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Introduction to Derivative

Lecture 2

In the last 20 years derivatives have become increasingly important in the world of finance A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables

Among many variations of derivative contracts, following are the major types:

Forward contracts

Future Contract

Swaps Options

Definition: an agreement to buy or sell an asset at a certain future time for a certain price A forward contract is traded in the over-thecounter market A party assuming to buy the underlying asset is said to have assumed a long-position The other party assumes a short-position and agrees to sell the asset

As you know next football world cup will be played in Brazil. Like South Arfica did, Brazil will need to construct football stadiums, seating arrangements, parking areas etc which need heavy consumption of cement. Brazil does not have the required amount of cement, it will call many producers of cement to send their quotations to Brazil. If from Pakistan, Lucky cement company is short-listed and approved for export of cement to Brazil at $10 a bag, 500,000 bags by May 2013, it will be an example of forward contract In the above contract, lucky cement has a short-position (sold cement now deliverable in future) and Brazil government has a long position

If the cost of raw material increases, it cannot be

passed on to the Brazilian government If the value of rupee against dollar increases, Lucky cement will receive fewer rupees per dollar

To control these risks, lucky cement should use forward/future contracts (HOW?)

Lucky cement should buy raw material (coal, oil, chemicals) in advance through future contracts (i.e going long) Lucky cement should sell dollars derivable in May 2013 (when it will receive them from Brazilian government)

A derivatives exchange A market where individuals trade standardized contracts that have been defined by the exchange Exchange standardizes contracts with regard to:

Standardization increases liquidity but reduce flexibility Contracts on exchange are marked-to-market on daily basis Margin requirements (usually 5%) Margin call if margin falls due to losses

Number of units in one contract (quantity) Maturity (usually at the end of a month) Quality/ grade Delivery place

Contracts outside an organized exchange are traded in over the counter market In over the counter market, there is no standardization, the parties themselves agree on different aspects of the contract Contracts in OTC are flexible, but not liquid Chances of default are comparatively higher in OTC as contracts are not marked-to-the-market The agrieved party can go to court against the defaulting party

The exchange provides a mechanism that gives the two parties a guarantee that the contract will be honored. Futures contracts are traded on organized exchanges that standardize

the size of the contract, the grade of the deliverable asset, the delivery month, and the delivery location.

FORWARDS Trade:

OTC Market

FUTURES Trade:

Standardized Exchanges

Risk:

Counter-party

Risk:

Basis

Price:

Expiry date settlement

Price:

Daily settlement

12

Say Prices increasing with + (S , r): It shows Excess Margin for long position holder (i.e. This extra cash could be either withdrawn or invested at Higher Interest Rate) Say if the Prices are going down with + (S , r): then Margin call would be put to the long position holder to maintain the Account (the favorable mode is to borrow at lower interest rate) When the Spot price (S) strongly positively correlated to Interest rate (r) then the Futures Price>Forwards Prices and vice versa

13

Derivative contracts are priced so that there is no arbitrage opportunity Arbitrage Any trading strategy that can make riskless profit

How forward price are determined? In other words, how to price future contracts? See example on the next slide and draw conclusion for yourself 1. 2 3. 4.

Suppose that the spot price of gold is $1000 per ounce and the risk-free interest rate for investments lasting one year is 5% per annum. What is a reasonable value for the one-year forward price of gold? Suppose first that the one-year forward price is $1300 per ounce. A trader can immediately take the following actions: 1. Borrow $1000 at 5% for one year. 2. Buy one ounce of gold. 3. Enter into a short forward contract to sell the gold for $1300 in one year The trader earns a riskless profit of?

The trader pays a total price for one ounce of gold = 1000 + (1000x5% interest) = $1050 The trader sell the gold for Rs. 1300 His riskless profit is = 1300-1050 = $250 The example shows that $1300 was too high a forward price

Forward price = So + CC Where So is the spot/current/cash price today CC is the cost of carry ( in the previous example CC is the financing cost / interest paid for buying gold) F = $1000 + (1000x.05) = 1000(1+.05) = $1050

Like in time value of money concept, when continuous compounding is the assumption, rT the interest rate formula becomes: i e Where e = 2.71828 Forward price for a non-dividend paying asset is F S e rT

o

Consider a four-month forward contract to buy a zerocoupon bond that will mature one year from today. The current price of the bond is Rs.930. (This means that the bond will have eight months to go when the forward contract matures.) Assume that the rate of interest (continuously compounded) is 6% per annum. T = 4/12 = .333 r = 0.06, and So = 930. The forward price,

F Soe

rT

930e

.006*.333

948.79

Since the forward contract holder does not receive dividend/interest on the underlying asset, but the present price So reflects the future income from the asset, the present value of dividends/interest should be deducted from So while calculating Forward price

F ( S o l )e

rT

Consider a 10-month forward contract on Nishat Mills Ltd (NML) stock with a price of Rs.50. Assume that the risk-free rate of interest (continuously compounded) is 8% per annum for all maturities. Also assume that dividends of is 0.75 per share are expected after three months, six months, and nine months. The present value of the dividends

0.75e

0.08*3 /12

0.75e

0.08*6 /12

0.75e

0.08*9 /12

2.162

F ( S o l )e

rT 0.08*10 / 12

F (50 2.162)e

Rs.51.14

Storage costs can be regarded as negative income If U is the present value of all the storage costs that will be incurred during the life of a forward contract, then the forward price is given by:

F ( S o U )e rT

Consider a one-year futures contract on gold. Suppose that it costs $2 per ounce per year to store gold, with the payment being made at the end of the year. Assume that the spot price is $450 and the risk-free rate is 7% per annum for all maturities. This corresponds to r = 0.07, and S0 = 450, T=1

U 2e

0.07*1

1.865

Option is a right to buy or sell a stated number of shares(or other assets) within a specified period at a specified price There are two types of option contracts: Put option Call option Put option A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.

Call Option: A call option gives the holder the right to buy 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

An investor is optimistic about share price of Lucky Cement which will increase substantially (Say to Rs. 100 from 80 now) if higher amounts were allocated for PSDP programs in the annual budget. However, he is also wary of the potential fall in share price (Say Rs. 60) if something unfavorable comes with the new budget. The investor wants a limit to his losses but no limit to his profit? What should the investor do?

The investor buys an American call option with strike price of Rs. 90 to purchase 10000 share of Lucky. The price of an option (option premium) to purchase one share is Rs.3. If the shares price actually goes up to Rs. 100, he will exercise the option and will make a profit of Rs. (10000x100) ((10000x(90+3))= Rs.70000 If price falls to Rs. 60, he will not exercise his option, his loss will be 10000x3 =Rs.30000 (This is the premium that he pays to the option writer)

You own a car which is worth Rs.500,000 now. Fortunate enough, you got scholarship from a foreign university. You need to move within next 4 months and arrange initial finance of Rs.10,00,000for ticket, bank statement etc. you are short of the target by Rs.400,000 for which you have to sell your car. You want to use the car for the next four month and sell it when you leave. But prices of cars fluctuate by wide margin, and you fear you may not be able to sell it for Rs.500,000 after 4 months. What to do?

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