expected return for bearing nonsystematic risk. Systematic risk, by contrast,
cannot be diversified away. It arises from a correlation between returns from the
investment and returns from the stock market as a whole. An investor generally requires a
higher expected return than the risk-free interest rate for bearing positive amounts of
systematic risk. Also, an investor is prepared to accept a lower expected return than the
risk-free interest rate when the systematic risk in an investment is negative.

Options

Options strategies
An option strategy is implemented by combining one or more option positions and
possibly an underlying stock position. Options are financial instruments that give the buyer
the right to buy (for a call option) or sell (for a put option) the underlying security at some
specific point of time in the future (European Option) or until some specific point of time
in the future (American Option) for a price (strike price), which is fixed in advance (when
the option is bought).

Calls increase in value as the underlying stock increases in value. Likewise puts increase in
value as the underlying stock decreases in value. Buying both a call and a put means that if
the underlying stock moves up the call increases in value and likewise if the underlying
stock moves down the put increases in value. The combined position can increase in value
if the stock moves significantly in either direction. (The position loses money if the stock
stays at the same price or within a range of the price when the position was established.)
This strategy is called a straddle. It is one of many options strategies that investors can
employ.

Options strategies can favor movements in the underlying stock that are bullish, bearish or
neutral. In the case of neutral strategies, they can be further classified into those that are
bullish on volatility and those that are bearish on volatility. The option positions used can
be long and/or short positions in calls and/or puts at various strikes.

Bullish strategies

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Bullish options strategies are employed when the options trader expects the underlying
stock price to move upwards. It is necessary to assess how high the stock price can go and
the time frame in which the rally will occur in order to select the optimum trading strategy.

The most bullish of options trading strategies is the simple call buying strategy used by
most novice options traders.

Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a
target price for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk
because the options can still expire worthless.) While maximum profit is capped for these
strategies, they usually cost less to employ for a given nominal amount of exposure. The
bull call spread and the bull put spread are common examples of moderately bullish
strategies.

Mildly bullish trading strategies are options strategies that make money as long as the
underlying stock price does not go down by the option's expiration date. These strategies
may provide a small downside protection as well. Writing out-of-the-money covered calls
is a good example of such a strategy.

Bearish strategies
Bearish options strategies are the mirror image of bullish strategies. They are employed
when the options trader expects the underlying stock price to move downwards. It is
necessary to assess how low the stock price can go and the time frame in which the decline
will happen in order to select the optimum trading strategy.

The most bearish of options trading strategies is the simple put buying strategy utilised by
most novice options traders.

Stock prices only occasionally make steep downward moves. Moderately bearish options
traders usually set a target price for the expected decline and utilise bear spreads to reduce
cost. While maximum profit is capped for these strategies, they usually cost less to employ.
The bear call spread and the bear put spread are common examples of moderately bearish
strategies.

Mildly bearish trading strategies are options strategies that make money as long as the
underlying stock price does not go up by the options expiration date. These strategies may
provide a small upside protection as well.

Straddle
An options strategy with which the investor holds a position in both a call and put with the
same strike price and expiration date.
Straddles are a good strategy to pursue if an investor believes that a stock's price will move
significantly, but is unsure as to which direction. The stock price must move significantly if
the investor is to make a profit. As shown in the diagram above, should only a small
movement in price occur in either direction, the investor will experience a loss. As a result,

31
a straddle is extremely risky to perform. Additionally, on stocks that are expected to jump,
the market tends to price options at a higher premium, which ultimately reduces the
expected payoff should the stock move significantly.

Strangle
An options strategy where the investor holds a position in both a call and put with different
strike prices but with the same maturity and underlying asset. This option strategy is
profitable only if there are large movements in the price of the underlying asset.
This is a good strategy if you think there will be a large price movement in the near future
but are unsure of which way that price movement will be.
The strategy involves buying an out-of-the-money call and an out-of-the-money put option.
A strangle is generally less expensive than a straddle as the contracts are purchased out of
the money.

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Box Spread
The box spread is a strategy that comes into play in the practice of options trading. The
idea behind a box spread is to create a situation in which there is zero risk in regard to the
payoff of the actions taken in the strategy. This essentially involves creating a chain of
events that results in a no arbitrage assumption. The total of the net premium used in the
acquisition process is to be equal to the present value of the payoff on the transaction.

Box spreads make use of a series of puts and calls to obtain the desired result. Within the
context of this strategy, the investor may choose to follow a bull spread with a bear spread
in order to create the desired balance between premium and payoff. The bull spread may
involve a long call option coupled with a short call option that is then followed by a bear
spread that involves a long put option and a short put option. This series of transactions,
when diagrammed, can easily be demonstrated in the form of a rectangular box, resulting in
naming the procedure a box spread.

Several factors can determine if a box spread is a feasible option for the investor. The
condition of arbitrages plays a central role, since the balance of the results is directly
impacted. Executing the puts and calls properly will also make a big difference to the
success of the strategy. Choosing to short the wrong call, for example, will throw the entire

33
equation out of line, and not result in the balance between the net premium and the present
value that was hoped for.

It is possible to create two different variations of the box spread. The long box spread will
involve the utilization of four options, generally with the same underlying asset and the
same terminal or payoff date. This is different from the short box spread, which will
usually involve two options. In both instances, the same basic combination of puts and calls
is used.

Butterfly spread
The butterfly spread is an options spread that is geared toward incurring only a limited
amount of risk, while having the potential to provide a small amount of profit from the
strategy. Essentially, the butterfly spread involves combining a bear spread with a bull
spread, and requires following a strict process in order to maximize the chance for making
a profit and still manage to limit risk.

The actual process of executing a butterfly spread involves three different strike prices
coupled with two lower transactions being part of the bull spread component and two
higher transactions arranged in a bear spread. The trades can be arranged in various
combinations of puts and calls, depending on the circumstances and the exact configuration
that is anticipated to have the best chance of realizing a profit. Most analysts agree that
there are four combinations of puts and calls that will result in a butterfly spread.

One basic requirement of the butterfly spread is to arrange the buying and selling so that
they involve a range of markets and several different expiration dates. Two of the options
should have a higher strike price. Executing the bull and bear spreads to accomplish the
butterfly spread is done with the hope that the underlying stock price will remain stable, as
this will result in a modest profit from the premium income that is realized on the
combination of the options.

While it is important to note that the butterfly spread is designed to be a relatively safe
investment tactic, there is some potential for loss. However, if the procedure is followed
closely, and the right combination of securities is utilized in the butterfly spread, the
chances for creating a small profit are very good. As an investment strategy for persons
who tend to be somewhat conservative with investing, but do want to make some attempt
to try something a little different, the butterfly spread is an excellent choice.

Swaps
A swap is an agreement between two companies to exchange cash flows in the future. The
agreement defines the dates when the cash flows are to be paid and the way in which they
are to be calculated. Usually the calculation of the cash flows involves the future values of

34
one or more market variables. A forward contract can be viewed as a simple example of a
swap. Suppose it is March 1, 2002, and a company enters into a forward contract to buy
100 ounces of gold for $300 per ounce in one year. The company can sell the gold in one
year as soon as it is received. The forward contract is therefore equivalent to a swap where
the company agrees that on March 1, 2003, it will pay $30,000 and receive 1005, where S
is the market price of one ounce of gold on that date. Whereas a forward contract leads to
the exchange of cash flows on just one future date, swaps typically lead to cash flow
exchanges taking place on several future dates. The first swap contracts were negotiated in
the early 1980s. Since then the market has seen phenomenal growth. In this chapter we
examine how swaps are designed, how they are used, and how they can be valued. Our
discussion centers on the two popular types of swaps: plain vanilla interest rate swaps and
fixed for- fixed currency swaps.

Types
Being OTC instruments interest rate swaps can come in a huge number of varieties and can
be structured to meet the specific needs of the counterparties. By far the most common are
fixed-for-fixed, fixed-for-floating or floating-for-floating. The legs of the swap can be in
the same currency or in different currencies. (A single-currency fixed-for-fixed rate swap is
generally not possible; since the entire cash-flow stream can be predicted at the outset there
would be no reason to maintain a swap contract as the two parties could just settle for the
difference between the present values of the two fixed streams; the only exceptions would
be where the notional amount on one leg is uncertain or other esoteric uncertainty is
introduced).

Fixed-for-floating rate swap, same currency

Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency A

indexed to X on a notional N for a term of T years. For example, you pay fixed 5.32%
monthly to receive USD 1M Libor monthly on a notional USD 1 million for 3 years. The
party that pays fixed and receives floating coupon rates is said to be long the interest swap.
Interest rate swaps are simply the exchange of one set of cash flows for another.

Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to
a floating rate asset/liability or vice versa. For example, if a company has a fixed rate USD
10 million loan at 5.3% paid monthly and a floating rate investment of USD 10 million that
returns USD 1M Libor +25 bps monthly, it may enter into a fixed-for-floating swap. In this
swap, the company would pay a floating USD 1M Libor+25 bps and receive a 5.5% fixed
rate, locking in 20bps profit.

Fixed-for-floating rate swap, different currencies

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Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B
indexed to X on a notional N at an initial exchange rate of FX for a tenure of T years. For
example, you pay fixed 5.32% on the USD notional 10 million quarterly to receive JPY 3M
(TIBOR) monthly on a JPY notional 1.2 billion (at an initial exchange rate of USD/JPY
120) for 3 years. For nondeliverable swaps, the USD equivalent of JPY interest will be
paid/received (according to the FX rate on the FX fixing date for the interest payment day).
No initial exchange of the notional amount occurs unless the Fx fixing date and the swap
start date fall in the future.

Fixed-for-floating swaps in different currencies are used to convert a fixed rate

asset/liability in one currency to a floating rate asset/liability in a different currency, or vice
versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid
monthly and a floating rate investment of JPY 1.2 billion that returns JPY 1M Libor +50
bps monthly, and wants to lock in the profit in USD as they expect the JPY 1M Libor to go
down or USDJPY to go up (JPY depreciate against USD), then they may enter into a
Fixed-Floating swap in different currency where the company pays floating JPY 1M
Libor+50 bps and receives 5.6% fixed rate, locking in 30bps profit against the interest rate
and the fx exposure.

Floating-for-floating rate swap, same currency

Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating

rate in currency A indexed to Y on a notional N for a tenure of T years. For example, you
pay JPY 1M LIBOR monthly to receive JPY 1M TIBOR monthly on a notional JPY 1
billion for 3 years.

Floating-for-floating rate swaps are used to hedge against or speculate on the spread
between the two indexes widening or narrowing. For example, if a company has a floating
rate loan at JPY 1M LIBOR and the company has an investment that returns JPY 1M
TIBOR + 30 bps and currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the
moment, this company has a net profit of 40 bps. If the company thinks JPY 1M TIBOR is
going to come down (relative to the LIBOR) or JPY 1M LIBOR is going to increase in the
future (relative to the TIBOR) and wants to insulate from this risk, they can enter into a
float-float swap in same currency where they pay, say, JPY TIBOR + 30 bps and receive
JPY LIBOR + 35 bps. With this, they have effectively locked in a 35 bps profit instead of
running with a current 40 bps gain and index risk. The 5 bps difference (w.r.t. the current
rate difference) comes from the swap cost which includes the market expectations of the
future rate difference between these two indices and the bid/offer spread which is the swap
commission for the swap dealer.

Floating-for-floating rate swap, different currencies

Party P pays/receives floating interest in currency A indexed to X to receive/pay floating

rate in currency B indexed to Y on a notional N at an initial exchange rate of FX for a
tenure of T years. For example, you pay floating USD 1M LIBOR on the USD notional 10

36
million quarterly to receive JPY 3M TIBOR monthly on a JPY notional 1.2 billion (at an
initial exchange rate of USDJPY 120) for 4 years.

To explain the use of this type of swap, consider a US company operating in Japan. To
fund their Japanese growth, they need JPY 10 billion. The easiest option for the company is
to issue debt in Japan. As the company might be new in the Japanese market without a well
known reputation among the Japanese investors, this can be an expensive option. Added on
top of this, the company might not have appropriate debt issuance program in Japan and
they might lack sophisticated treasury operation in Japan. To overcome the above
problems, it can issue USD debt and convert to JPY in the FX market. Although this option
solves the first problem, it introduces two new risks to the company:

• FX risk. If this USDJPY spot goes up at the maturity of the debt, then when the
company converts the JPY to USD to pay back its matured debt, it receives less
USD and suffers a loss.
• USD and JPY interest rate risk. If the JPY rates come down, the return on the
investment in Japan might go down and this introduces an interest rate risk
component.

Fixed-for-fixed rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B

for a term of T years. For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and
receive USD 5.36% on the USD equivalent notional of 10 million at an initial exchange
rate of USDJPY 120.

Valuation and pricing

The present value of a plain vanilla (i.e. fixed rate for floating rate) swap can easily be
computed using standard methods of determining the present value (PV) of the fixed leg
and the floating leg.

The value of the fixed leg is given by the present value of the fixed coupon payments
known at the start of the swap, i.e.

where C is the swap rate, M is the number of fixed payments, P is the notional amount, ti is
the number of days in period i, Ti is the basis according to the day count convention and dfi
is the discount factor.

37
Similarly, the value of the floating leg is given by the present value of the floating coupon
payments determined at the agreed dates of each payment. However, at the start of the
swap, only the actual payment rates of the fixed leg are known in the future, whereas the
forward rates (derived from the yield curve) are used to approximate the floating rates.
Each variable rate payment is calculated based on the forward rate for each respective
payment date. Using these interest rates leads to a series of cash flows. Each cash flow is
discounted by the zero-coupon rate for the date of the payment; this is also sourced from
the yield curve data available from the market. Zero-coupon rates are used because these
rates are for bonds which pay only one cash flow. The interest rate swap is therefore treated
like a series of zero-coupon bonds. Thus, the value of the floating leg is given by the
following:

where N is the number of floating payments, fj is the forward rate, P is the notional amount,
tj is the number of days in period j, Tj is the basis according to the day count convention
and dfj is the discount factor. The discount factor always starts with 1. The discount factor
is found as follows:

[Discount factor in the previous period]/[1 + (Forward rate of the floating

underlying asset in the previous period × Number of days in period/360)].

(Depending on the currency, the denominator is 365 instead of 360; e.g. for GBP.)

The fixed rate offered in the swap is the rate which values the fixed rates payments at the
same PV as the variable rate payments using today's forward rates, i.e.:

Therefore, at the time the contract is entered into, there is no advantage to either party, i.e.,

Thus, the swap requires no upfront payment from either party.

During the life of the swap, the same valuation technique is used, but since, over time, the
forward rates change, the PV of the variable-rate part of the swap will deviate from the
unchangeable fixed-rate side of the swap. Therefore, the swap will be an asset to one party
and a liability to the other. The way these changes in value are reported is the subject of

38
IAS 39 for jurisdictions following IFRS, and FAS 133 for U.S. GAAP. Swaps are marked
to market by debt security traders to visualize their inventory at a certain time.

Risks
Interest rate swaps expose users to interest rate risk and credit risk.

• Interest rate risk originates from changes in the floating rate. In a plain vanilla
fixed-for-floating swap, the party who pays the floating rate benefits when rates
fall. (Note that the party that pays floating has an interest rate exposure analogous to
a long bond position.)

• Credit risk on the swap comes into play if the swap is in the money or not. If one of
the parties is in the money, then that party faces credit risk of possible default by
another party. This is not true with FTSE MTIRS Index

MECHANICS OF INTEREST RATE SWAPS

The most common type of swap is a "plain vanilla" interest rate swap. In this, a company
agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional
principal for a number of years. In return, it receives interest at a floating rate on the same
notional principal for the same period of time. The floating rate in many interest rate swap
agreements is the London Interbank Offer Rate (LIBOR). This was introduced in Chapter
5. LIBOR is the rate of interest offered by banks on deposits from other banks in
Eurocurrency markets. One-month LIBOR is the rate offered on one month deposits, three-
month LIBOR is the rate offered on three-month deposits, and so on. LIBOR rates are
determined by trading between banks and change frequently so that the supply of funds in
the interbank market equals the demand for funds in that market. Just as prime is often the
reference rate of interest for floating-rate loans in the domestic financial market, LIBOR is
a reference rate of interest for loans in international financial markets. To understand how it
is used, consider a five-year loan with a rate of interest specified as six-month LIBOR plus
0.5% per annum. The life of the loan is divided into ten periods, each six months in length.
For each period the rate of interest is set at 0.5% per annum above the six-month LIBOR
rate at the beginning of the period. Interest is paid at the end of the period.

Valuation of options price

Black scholes model
In the early 1970s, Fischer Black, Myron Scholes, and Robert Merton made a major
breakthrough in the pricing of stock options. This involved the development of what has

39
become known as the Black-Scholes model. The model has had a huge influence on the
way that traders price and hedge options. It has also been pivotal to the growth and success
of financial engineering in the 1980s and 1990s. In 1997, the importance of the model was
recognized when Robert Merton and Myron Scholes were awarded the Nobel prize for
economics.

In order to understand the model itself, we divide it into two parts. The first part, SN(d1),
derives the expected benefit from acquiring a stock outright. This is found by multiplying
stock price [S] by the change in the call premium with respect to a change in the underlying
stock price [N(d1)]. The second part of the model, Ke(-rt)N(d2), gives the present value of
paying the exercise price on the expiration day. The fair market value of the call option is
then calculated by taking the difference between these two parts.

Assumptions of the Black and Scholes Model:

1) The stock pays no dividends during the option's life

Most companies pay dividends to their share holders, so this might seem a serious
limitation to the model considering the observation that higher dividend yields elicit lower
call premiums. A common way of adjusting the model for this situation is to subtract the
discounted value of a future dividend from the stock price.

40
2) European exercise terms are used
European exercise terms dictate that the option can only be exercised on the expiration
date. American exercise term allow the option to be exercised at any time during the life of
the option, making american options more valuable due to their greater flexibility. This
limitation is not a major concern because very few calls are ever exercised before the last
few days of their life. This is true because when you exercise a call early, you forfeit the
remaining time value on the call and collect the intrinsic value. Towards the end of the life
of a call, the remaining time value is very small, but the intrinsic value is the same.

3) Markets are efficient

This assumption suggests that people cannot consistently predict the direction of the market
or an individual stock. The market operates continuously with share prices following a
continuous Itô process. To understand what a continuous Itô process is, you must first
know that a Markov process is "one where the observation in time period t depends only on
the preceding observation." An Itô process is simply a Markov process in continuous time.
If you were to draw a continuous process you would do so without picking the pen up from
the piece of paper.

4) No commissions are charged

Usually market participants do have to pay a commission to buy or sell options. Even floor
traders pay some kind of fee, but it is usually very small. The fees that Individual investor's
pay is more substantial and can often distort the output of the model.

5) Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent this constant and known
rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S.
Government Treasury Bills with 30 days left until maturity is usually used to represent it.
During periods of rapidly changing interest rates, these 30 day rates are often subject to
change, thereby violating one of the assumptions of the model.

6) Returns are log normally distributed

This assumption suggests, returns on the underlying stock are normally distributed, which
is reasonable for most assets that offer options.

Delta:

Delta is a measure of the sensitivity the calculated option value has to small changes in the
share price.

Gamma:

Gamma is a measure of the calculated delta's sensitivity to small changes in share price.

41
Theta:

Theta measures the calcualted option value's sensitivity to small changes in time till
maturity.

Vega:

Vega measures the calculated option value's sensitivity to small changes in volatility.

Rho:

This following graphs show the relationship between a call's premium and the underlying
stock's price.

The first graph identifies the Intrinsic Value, Speculative Value, Maximum Value, and the
Actual premium for a call.

Binary model

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A useful and very popular technique for pricing a stock option involves constructing a
binomial tree. This is a diagram that represents different possible paths that might be
followed by the stock price over the life of the option.

Risk Management Tools

Derivatives are powerful risk management tools. To illustrate, lets take the example of an
investor who holds the stocks of Infosys, which are currently trading at Rs 2,096.
Infosys options are traded on the National Stock Exchange of India, which gives the owner
the right to buy (call) shares of Infosys at Rs 2,220 each (exercise price), expiring on 30th
June 2005. Now if the share price of Infosys remains less than or equal to Rs 2,200, the
contract would be worthless for the owner and he would lose the money he paid to buy the
option, known as premium.
However, the premium is the maximum amount that the owner of the contract can lose.
Hence he has limited his loss. On the other hand, if the share price of Infosys goes above
Rs 2,220, the owner of the call option can exercise the contract, buy the share at Rs 2,220
and make profits by selling the share at the market price of Infosys. The upward gain can
be unlimited. Say the share price of Infosys zooms to Rs .3,000 by June 2005, the owner of
the call option can buy the shares at Rs 2,220, the exercise price of the option, and then sell
it in the market for Rs 3,000. Making a profit of Rs 780 less the premium that has been
paid. If the premium paid to buy the call option is say Rs 10, the profit would be Rs 770.

Counter-party risk

Derivatives (especially swaps) expose investors to counter-party risk.

For example, suppose a person wanting a fixed interest rate loan for his business, but
finding that banks only offer variable rates, swaps payments with another business who
wants a variable rate, synthetically creating a fixed rate for the person. However if the
second business goes bankrupt, it can't pay its variable rate and so the first business will
lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it
is possible that the first business may be adversely affected, because it may not be prepared
to pay the higher variable rate.

Different types of derivatives have different levels of risk for this effect. For example,
standardized stock options by law require the party at risk to have a certain amount
deposited with the exchange, showing that they can pay for any losses; Banks who help
businesses swap variable for fixed rates on loans may do credit checks on both parties.
However in private agreements between two companies, for example, there may not be
benchmarks for performing due diligence and risk analysis.

Unsuitably high risk for small/inexperienced investors

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Derivatives pose unsuitably high amounts of risk for small or inexperienced investors.
Because derivatives offer the possibility of large rewards, they offer an attraction even to
individual investors. However, speculation in derivatives often assumes a great deal of risk,
requiring commensurate experience and market knowledge, especially for the small
investor, a reason why some financial planners advise against the use of these instruments.
Derivatives are complex instruments devised as a form of insurance, to transfer risk among
parties based on their willingness to assume additional risk, or hedge against it.

Add Moral Hazard spread over the risk.

Large notional value

• Derivatives typically have a large notional value. As such, there is the danger that
their use could result in losses that the investor would be unable to compensate for.
The possibility that this could lead to a chain reaction ensuing in an economic crisis,
has been pointed out by legendary investor Warren Buffett in Berkshire Hathaway's
annual report. Buffett called them 'financial weapons of mass destruction.' The
problem with derivatives is that they control an increasingly larger notional amount
of assets and this may lead to distortions in the real capital and equities markets.
Investors begin to look at the derivatives markets to make a decision to buy or sell
securities and so what was originally meant to be a market to transfer risk now
becomes a leading indicator.

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for
the underlying real economy to service its debt obligations and curtailing real economic
activity, which can cause a recession or even depression. In the view of Marriner S. Eccles,
U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level
of debt was one of the primary causes of the 1920s-30s Great Depression.

Benefits
Nevertheless, the use of derivatives also has its benefits:

• Derivatives facilitate the buying and selling of risk, and thus have a positive
impact on the economic system. Although someone loses money while someone
else gains money with a derivative, under normal circumstances, trading in
derivatives should not adversely affect the economic system because it is not zero
sum in utility.
• Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that
he believed that the use of derivatives has softened the impact of the economic
downturn at the beginning of the 21st century.

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Definitions
• Bilateral netting: A legally enforceable arrangement between a bank and a counter-
party that creates a single legal obligation covering all included individual
contracts. This means that a bank’s obligation, in the event of the default or
insolvency of one of the parties, would be the net sum of all positive and negative
fair values of contracts included in the bilateral netting arrangement.

• Credit derivative: A contract that transfers credit risk from a protection buyer to a
credit protection seller. Credit derivative products can take many forms, such as
credit default swaps, credit linked notes and total return swaps.

• Derivative: A financial contract whose value is derived from the performance of

assets, interest rates, currency exchange rates, or indexes. Derivative transactions
include a wide assortment of financial contracts including structured debt
obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and
various combinations thereof.

• Exchange-traded derivative contracts: Standardized derivative contracts (e.g.

futures contracts and options) that are transacted on an organized futures exchange.

• Gross negative fair value: The sum of the fair values of contracts where the bank
owes money to its counter-parties, without taking into account netting. This
represents the maximum losses the bank’s counter-parties would incur if the bank
defaults and there is no netting of contracts, and no bank collateral was held by the
counter-parties.

• Gross positive fair value: The sum total of the fair values of contracts where the
bank is owed money by its counter-parties, without taking into account netting. This
represents the maximum losses a bank could incur if all its counter-parties default
and there is no netting of contracts, and the bank holds no counter-party collateral.

• Lot size: Lot size refers to number of underlying securities in one

contract. The lot size is determined keeping in mind the minimum contract size
requirement at the time of introduction of derivative contracts on a particular
underlying.

For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum
contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be
200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

• High-risk mortgage securities: Securities where the price or expected average life is
highly sensitive to interest rate changes, as determined by the FFIEC policy
statement on high-risk mortgage securities.

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• Notional amount: The nominal or face amount that is used to calculate payments
made on swaps and other risk management products. This amount generally does
not change hands and is thus referred to as notional.

• Over-the-counter (OTC) derivative contracts : Privately negotiated derivative

contracts that are transacted off organized futures exchanges.

• Structured notes: Non-mortgage-backed debt securities, whose cash flow

characteristics depend on one or more indices and/or have embedded forwards or
options.

• Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists
of common shareholders equity, perpetual preferred shareholders equity with non-
cumulative dividends, retained earnings, and minority interests in the equity
accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt,
intermediate-term preferred stock, cumulative and long-term preferred stock, and a
portion of a bank’s allowance for loan and lease losses.

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