FINANCIAL DERIVATIVES

What is Risk?
Three important players: Hedger, speculator, Arbitrageur. Functions performed by derivative markets. (a) Price Discovery (b) Risk transfer (C) Market completion
What are derivatives ?

Forward contract Futures
Hedging using futures Contract Valuation of Futures Option : Call option & Put option, Different terminologies Examples of Call option Examples of Put option Hedging with option Factors affecting option price Valuation of option Black and scholes model SWAP

What are derivatives?
A derivative instrument, broadly, is a financial contract whose pay off structure is determined by the value of an underlying commodity, security, interests rate, share price index, exchange rate, oil price etc. A derivative instrument derives its value from some underlying variables. Financial Derivatives

Forward

Future

Option

Swap

1. Forward Contract A forward contract is a simple derivative that involves an agreement to buy/sell an asset on a certain date at an agreed price. This is a contract between two parties: Buyers and sellers
Money

Buyer
Security Who takes a long position

Seller
Who takes a short position

Problems of Forwards
Counter - party risk:
A party to the contract may not fulfil the obligation. Thus each party faces the risk of default.

Low degree of liquidity:
Both the parties have to wait till maturity. No one can come out from the contract.

Future Contracts
A future contract is a standardized forward contract between two parties where one of the parties commits to sell and the other to buy a stipulated quantity of a security or an index at an agreed price on or before a given date in the future. Seller A
(Buyer)

Buyer

Clearing House

B
(Seller)

Futures v/s Forwards ‡ Exchange traded & transparent v/s Private contracts ‡ Standardised v/s Customised ‡ Settlement through Clearing House v/s Settlement between Buyers and Sellers ‡ Require margin payment v/s no margins ‡ Mark .to .party risk is absent in Futures (settlement of trades is guaranteed) ‡ Most settled by offset and very few by delivery v/s most settled by actual delivery. .Market margins v/s no margins ‡ Counter .

Futures Individual stock future Underlying asset is the individual stock Index futures Underlying asset is the stock index BSE SENSEX? 30 shares S & P Nifty? 50 shares BSE Sensex Future One lot = 50 indices S & P Nifty Future one lot= 200 indices .

last Thursday) .3 CL. CL.4 CL. 1 CL.1000 + 1500 Future Price of January Index Future (maturing on 27th Jan. -1650 + 2750 .4700 Future Price 4590 4568 4570 4535 Spot price 4500 4600 Future Price= Spot price Op.2 CL.27 Jan.

4570) X 50 = 20 X 50 = 1000 4th day Gain (4600 .4535 loss per index = Rs.Margin Money Margin Money @ 5%= Rs.4568) x 50 = 32 x 50 = 1600 i.11420 = 1600 . 33 (4568 .228400 x 5/100=Rs.1000 + 1500= 13020 Total gain upto 4th day (4600 .1650 + 2750 . 11420 1st day Less: Loss 2nd day Add: Gain 3rd day Loss : Loss 4th day Add : Gain .11420 Marking to Market 1st day when price decreases from Rs.e.4535) X 50 = 55 X 50 = 2750 3rd day Loss (4590 . 50 X 33= 1650 2nd day Gain (4590 .4535) Total loss= Rs. 13020 . 4568x50x 5/100= Rs. 4568 to Rs.4570) X 50 = 30 X 50 = 1500 Margin (at the beginning)= Rs.

Beta of the portfolio = weighted average of betas of individual stocks . with short position on Nifty futures .How to protect your portfolio from market crash ‡ ‡ What can go wrong in times of volatility panic selling What can be done Hedge long position on the portfolio.

portfolio dropped by Rs.e.095 ‡ Raju unwound the position making a profit of Rs. 1090.e.60 ‡ Portfolio value reduces to Rs. 32990 and his sell position on Nifty gained by Rs. 1. 1.87.34080 .77.The beta of the portfolio is 0.95*187085 = Rs. 1.How ? 25th January 2007 ‡ Raju has a portfolio of 5 securities worth Rs. 1 market lot ‡ The expiry date of Nifty Jan. futures is 27th March 2007 ‡ Sell Nifty futures at 1141 ‡ 10 March 2007 Nifty July futures trading at 970. i.731 i.085 .54.95 ‡ Hence he needs to sell index futures worth 0.

say.9.ADJUSTING THE BETA OF A PORTFOLIO USING STOCK INDEX FTURES A manager has a portfolio consisting of three secuirities of Rs20 lakh. (a) Decrease the portfolio beta to 0. and (b) Increase the portfolio beta to 1. We may now see as to how to use stock index futures to.5 .17. with a beta value of 1.

17 to 0.76923 .9.‡ (a) To decrease the portfolio beta from 1. ‡ If we designate the existing portfolio as asset 1 and the riskfree security as asset 2. and 2 = 0(this being a risk free asset).17. we get ‡ 0. ‡ p =w1 1 + w2 2= w1 1 + (1-w1) 2 ‡ (since the new portfolio consists of only two assets) ‡ We have p = 0. we have. w1 = 0.17 + (1.w1)0 ‡ Or.9. the portfolio manager may sell off a portion of equities and use the proceeds to buy riskfree securities.9 = w1 x1. ‡ Substituting the known values. 1 = 1.

76923 x Rs20 lakh).3846 lakh) in riskfree securities would have a beta of 0. (0.9. invested in three securities and Rs 4.‡ This implies that a portfolio consisting of Rs 15.3846 lakh. .6154 lakh (Rs20 lakh ±Rs15.

4 lakh .17 x Rs4. ‡ Rupee value of the spot position to be hedged = Rs4.‡ Alternatively.6154 lakh =Rs 5.6154 lakh ‡ The amount of future contract to be sold ‡ = 1. the manager can sell stock index futures contracts.

e.17 to 0.9. by Rs 20. i.80.00. it is better to have low portfolio beta. Thus if price reduces by 10%.000 .. their portfolio value will reduce by 9%. ‡ Their portfolio value = Rs20 lakh ‡ They want to reduce their portfolio beta from 1.000x(9/100) =Rs1.‡ If they apprehend that price may reduce.

they will earn from future selling = Rs 5.7% for a 10% decline of market price.117)=Rs2.1 = Rs 54. ‡ Less: Earning from future selling = 54.000.000 ‡ Total loss = Rs1.000.17. portfolio value will reduce by 11. ‡ Now.000x. ‡ Thus portfolio reduces by Rs20 lakh x(.000 (the same loss) .4 lakh ‡ If future price reduce by 10% because of general decline of market of 10%.40.80. since they are holding the same portfolio having =1.34.‡ They have sold future for Rs5.

28205 lakh = Rs 5.28205 ‡ This implies shorting the risk free TB with a market value of Rs 20x0. p = w1 1 + (1-w1) 2 ‡ Or 1.641 lakh and Rs 5.641 lakh is borrowed.5 = w1x1.641 lakh.‡ (b) To increase the portfolio beta from 1. so that the total investment in the portfolio of three securities be Rs 25.17 to 1.50. we proceed as follows: ‡ We have.17 + (1-w1) 0 ‡ Or w1 =1. .

6 lakh.641 lakh= Rs 6.5 can be achieved alternatively by buying stock index futures contract equivalent to Rs 1.‡ The aim of increasing the beta to 1. .17 x Rs5.

5 so that if market price increase by 10%.15) = Rs 3 lakh. lakh x (.17 to 1. i. portfolio value will increase by 15%..‡ Anticipating bullish condition of the market the manager wanted to increase the portfolio from 1.e. by Rs20. .

6 lakh x (.1) = Rs 66.000 ‡ Total Profit = Rs 3.00.117)=Rs 2.000.6 lakh.‡ Now since he has bought future contract amounting to Rs 6. . ‡ Profit from future buying ‡ =Rs6.34.000 ‡ Profit from portfolio ‡ =Rs 20 lakh x (.

71.08 (Compounded continuously). F = So e rt = Rs.months¶ time r = .Carry Return Case 1 : Securities Providing No Income F = Soe rt. 70 e(. 70 (1.02 = Rs.41 .0202)= Rs. Where F = Future price S = Spot Price r = the risk free rate of interest p.25) = Rs.Valuation of Futures Prices Price = Spot Price + Carry Costs . 70.a.08) (.7183 Example: Consider a forward contract on a non-dividend paying share which is available at Rs. with continuous compounding t = the time to murturity e = exponential value = 2. 70 e . to mature in 3 .

1)(4/12) = 150 x 0. What is F ? Div.5) = 3654.08) e (0. I = PV of Income D received after t time. The risk free rate of interest (continuously compounded) is 10% p.50 in 4 months from now.I) e rt.92 X 1.08 F = (3800 . 145. I = 150 e-(0.V.1) (0.50 = 150 P. The share in question is expected to yield a dividend of Rs. 3842. 38 each.145.Case 2 : Securities Providing a known cash Income F = (S .a.month future contract on 100 shares with a price of Rs. Receivable after 4 months = 100 X 1.31 . I = De-rt Example : Let us consider a 6.9672 = Rs. of the div. 1.05127 = Rs.

y = 0. 527.10.04..Case 3 : Securities Providing a Known Yield F = S e (r .85 .04) (0.0.25) = 520 x 1.0151 = Rs.25 Thus : F = 520 e (0.25) = 520 e (0.y) t y = Yield rate (continuously compounded) Example : Assume that the stocks underlying an index provide a dividend yield of 4% p. Here S = 520.1 .a. the current value of the index is Rs. 520 and that the continuously compounded risk free rate of interest is 10% p. r = 0. t= 3/12 = 0.06) (0.a.

but not the obligation.OPTION An option is a contract which gives the right.2001 Indices S & P CNX Nifty (introduced on 4. to buy or sell the underlying at a stated date and at a stated price.6. Underlying assets Individual Stock (Introduced on 2.7.2001 in NSE) .

Option Call option Put option Option Type Buyer of option (option holder) Seller of option (option writer) obligation to sell obligation to buy (a) Call (b) Put Right to buy Right to sell .

Exercise Price : the price at which the contract is settled (strike price) Expiration date : the date on which the option expires. Style of option American option Exercised at any time prior to expiration Option Premium : European option Exercised on the expiration date The price that the holder of an option pays and the writer of an option received for the rights conveyed by the option. .

) 100 (100 X 1) 100 (100 X 1) 100 (100 X 1) 0 .I.100 (100 X 1) .Option on individual stock Call Option : X = option writer (Seller) Y = option buyer (holder) Size of the contract = 100 R.04. Shares Spot price on 25.200 (100 X 2) .100 0 100 200 300 . 42 per share Date of maturity = 24. 40 per share Exercise price = Rs.) .2006 Option price = Re 1 per share for call option Profit/ Loss Profile for seller & buyer Possible spot price at call maturity 40 41 42 BEP 43 44 45 46 X (Rs.100 .02.2006 = Rs.300 (100 X 3) Y (Rs.100 .

Profit 300 200 100 0 -100 -200 -300 (a) For Call option writer X Share Price 40 41 42 43 44 45 46 .

Profit 300 200 100 0 100 200 300 (b) For Call option buyer 40 41 42 43 44 45 46 Share Price .

105 per share .Example of Put option : X = Option writer => obligation to buy Y = Option buyer => right to sell Exercise price = Rs. size of the contract = 100 ACC shares.option premium = Rs. 100 per ACC share. spot price today = Rs. 10 per share Profit/ Loss Profile for X and Y Possible sport price (Rs.) 60 70 80 BEP --> 90 100 110 120 X -3000 (100 X 30) -2000 (100 X 20) -1000 (100 X 10) 0 1000 1000 1000 Y 3000 2000 1000 0 -1000 -1000 -1000 .

Profit 3000 2000 1000 Share Price 60 70 80 90 100 110 120 -1000 -2000 -3000 (a) Option writer (X) .

Profit 3000 2000 1000 Share Price 60 70 80 90 100 110 120 -1000 -2000 -3000 (b) Option buyer (Y) .

1470 Option Value : = Rs. 20 Total premium = Rs.e.Have a view on the market ? A. 1400 Buy one Nifty. (20 X 200) = Rs. 4000 If at expiration Nifty advances by 5% i.1430) Less : option Premium = 20 Profit per Nifty: 20 Profit on the contract = 20 X 200 = 4000 . The strike price 1430 Option premium = Rs. 40 (1470 . Assumption : Bullish on the market over the short term: Action : Buy Nifty Calls Example : Current Nifty is Rs.

The strike price is 1370 if at expiration Nifty declines by 5% i.1330) = 23 = 17 Profit on the contract = Rs. 3400 (17 X 200) .B. Assumption : Bearish on the market over the short term. 23 each. Option Value Option Premium Profit per Nifty = 40 (1370 . Possible Action : Buy Nifty Put Example : Nifty in cash market is Rs. Buy one contract of Nifty puts for Rs. 1330. 1400. Rs.e.

10 lakhs Portfolio Beta = 1.000] If at expiration Nifty declines to 1329 and your portfolio falls to Rs. Possible Action : Buy Nifty Puts You held a portfolio valued at Rs. 948276. (10 X 1. 276 Profit on the contract = Rs.13 Current Nifty = 1440 Strike price = 1420 Premium = Rs.1329) = 26 = 65 = Rs.Use Put as a portfolio hedge ? To protect your portfolio from possible market crash.30. then Option Value Option premium Profit per Nifty Loss on Portfolios Net Profit = 91 (1420 . 26 To hedge. you bought 4 puts [800 Nifty. 51724 = Rs.13) lakhs or 11. equivalent to Rs. 52000 (65 X 800) .

Cash outflow = Rs. Sell a Call option Same E1 Same E2 E1 <E2 P1 P2 P1 >P2 Since. Buy a Call option 2. P2 = Rs.e. 6 i. (8 . E2 = 50. 2.SPREADS A spread trading strategy involves taking a position in two or more options of the same type. initial cost of the spread Let E1 = 30.P2 If P1 = Rs. Premium Paid (P1)> Premium Received (P2) Cash outflow for option premium = P1 . Bull Spreads A bull spread reflects the bullish sentiment of a trader. . It can be created by taking the following position: Expiry Exer. Price Option Premium 1. 8.2) = Rs.

10 Rs.E1 (50-30=20) . 10 Rs.E1 (40-30=10) E2 .E1 (40-30=10) S1 .S1 (50-60) If S1= 60 (3) Rs.E1 (60-30) Total Pay off 0 S1 .Possible spot Price on Expiry If S1= 20 If S1=40 (1) (2) Rs. 10 20 30 (E1) 40 50 (E2) 60 (S1) 70 Price of Share Pay off from Long Call (1) S1<E1 (2) E1<S1<E2 (3) S1>E2 0 S1 . 10 20 20 (S1) 20 30 30 (E1) 30 (E1) 40 40 40 (S1) 50 50 (E2) 50 (E2) 60 60 60 70 70 70 Pay offs from a Bull spread (Using Call) Pay off from Short Call 0 0 E2 .

Buy a Call 2. (8 . Sell a Call Expiry Same Same Exer.P1) If P1 = 2.2) = Rs.Bear Spread In Contrast to the bull spreads. It can be created by taking the following position: 1. Premium P1 P1<P2 P2 Since premium paid (P1) < premium received (P2). a bear spread involves an initial cash inflow of Rs. bear spreads are used as a strategy when one is bearish of the market. (P2 . Price E1 E1>E2 E2 O. E2 = 30 . P2 = 8 Initial cash inflow = Rs. believing that it is more likely to go down than up. 6 Let E1 = 50.

10 Rs.S1 (3) E1>S1 S1 . 10 20 20 (S1) 20 20 30 (E2) 30 (E2) 30 (E2) 30 (E2) 40 40 40 (S1) 40 50 (E1) 50 (E1) 50 (E1) 50 (E1) 60 60 60 60 (S1) 70 70 70 70 E2<E1 S1<E2<E1 E2<S1<E1 E2<E1<S1 Pay offs from a Bear spread (Using Call) Price of Share Pay off from Pay off from Total Long Call Short Call Pay off (1) S1<E2 0 0 0 (2) E2<S1<E1 0 E2 .S1 E2 . 10 Rs.If S1= 20 If S1=40 If S1= 60 (1) (2) (3) Rs. 10 Rs.E1 (30-50= -20) Possible spot Price on Expiry .10) E2 .E1 (60-50) (30-40= .S1 (30-60) (-10) E2 .

Buy 1st call (right to buy for E1) 2. Buy 2nd call (right to buy for E3) 3. Buy another call 3.Butterfly Spreads. The strategy is obviously meant for an investor who feels that large price changes are unlikely 1. Sell 2 calls (obligation to sell 2 shares at E2) . Buy a Call 2. Sell 2 Calls E1 E3 E2 E1<E2<E3 E2 = E1 + E3 2 E2 is usually close to current share price 1.

10 20 30 (E1) 35 40 (E2) 45 50 (E3) 60 70 E1<E2<E3 (1) If S1= 20 Rs. 10 20 30 (E1) 35(S1) 40 (E2) 45 50 (E3) 60 70 (3) (4) If S1= 45 If S1=60 Rs. 10 20 20 30 (E1) 30(E1) 35 35 40 (E2) 40(E2) 45(S1) 50 (E3) 60 70 45 50(E3) 60(S1) 70 E1<E2<E3<S1 E1<S1<E2 < E3 E1<E2<S1<E4 All calls are exercised . 10 20 (S1) 30 (E1) 35 40 (E2) 45 50 (E3) 60 70 S1<E1<E2<E3 No call is excised (2) If S1=35 Rs. 10 Rs.Possible spot Price on Expiry Rs.

S1 .E 1 S1 .S1-E1 = E3.S1) 0 S1 .S1 (50-45=5) 0 (2) E1<S1<E2 (3) E2<S1>E3 (4) E3<S1 Since.E 1 S1.Pay offs from a Butterfly spread Price Stock Pay off from Ist long call (E1) Pay off from Pay off from Total Pay off 2nd long call(E3) short calls(E3) (1) S1<E1 0 S1 .S1) 2(E2 .S1) + S1.E1 0 0 0 S1 ± E3 0 0 2( E2 . 2 (E2 .E 1 (35 ± 30 = 5) E 3 .E1 = 2E2-2S1 + S1 .E1 = E1 + E3 .

the higher the P (S>E). (iii) Potential variability of stock Price The greater the Variability. .Factors Affecting Call option Premium (i)Level of existing spot price relative to strike price (exchange price) S>E. (ii) Length of time before the expiration date. the higher will be the option premium.

The higher the spot rate (S) relative to exercise price (E). If S = 40. (right to buy) * Level of Existing Spot Price (s) relative to Exercise Price (E). higher option price. higher is the probability to exercise the option => higher option price. E = 42 33 34 35 36 37 38 39 40 If S = 40.Call Option. If E = 42 option is exercised when S is greater than or equal to 43 41 42 43 44 45 46 .e. S>E lower E compared to S. E = 37 i. If S>E. the higher the option price. higher probability of exercise of option.

High option premium 34 35 36 37 38 39 40 41 42 43 44 45 46 47 S> E If E1 = 39. the higher the probability to exercise the option. the higher the option price. the higher probability to exercise the option 33 If S= 40 E2 = 45 S<E S is relatively low. Relating S>E. S = 40 Option will be exercised when price is les than or equal to 39 .Put Option (right to Sell) The lower the spot rate (s) relative to exercise price (E).

D.5 ( t ) 1/2 C = Current value of the option r = Continuously compounded riskless rate of returns S0 = Current price of stock E = Exercise Price t = time remaining before the expiration date (expressed as a fraction of a year) 2) t t 2) = S.E e -rt.The Black and Scholes Model (1973) C = S0 N (d1) . of continuously compounded annual rate of return Log= Natural logarithm N(d) = value of the commulative normal distribution evaluated at d .5 ( t ) 1/2 d2 = log (S0 / E) + (r . N (d2) Where d1 = log (S0 / E) + (r + 0.0.

0279 d2 = 0.10 .5 X 0.6 V 0.07 .6 2).0.6443 N (d2) = 0.10 + 0..6 r = 0. thus t = 0.5279 . 115 Time period = 3 months.10 d1 = log (120/115) + (0.25 = 0.1443 d1 =0.Example : Consider the following information with regard to call option on the stock of X Ltd.25 .25 year = 0.37 N (d1) = 0. 120 E = Rs.5 X 0.6 2 ) X .6 V 0.37 = log (120/115) + (0.25 =0. S0 = Rs.25 d2 0.07 0.

N (d2) = 120 X (0.11 Using the put.120 = Rs.10 (0.25) .6443) .27 .11 + 115 X e .The value of the Call is C = S0 N (d1) . -S0 = 18.call parity.115 e -0. we can determine the put option value on the share as follows: P = C + E e -rt.5279) = 18. 10.E e -rt.0.10 (.25) X (0.

rt. Portfolio P2:One European put option & one share of stock worth S0 Determination of TERMINAL Values of Portfolios Portfolio Cash Flow at t = 0 S1> E S1” E P1 C E e -rt.. they must have equal values at present as well.E E S1 0 S1 S1 0 E E E .. = P + S0 or P = C + E e .Relationship between European Call and put options: Portfolio P1:One European call option & cash for an amount of E e -rt.S1 S1 E P2 Since both the portfolios have identical values on expiration. Total P S0 Total S1 ..rt.S0 . Accordingly we have C + E e . .

000 from a bank at Floating rate B borrows Rs.SWAP A SWAP transaction is one where two or more parties exchange (SWAP) one set of predetermined payments for another.5 M IBOR + 0.5% .000 from a bank at Fixed rate As a separate transaction A and B agree as follows: (i) A will pay B a fixed rate of 7% (ii) B will pay A a floating rate of MIBOR + 0.5% B 9 M IBOR + 3. 10.5% A borrows Rs. 10. Interest Rate SWAP. Company Fixed (%) Floating (%) A 7.

5%) (b) For B. a fixed rate obligation at 7% (this is better than the 7.SWAP A (7%) B To understand the benefits from the swap consider the net cash flows of A and B (MIBOR + 0.5%) B .5%) Party Swap Swap Swap outflows on Total Outflow (%) Inflow(%) A -7 (MIBOR + 0.5%) + 7% loan from bank (%) -(MIBOR + 0.5) It may be seen that the net result is (a) For A. (A gains 0.5% (this is better then MIBOR + 3.9% .5%) (B gains 1%) .(MIBOR+2.(MIBOR + 0.5% which A would have paid if it had directly taken a fixed rate loan). a floating rate obligation at MIBOR + 2.5%) -7 .

5% (iv) B will receive from C a fixed rate of 6.B.Presence of a Broker C As a separate transaction A.5%) = 0.5% B . and C agree as follows: (i) A will pay C a fixed rate of 7% (ii) A will receive from C a floating rate of MIBOR + 0.5 A 7% C 6.5% C gains (7% .5% MIBOR + 0.6.5%.5% SWAP MIBOR + 0. (iii) B will pay C a floating rate of MIBOR + 0.

(M+0.5) + 6.5 M + 0.(M + 3) + 0. a floating rate obligation at (MIBOR+ 3%) which is better than (MIBOR + 3.0 .5%] (c) for C.0 .5 .5) M + 0. .5 + +7 . B.5 A B C .5% (7.5 + (M + 0.7.(M + o.7.5% for earning the transaction.5) -9 Nil It may be seen that the net result is (a) for A. and C Party Swap Outflow (%) Swap inflows (%) Outflows on loan Total .7)] (b) for B.5 .To understand the benefits from the Swap consider the net cash flows of A. [B gains 0.5%).5% [A gains 0. fixed rate obligation at 7% (this is better than the 7.+ 6. a profit of 0.

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