FINANCIAL DERIVATIVES

A financial derivative is a financial instrument that derives its value from an

underlying asset. There are different types of derivatives in use., viz., currency,
interest rate, stock and commodities. The popular examples are forward contracts,
futures, options and swaps.

Features

• These relate to future period, which may be short or long.

• Value of derivative is dependent on the value of the underlying asset,
which changes from time to time.
• The nature of obligation of counter parties differs depending upon the
type of derivative.
• These can be over-the –counter (OTC) or traded on regulated
exchanges.
• Usually these are carried off-balance sheet.
• Mostly physical delivery of underlying assets does not take place
instead transactions are settled by taking offsetting positions.

Forward Contracts

A forward contract is an agreement between two parties for the purchase or sale of a
specified amount of an asset at a predetermined price at a certain time in future.
These are negotiated contracts or over-the-counter (OTC) contracts. These are unique
in terms of contract size, expiration date, the asset type, quality etc. Foreign currency
forward contracts and forward interest rate agreements (FRAs) are very popular. One
party takes a long position by agreeing to buy the asset and the other party assumes a
short position by agreeing to sell the same asset.

Merits
1. These are tailor-made to the specific needs of the parties
concerned.
2. No upfront payment is required.
3. No certainty and hence facilitates accurate planning.

Demerits

1. Available for short periods only.

2. Contracts are binding and customers will not be able to take
advantage of favourable price movements (market risk).
3. These are exposed to counter-party risk and hence riskier than
future contracts.

Futures

A future is a standardized contract covering the sale or purchase of an asset at a

predetermined price at a set future date. Normally the contract sizes and settlement
dates are standardized and are traded on an exchange.

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The hedge is set up by buying/selling a specified number of futures of a particular
settlement date. A deposit, known as the initial margin must be paid upfront.
Thereafter, any variations in the contract price are covered by a variation margin.
Profits are advanced to the customer’s account but losses must be covered by
advancing further sums to the exchange. This process is known as marking-to-
market.

On the due date the customer closes out his position by entering into a second futures
contract, which reverses the effect of the first one. Normally a loss on spot/cash
market is associated with a gain on futures and a gain on spot/cash market with a loss
on futures. However, the profit and loss may not exactly match and hence resulting in
hedge inefficiency.

Most of the future contracts are settled in cash by making cash payment on the
difference between the future price at which the contract was entered into and the
cash price at the expiration date.
.
Hedge set up: i. Buy/sell; ii.delivery date; iii.number of contracts.

Close out: A future position can be ‘closed out’ by selling the future contract in the
market to realize any profit or loss without actually taking delivery of the underlying
currency.

Merits

1. Price transparency as there is a single specified price.

2. Default risk is minimal as contracts are ‘marked to market’
daily by the clearinghouse ad the exchanges are regulated.
3. There is a central market place, with quick access to large
number of buyers and sellers.

Demerits

1. Future contracts are not very flexible due to the standard nature
of the contracts.
2. An initial margin is required and further variation margin
may be necessary.
3. It is not possible to take advantage of favourable price
movements (market risk).

Options

An option is an agreement involving a right, but not an obligation, to buy or sell a

certain quantity of an asset at a stated price (exercise price/strike price) at some time
in the future. These are useful when future cash flows are uncertain. Options while
protecting against adverse price movements, allow hedgers to benefit from favourable
movements.

OTC Options are tailored to the company’s exact requirements and Traded Options
are standardized contracts, which may not achieve perfect hedge efficiency.

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A Call Option gives the buyer of the option the right to buy the underlying asset at a
fixed price (seller of the option would be required to sell currency) and a Put Option
gives the buyer of the option the right to sell the underlying asset at a fixed price
(seller of the option would be required to buy the asset). The purchaser of the option
pays a premium and the seller of the option receives the premium.

American and European options: American-styled options can be exercised on any

day before the expiry date and European-styled options can only be exercised on the
expiry date.

An option value consists of two components, intrinsic value and time value.

Hedge Set Up: i. Buy call/put; ii. delivery date; iii. strike price; iv. number of
contracts; v. premium; vi. opportunity cost on premium.

On the due date the holder of the option has to either exercise the option or allow the
option to lapse depending on the ruling spot rates vis-à-vis the exercise price. If he
chooses the later option, he will have to transact on the spot/cash market. The usual
cash flows involve the cost of premium, opportunity cost on premium, purchase or
sale of asset either using options or on the spot market, purchase or sale of
surplus/deficit on the forward or spot market.

Merits

The holder will be able to take advantage of favourable price movements,

while protecting against downside risk.

In the case of traded options there is price transparency, better regulation,

liquidity and central market place.

OTC options are tailor-made and may be arranged for longer periods. Options
are suitable when there is uncertainty about cash flows and price movements.

Demerits

Available for short periods, upfront payment (premium) required.

Straddles

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 is likely to move significantly, but is not
sure as to which direction. The stock price must move significantly if the investor is
to make a profit. However, if the price movements are smaller than expected the
investor will experience a loss. Under this strategy, both call and put options are
bought at the same strike price.

As a result, straddles are extremely risky and are used by speculators. Additionally,
on stocks that are expected to jump, the market tends to price options at a higher

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premium, which ultimately reduces the expected payoff should the stock move
significantly.

Straddles can also be used by currency traders (for speculation purpose) when they
expect volatility in currency markets.

Strangles

The strategy involves buying an out-of-the-money call and an out-of-the-money put

option. In an out-of-the-money (OTM) call option, the price of the underlying security
is below the strike price and in an OTM put option, the price of the underlying
security’s price is above the strike price. A strangle is generally cheaper than a
straddle as the contracts are purchased out of the money. Strangle is an unlimited
profit, limited risk strategy that is taken when the options trader thinks that the
underlying stock will experience significant volatility in the near term. Unlike
straddles, they have two different strike prices.

Embedded Options

An embedded option is a special feature of a financial instrument that allows both

issuers and holders take specified actions against one another at a later date. An
embedded option is an inseparable part of another security that cannot exist as a
stand-alone instrument. Examples are ‘callable bonds’ that give the issuer the right to
redeem the bonds before the maturity date and ‘puttable bonds’ that give the investor
(holder) the right to demand for early redemption. Redeemable bonds are another
example where the holder is given the right but not an obligation to convert bonds
into shares at a predetermined number of shares at some future date.

Since the options are embedded in the instrument/security and hence linked to the
financial instrument they influence the value of that security. A callable bond exposes
investors to reinvestment risk and hence is not likely to experience significant price
appreciation. It is, therefore, less valuable than a non-callable bond.

Embedded options vs. Bare options:

Bare options trade separately from their underlying financial instruments, while
embedded options are linked to the underlying financial instrument and consequently
may not be bought or sold as standalone securities.

Warrants and convertibles

Share warrants are issued as sweeteners attached to bonds to improve their

marketability. These are rights to subscribe to company’s shares at a predetermined
price (exercise price) during a specified period. If the holders exercise their rights,
the number of shares will increase and the Earnings Per Share (EPS) is likely to be
diluted. These can be detached and traded separately.

Convertibles are hybrid instruments combining the features of both debt and equity
instruments. Examples are convertible debentures and convertible preference shares,

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which can be converted into equity shares at a predetermined ratio (called conversion
ratio). While showing them in the balance sheet, these need to be broken down into
‘debt component’ and ‘equity component’.

Swaps

A swap is an agreement between two parties to exchange underlying

assets/obligations in future. The popular examples are interest rate swaps
(exchanging fixed interest rate with floating rate) and currency swaps (exchanging
predetermined amounts at predetermined exchange rates). These are long-term in
nature compared to other derivatives.

However, they carry counterparty risk (also known as credit risk/default risk),
sovereign risk (also known as political risk caused by the actions of the government
of foreign countries when the two parties are located in two different countries) and
market risk (the risk of exchange rates/interest rates moving in a different direction
than anticipated).

A swaption is an option to enter into a swap agreement in future and thus combining
the features of both swaps and options.

Swaptions are traded over the counter, for both short and long maturity expiry dates,
and for wide range of swap maturities. The price of a swaption depends on the strike
rate, maturity of the option, and expectations about the future volatility of swap rates.

Uses of swaptions:

• Swaptions can be used as an effective tool to swap into or out of fixed

rate or floating rate interest obligations, according to expectation on
likely interest rate movements.
• Swaptions can also be used when future cash flows are uncertain. In
the case of international tendering, bidders can use swaptions (an
option to enter into a foreign currency swap), since the outcome of the
bid is uncertain.
• Swaptions are useful for borrowers targeting an acceptable borrowing
rate. By paying an upfront premium, a holder of a payer’s swaption
can guarantee to pay a maximum fixed rate on a swap, thereby hedging
his floating rate borrowings.

Collar Option Strategy (Hedge Wrapper)

It refers to the strategy of simultaneous purchase and sale of out-of-the-money

options, not necessarily at the same strike price. It reduces both positive and
negative returns of an underlying asset. In other words, it limits both upside
and downside. When the premium paid on put option is the same as the
premium received on call option, it is called zero-cost collar.

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How does it work?

These are usually set up by investors who want to hedge a long position from
short-term downside risk. An investor who holds shares in a company, buys an
out-of-the-money put option and sells an out-of-the-money call option. As the
price of the underlying share decreases, the investor will incur a loss but the
put option value increases thus negating the loss caused by falling stock
prices. If the price of the underlying share increases, the investor will
experience a profit but the buyer of the call option will exercise the option to
gain. As a seller of the call option the investor will have a loss, which is
neutralized by gain on owning the shares.

Example: X is holding a share in Apple and the share price has appreciated to
$330. He is worried that the price may go down in the near-term future and
wants to make use of a collar strategy. A put option at a strike price of $310
and a call option at a price of $350 are available and in each case the premium
is $10.

Required: (i) Show how a collar can be constructed; (ii) Calculate the payoff if
the share price moves to (a) $300, (b) $340 and (c) $370.

Solution:

(i) A collar can be constructed by buying a put option at a strike price of

$310 and selling a call option at a strike price of $350. Since the
premium paid is the same as premium received, it is also called zero-
cost collar.
(ii) (a) Payoff if the share price moves to $300:

The put option is exercised by X and the gain is $10 (310-300) less
premium of $10, the net benefit is $0.
The call option is not exercised by the buyer and the payoff is a gain of
$10 (premium received).
Since the price has gone down, the loss is $30 (330-300).
The overall payoff is a loss of $20 (30-10).
Had X not used collar strategy his loss would have been $30.

(b) Payoff if the share price moves to $340:

The put option is not exercised by X and the loss is the premium paid
of $10.
The call option is not exercised by the buyer and the payoff is a gain of
$10.
Since the price has gone up, the gain is $10 (340-330).
The overall pay off is $10, which is the same as the gain in the cash
market.

(c) Payoff if the share price moves to $370

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 The put option is not exercised by X and the loss is the premium paid
of $10.
The call option is exercised by the buyer and the loss is $20 (370-350)
less the premium received $10, resulting in a net payoff of -$10.
Since the price has gone up, the gain is $40 (370-330).
The overall pay off is $40-10-10= $20.
Had X not used collar strategy, the gain would have been $40.

Quiz
1. A derivative is a financial contract that has a specific expiration date
and includes rights and/or obligations for the buyer and the seller.
(T/F)

2. Exchange-traded options can be customized to fit specific

circumstances and Over-the-Counter (OTC) derivatives are
standardized contracts. (T/F)

3. ………….. are investors who attempt to boost returns on an underlying

investment portfolio by taking a speculative position based on
expected market movements.

4. …………. means , when the same asset is traded at different prices in

two separate markets by purchasing low in one market and selling high
in the other market, profits can be locked in at no risk.

5. The buyer of …………… option has the right, but not the obligation,
to buy or sell a specified quantity of the underlying asset in the future
at a price agreed on today.

6. The seller of ……… is obligated to complete the transaction if called

on to do so.

7. Option sellers must pay buyers a fee known as the option price or
option premium. (T/F)

8. The most that the buyer of an option can lose is the premium paid.
(T/F)

9. European style options can be exercised at any time up to and

including the expiration dates while American style options can be
exercised only on the expiration dates. (T/F)

10. The price at which the underlying asset can be purchased or sold in the
future is called ………. …

11. A call option is called ………... option when the price of the
underlying asset is higher than the strike price.

The holder purchases the shares at the strike price, and sells them in
the market for more.

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 12. A put option is called………. option when the price of the underlying
asset is lower than the strike price.

The holder buys shares in the market, and sells them at the higher
strike price for profit.

13. If an option is not in-the-money, it has zero intrinsic value (T/F).

14. The amount that an option is trading above its intrinsic value is the
option's time value. (T/F)

15. Financial derivatives when used correctly can lower the risk. (T/F)

16. Hedgers attempt to reduce their risk while speculators increase their
risk in an attempt to receive higher returns. (T/F)

17. An increase in the market price of the underlying asset will cause the
price of a call option to…………..

18. ……….. are smart investors who switch their investments around in
order to make risk-free gains to take advantage of market imbalances,
imperfections and inefficiencies.

19. An option that fixes the maximum limit is known as ………..

20. An option that fixes the minimum limit is called ………

21. The price (or premium) on an option is paid ………(up front/at the
expiry of the contract).

22. …………(OTC/Traded options) may result in under or over hedging.

23. Options provide protection against adverse movements while allowing

the option holders to benefit from favourable movements thus offering
best of both worlds. (T/F)

24. Employers in a bid to motivate key employees for better performance

and achieve goal congruence grant ………….(call/put) options.

Questions

1. A Mutual Fund is holding the following assets in INR` Crores :

Investments in diversified equity shares 90.00

Cash and Bank Balances 10.00

The Beta of the portfolio is 1.1. The index future is selling at 4300
level. The Fund Manager apprehends that the index will fall at the
most by 10%. How many index futures he should short for perfect

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hedging? One index future consists of 50 units. Substantiate your
answer assuming the Fund Manager's apprehension will materialize.

2. Calculate the price of 3 months PQR futures, if PQR (FV

INR10) quotes INR220 on NSE and the three months future price
quotes at INR230 and the annual borrowing rate is given as 15 percent
and the expected annual dividend is 25 percent per annum payable
before expiry. Also examine arbitrage opportunities.