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Introduction to Derivatives

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The Nature of Derivatives
A derivative is an instrument whose value depends on the values of other more basic underlying variables called bases (underlying asset, index, or reference rate), in a contractual manner

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Derivatives
The underlying asset can be equity, forex, commodity or any other asset. ‡ For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. ‡ Such a transaction is an example of a derivative. ‡ The price of this derivative is driven by the spot price of wheat which is the ³underlying´.

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Examples of Derivatives
‡ ‡ ‡ ‡ Futures Contracts Forward Contracts Swaps Options

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Categories of Derivatives
Futures Listed, OTC futures Forward contracts Derivatives Options Calls Puts

Swaps Interest rate swap Foreign currency swap

6 Players in the Derivative Market ‡ The following three broad categories of participants ‡ Hedgers ‡ Speculators ‡ Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators .

7 Ways Derivatives are Used ‡ To discover price ‡ To hedge risks ‡ To speculate (take a view on the future direction of the market) ‡ 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 .

8 Uses of Derivatives ‡ Risk management ‡ Income generation ‡ Financial engineering .

2002 .9 Risk Management ‡ The hedger¶s primary motivation is risk management ± ³Banks appears to have effectively used such instruments to shift a significant part of the risk from their corporate loan portfolios´ ‡ Alan Greenspan.

10 Risk Management (cont¶d) ‡ Someone who is bullish believes prices are going to rise ‡ Someone who is bearish believes prices are going to fall ‡ We can tailor our risk exposure to any points we wish along a bullish/bearish continuum .

11 Risk Management (cont¶d) ± FALLING PRICES EXPECTED FLAT MARKET EXPECTED RISING PRICES EXPECTED BEARISH NEUTRAL BULLISH Increasing bearishness Increasing bullishness .

12 Income Generation ‡ Writing a covered call is a way to generate income ± Involves giving someone the right to purchase your stock at a set price in exchange for an up-front fee (the option premium) that is yours to keep no matter what happens ‡ Writing calls is especially popular during a flat period in the market or when prices are trending downward .

and other derivatives ± Know that derivatives are neutral products (neither inherently risky nor safe) . calls futures.13 Financial Engineering ‡ Financial engineering refers to the practice of using derivatives as building blocks in the creation of some specialized product ‡ Financial engineers: ± Select from a wide array of puts.

.14 Effective Study of Derivatives ‡ The study of derivatives involves a vocabulary that essentially becomes a new language ± Implied volatility ± Delta hedging ± Short straddle ± Near-the-money ± Gamma neutrality ± Etc.

1956 (SC(R)A) defines ³derivative´ to include ± 1. A contract which derives its value from the prices. . A security derived from a debt instrument. share. loan whether secured or unsecured. risk instrument or contract for differences or any other form of security. of underlying securities. or index of prices. 2.15 Derivatives in India ‡ In the Indian context the Securities Contracts (Regulation) Act.

16 Derivatives in India ‡ Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. .

but increasingly they are switching to electronic trading ± Contracts are standard there is virtually no credit risk ‡ Over-the-counter (OTC) ± A computer.17 Derivatives Markets ‡ Exchange traded ± Traditionally exchanges have used the openoutcry system.and telephone-linked network of dealers at financial institutions. and fund managers ± Contracts can be non-standard and there is some small amount of credit risk . corporations.

Chart shows total principal amounts for OTC market and value of underlying assets for exchange market .18 Size of OTC and Exchange Markets 240 Siz f M rk t ($ 220 trilli n) 200 180 160 140 120 100 80 60 40 20 0 JunJun-00 Jun.8 TC Exc nge Jun-01 Jun-02 Jun-03 Jun-04 Source: Bank for International Settlements.

19 Forward Contracts ‡ Forward contracts are similar to futures except that they trade in the over-thecounter market ‡ Forward contracts are particularly popular on currencies and interest rates .

2008 (example) Spot 1-month forward 3-month forward 6-month forward Bid 1.6100 .6192 1.6248 1.6281 1.6253 1.6187 1.20 Foreign Exchange Quotes for GBP June 3.6285 1.6094 Offer 1.

.21 Forward Price ‡ The forward price for a contract is the delivery price that would be applicable to the contract if it were negotiated today (i.e. it is the delivery price that would make the contract worth exactly zero) ‡ The forward price may be different for contracts of different maturities .

22 Terminology ‡ The party that has agreed to buy has what is termed a long position ‡ The party that has agreed to sell has what is termed a short position .

610.23 Example (page 4 of text) ‡ On June 3.000 for £1 million on December 3.6100 ‡ This obligates the corporation to pay 1. 2003 ‡ What are the possible outcomes? . 2003 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.

24 Profit from a Long Forward Position Profit K Price of Underlying at aturity. ST .

ST .25 Profit from a Short Forward Position Profit K Price of Underlying at aturity.

26 Futures Contracts ‡ A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price ‡ By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time) .

27 Exchanges Trading Futures ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ Chicago Board of Trade Chicago ercantile Exchange LIFFE (London) Eurex (Europe) BM&F (Sao Paulo. MCX and other commodity exchanges in India . NBOT. Brazil) TIFFE (Tokyo) NSE & BSE NCDEX.

28 Futures Price ‡ The futures prices for a particular contract is the price at which you agree to buy or sell ‡ It is determined by supply and demand in the same way as a spot price .

29 Electronic Trading ‡ Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange ‡ Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers .

30 Terminology ‡ The party that has agreed to buy has a long position ‡ The party that has agreed to sell has a short position .

31 Over-the Counter Markets ‡ The over-the counter market is an important alternative to exchanges ‡ It is a telephone and computer-linked network of dealers who do not physically meet ‡ Trades are usually between financial institutions. corporate treasurers. and fund managers .

(ii) information asymmetries (iii) the effects of OTC derivative activities on available aggregate credit (iv) the high concentration of OTC derivative activities in major institutions (v) The central role of OTC derivatives markets in the global financial system.Limitations ‡ The following features of OTC derivatives markets can give rise to instability in institutions markets. and the international financial system: (i) the dynamic nature of gross credit exposures.32 OTC Markets. .

such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts occur. the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions.Limitations ‡ Instability arises when shocks.33 OTC Markets. which significantly alter the perceptions of current and potential future credit exposures. ‡ When asset prices change rapidly. .

Limitations ‡ The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events. those who provide OTC derivative products.34 OTC Markets. . hedge their risks through the use of exchange traded derivatives. ‡ Moreover. which fall outside the more formal clearing house structures.

35 Forward Contracts ‡ Forward contract are similar to futures except that they trade in the over-thecounter market ‡ Forward contracts are popular on currencies and interest rates .

78 .58 76.72 Offer 76.51 75.58 76.36 Foreign Exchange Quotes for GBP (Example in Rs) Spot 1-month forward 3-month forward 6-month forward Bid 75.56 76.56 76.51 76.

37 Options ‡ A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) ‡ A put option is an option to sell a certain asset by a certain date for a certain price (the strike price) .

38 American vs European Options ‡ An American options can be exercised at any time during its life ‡ A European option can be exercised only at maturity .

Stock Price=62. Strike Price 50 65 80 July Oct Call Call 16.62 8.87 18.00 17.62 5.75).87 7.00 10.00 July Put 2.87 2. 2008.25 10.50 19.50 .69 Oct Put 4.39 WIPRO Options (Jun 1.

40 Exchanges Trading Options ‡ ‡ ‡ ‡ ‡ ‡ ‡ Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) NSE & BSE in India .

41 Options vs Futures/Forwards ‡ A futures/forward contract gives the holder the obligation to buy or sell at a certain price ‡ An option gives the holder the right to buy or sell at a certain price .

42 Types of Traders ‡ Hedgers ‡ Speculators ‡ Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators .

Examples ‡ An investor owns 1. A two-month put with a strike price of 27.43 Hedging. The investor decides to hedge by buying 10 contracts ‡ A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract .50 costs 1.000 Microsoft shares currently worth 28 per share.

44 Value of Microsoft Shares with and without Hedging 40.000 Stock Price ($) 20.000 20 25 30 35 40 .000 No Hedging 30.000 Value of Holding ($) 35.000 Hedging 25.

000 to invest feels that RIL¶s stock price will increase over the next 2 months.45 Speculation Example ‡ An investor with Rs4. The current stock price is Rs40 and the price of a 2-month call option with a strike of 45 is Rs2 ‡ What are the alternative strategies? .

46 Speculation Example ‡ An investor with Rs4. ‡ What are the alternative strategies? . The current stock price is Rs400 and the price of a 2-month call option with a strike of 450 is Rs20.000 to invest feels that WIPRO¶s stock price will increase over the next 2 months.

7500 ‡ What is the arbitrage opportunity? .47 Arbitrage Example ‡ A stock price is quoted as £100 in London and 172 in New York ‡ The current exchange rate is 1.

48 Arbitrage Example ‡ A stock price is quoted as £100 in London and 172 in New York ‡ The current exchange rate is 1.7500 ‡ What is the arbitrage opportunity? .

49 1. Gold: An Arbitrage Opportunity? ‡ Suppose that: ± The spot price of gold is US 390 ± The quoted 1-year futures price of gold is US 425 ± The 1-year US interest rate is 5% per annum ‡ Is there an arbitrage opportunity? .

Gold: Another Arbitrage Opportunity? ‡ Suppose that: ± The spot price of gold is US 390 ± The quoted 1-year futures price of gold is US 390 ± The 1-year US interest rate is 5% per annum ‡ Is there an arbitrage opportunity? .50 2.

05) = 409. S=390.50 .51 The Futures Price of Gold If the spot price of gold is S & the futures price is for a contract deliverable in T years is F. T=1. and r=0. In our examples.05 so that F = 390(1+0. then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest.

Oil: An Arbitrage Opportunity? Suppose that: ± The spot price of oil is US 49 ± The quoted 1-year futures price of oil is US 55 ± The 1-year US interest rate is 5% per annum ± The storage costs of oil are 2% per annum ‡ Is there an arbitrage opportunity? .52 1.

53 2. Oil: Another Arbitrage Opportunity? ‡ Suppose that: ± The spot price of oil is US 49 ± The quoted 1-year futures price of oil is US 46 ± The 1-year US interest rate is 5% per annum ± The storage costs of oil are 2% per annum ‡ Is there an arbitrage opportunity? .

speculation and arbitrage . page 9) ‡ ‡ ± ± ± ± Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. Hedge funds use complex trading strategies are big users of derivatives for hedging. Mutual funds must disclose investment policies. make shares redeemable at any time.1. limit use of leverage take no short positions.54 Hedge Funds (see Business Snapshot 1. ‡ ‡ Hedge funds are not subject to these constraints.

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