05-11-2020

Introduction to Derivatives

Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore

What is a Derivative Security?

• A Derivative Security is a security whose
value depends on the values of other, more basic
underlying variables.

Example:
• An Indian exporter is likely to receive USD 1000
after one month goes to a bank and contracts to
sell the USD money for Rs.61 per USD.
• This contract is an example of derivative
contract where the underlying is the foreign
currency (USD)

History of Derivatives
• 332 BC Greece: Thales of Miletus – first option idea
The earliest known options trade dates from 4th century BC. Thales of
Miletus speculated that the year's olive harvest would be especially
bountiful, and put a deposit on every olive press in his region of Greece.
This gave him the right to use the olive press if he wanted to after the
harvest. The harvest was huge, demand for olive presses skyrocketed, and
Thales sold his rights, or options, at substantial profit.

• 1636 : Options on Tulips

• 1859 CBOT: First agricultural derivatives contract

• The modern history of stock options trading begins with the 1973
establishment of the Chicago Board Options Exchange (CBOE) and the
development of the Black-Scholes option pricing model.

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Derivatives Markets
• Two types:
– Exchange traded and Over-the-counter (OTC)
• Exchange traded
– Exchanges mostly use electronic trading.
– Contracts are standard, virtually no credit risk
– Example: Futures, Options
• Over-the-counter (OTC)
– A computer- and telephone-linked network of dealers at
financial institutions, corporations, and fund managers
– Financial institutions often act as market makers.
– Contracts can be non-standard and there is some amount of
credit risk
– Example: Swaps, FRAs, Exotic options

Types of Derivatives
• Forward Contracts - OTC
• Futures Contracts – Exchange traded
• Swaps - OTC
• Options – Exchange traded / OTC

How are Derivatives Used?

• To hedge price risk and other risks
• To speculate with a view on the future direction
of the market price of a commodity or financial
instrument or even relative price of two
commodities or instruments
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment without
incurring the costs of selling one portfolio and
buying another

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Forward Contract
• A forward contract is an agreement to buy or
sell an asset at a certain future time for a certain
price.
• It can be contrasted with a spot contract, which
is an agreement to buy or sell an asset today.
• The contract is between two financial
institutions or between a financial institution
and one of its corporate clients.
• It is not traded on an exchange.
• Forward contracts are particularly popular on
currencies and interest rates.

Terminology
• Long position agrees to buy the underlying
asset on a certain specified future date for a
certain specified price.

• Short position is the other party and agrees to

sell that asset on same future date for the same
price.

• The specified price in a forward contract is

referred to as the delivery price.

Example of Forward Contract

• Suppose on April 01,2016 the treasurer of
an export company in India knows that it
will receive USD 1 million in 6
months (i.e. on October 01,2016) and
wants to become indifferent against
exchange rate moves.
– He can undertake currency forward contract
with a bank now to sell USD 1 million in 6
months at a particular INR/USD forward rate.
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Spot and Future Quotes for

INR/USD (Not Actual Values)
Bid Price Offer Price
Spot 61.85 62.10
6 month 62.80 63.15
Forward

• INR/USD means Rs. per USD

• Bid – price at which one market maker is prepared to buy
• Ask – price at which one market maker is prepared to sell
• These quotes are for inter-bank transactions, for retail investors spread
(difference between bid and ask) is more

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Payoffs From Long Forward

Contracts
Payoff from
Long Position

K
Price of Underlying
at Maturity, ST

The payoff from a long position in a forward contract on one

unit of an asset = ST – K (K = delivery price, ST = Price of
the underlying security at maturity )

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Payoffs From Short Forward

Contracts
Payoff from
Short Position

Price of Underlying
at Maturity, ST
K

The payoff from a short position in a forward contract on one

unit of an asset = K – ST (K = delivery price, ST = Price of the
underlying security at maturity )
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Futures Contract
• Agreement (obligation) to buy or sell
an asset for a certain price at a certain
time
• Similar to forward contract but futures
contracts are traded on an exchange

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Swaps
• A swap is an agreement to exchange cash flows
at specified future times according to certain
specified rules.

• Examples: Interest rate swap, currency swap etc.

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Options
• A call option is an option to buy a certain
asset by a certain date for a certain price.
• A put option is an option to sell a certain
asset by a certain date for a certain price.

• The price of the contract is known as

strike price/exercise price.
• The date in the contract is known as
expiration date/maturity.
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Options – contd.
• An American option can be exercised at any
time during its life.
• An European option can be exercised only at
maturity.
–The terms American or European do not refer to the
location of the option.

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Payoff Diagram – Long Call

Payoff from
Long Call

K ST
-C

The payoff from a long position in a call option

= Max (ST – K, 0) (K = Strike price, ST = Price of the
underlying security at maturity, C = Call option premium )

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Payoff Diagram – Short Call

Payoff from
Short Call

C
K ST

The payoff from a short position in a call option

= – Max (ST – K, 0) = Min (K - ST, 0) (K = Strike price, ST =
Price of the underlying security at maturity, C = Call option
premium )

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Payoff Diagram – Long Put

Payoff from
Long Put

K
ST
-P

The payoff from a long position in a put option

= Max (K – ST, 0) (K = Strike price, ST = Price of the
underlying security at maturity, P = Put option premium )

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Payoff Diagram – Short Put

Payoff from
Short Put

P
K ST

The payoff from a short position in a put option

= – Max (K – ST, 0) = Min (ST – K, 0) (K = Strike price, ST =
Price of the underlying security at maturity, P = Put option
premium )

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Types of Traders
• Hedgers
• Speculators
• Arbitrageurs

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Hedging
• Hedgers are essentially spot market players.

• Hedgers are interested in reducing price risk (that they already

face in the spot market) with derivative contracts and options.

• Forward contracts are designed to neutralize risk by fixing the price

that hedger will pay or receive for the underlying asset.

• Future contracts can be used to undertake minimum variation

hedging.

• Option strategy enables the hedger to insure itself against adverse

exchange rate movements while still benefiting from favorable
movements.

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Speculation
• Speculators wish to take a position in the
market either by betting that the price will go
up or down.

• Futures and options can be used for speculation

• When a speculator uses futures then the

potential gain or loss is high.

• When a speculator uses options, speculator’s

loss is limited to the amount paid for the option.

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Arbitrageurs
• Arbitrage involves locking in a riskless profit by
simultaneously entering into transactions in two
markets.

• Example:
– Consider a stock that is traded in both New York and London.
Suppose that the stock price is $172 in New York and £100
in London at a time when the exchange rate is $1.7500
per pound.
– An arbitrageur could simultaneously buy 100 shares of the stock
in New York and sell them in London
– He will obtain a risk-free profit of:
100*($1.75*100 – $172) or $300 in the absence of transactions
costs.

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Problem No. 1
An investor enters into a short forward
contract to sell 100,000 British pounds for
US dollars at an exchange rate of 1.9000
US dollars per pound. How much does the
investor gain or loose if the exchange rate
at the end of the contract is (a) 1.8900 and
(b) 1.9200?

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Problem No. 1 (Ans.)

a. Gain = $1,000
b. Loss = $2,000

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Problem No. 1 (Explanation)

Part a:
• The trader sells 100,000 British pounds for
1.9000 US dollar per pound when the exchange
rate is 1.8900 US dollar per pound.
• The gain is 100,000*(1.9000 – 1.8900) = $1,000
Part b:
• The trader sells 100,000 British pounds for
1.9000 US dollar per pound when the exchange
rate is 1.9200 US dollar per pound.
• The loss is 100,000*(1.9200 – 1.9000) = $2,000
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Problem No. 2
You would like to speculate on a rise in the
price of a certain stock. The current stock
price is $29, and a three-month call with a
strike of $30 costs $2.90. You have $5,800
to invest. Identify two alternative
strategies, one involving an investment in
the stock and the other involving
investment in the option. What are the
potential gains and losses from each?
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Problem No. 2 (Ans.)

• Strategy 1: Buy 200 shares
• Strategy 2: Buy 2000 options
• If share price does well strategy 2 will give
better gain
• If share price does badly strategy 2 will
give greater loss

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Problem No. 3
• Suppose that sterling-USD spot and forward
exchange rates are as follows:
Spot 2.0080
90-day forward 2.0056
180-day forward 2.0018
• What opportunities are open to an arbitrageur in
the following situations?
a. A 180-day European call option to buy £1 for $1.97
costs 2 cents.
b. A 90-day European put option to sell £1 for $2.04
costs 2 cents.
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Problem No. 3 (Ans. – Part A)

• The trader buys a 180-day call option and takes a short position in a 180-
day forward contract
• If ST is the terminal spot price,
• The profit from the call option is
= max (ST – 1.97,0) – 0.02
• The profit from the short forward contract
= 2.0018 – ST
• The profit from the strategy is therefore
= max (ST – 1.97,0) – 0.02 +2.0018 – ST
= max (ST – 1.97,0) +1.9818 – ST
• This is
1.9818 – ST when ST < 1.97
0.0118 when ST > 1.97
• Hence profit is always positive

The time value for money has been ignored in these calculations.

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Problem No. 3 (Ans. – Part B)

• The trader buys a 90-day put option and takes a long position in a 90-day
forward contract
• If ST is the terminal spot price,
• The profit from the put option is
= max (2.04 – ST,0) – 0.02
• The profit from the long forward contract
= ST – 2.0056
• The profit from the strategy is therefore
= max (2.04 – ST,0) – 0.02 + ST – 2.0056
= max (2.04 – ST,0) + ST – 2.0256
• This is
ST – 2.0256 when ST > 2.04
0.0144 when ST < 2.04
• Hence profit is always positive

The time value for money has been ignored in these calculations.

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Problem No. 4
The price of gold is currently $600 per
ounce. The forward price for delivery in
one year is $800. An arbitrageur can
borrow money at 10% per annum. What
should the arbitrageur do? Assume that
the cost of storing gold is zero and that
gold provides no income.

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Problem No. 4 (Ans.)

• The arbitrageur could
– Borrow money to buy 100 ounces of gold today and
– Short futures contracts on 100 ounces of gold for delivery in one
year
• This means gold
– Purchased for $600 per ounce
– Sold for $800 per ounce
• The return = 33.3% per annum >> 10% cost of borrowing
fund
• The arbitrageur should do this as much he can.
• Unfortunately this type of opportunity rarely arise in
practice.
– Even if this arises this does not sustain.

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Problem No. 5
A bond issued by Standard Oil worked as follows. The
holder received no interest. At the bond’s maturity the
company promised to pay $1,000 plus an additional
amount based on the price of oil at that time. The
additional amount was equal to the product of 170 and
the excess (if any) of the price of a barrel of oil at
maturity over $25. the maximum additional amount paid
was $2,550 (which corresponds to a price $40 a barrel).
Show that the bond is a combination of regular bond, a
long position in call options on oil with a strike price of
$25 , and a short position in call options on oil with a
strike price of $40.

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Problem No. 5 (Ans.)

• Suppose ST is the price of oil at the bond’s maturity
• In addition to $1,000 the standard oil bond pays:
ST < $25 : 0
$40 > ST > $25 : 170(ST – 25)
ST > $40 : 2,550
• This is the payoff from 170 call options on oil with a
strike price of 25 less the payoff from 170 call options on
oil with a strike price of 40
• The bond is a combination of regular bond, a long
position in 170 call options on oil with a strike price of
$25 , and a short position in 170 call options on oil with a
strike price of $40
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