FINANCIAL DERIVATIVES

DERIVATIVES
 Derivatives are products whose values are derived from one
or more, basic underlying variables.
 Types of derivatives are many-
1. Forwards
2. Futures
3. Options
4. Warrants
5. Swaps
The markets for derivatives exchange:
 Exchange Market
 Over the counter market
FORWARD CONTRACTS
 A forward contract is a customized contract between
two entities, where settlement takes place on a specific
date in the future at a certain price agreed upon.
 Can be contrasted with the spot contract which deals
with buying or selling an asset today.
 Is traded in the over-the-counter market-not
standardized
 Long position and short position
 Used to hedge foreign exchange risk.
FUTURES CONTRACTS
 A standardized forward contract.
 Two types of futures :
 Commodity futures
 Financial futures
 Key differences between forward and futures contract would
be :
 Forward contract is tailor made; Futures is a standardized contract
 No collateral required for forward contracts; margin required for
futures
 Forwards are settled on the maturity date; futures are marked to
market on a daily basis
MARGINS IN FUTURES CONTRACT
 Clearing margin are financial safeguards to ensure that
companies or corporations perform on their customers'
open futures and options contracts.
 Customer margin Within the futures industry, financial
guarantees required of both buyers and sellers of futures
contracts and sellers of options contracts to ensure
fulfillment of contract obligations.
 Initial margin is the equity required to initiate a futures
position.
 Maintenance margin A set minimum margin per
outstanding futures contract that a customer must
maintain in his margin account.
FUTURES CALCULATIONS

CASE 1:
 S :Spot price today
0

 F0:Futures or forward price today

 T:Time until delivery date
 R:Risk-free interest rate for maturity T
The formula for calculation
rT is:
F0  S 0 e
Example
 IBM stock is selling for $68 per share. The zero
coupon interest rate is 4.5%. What is the likely
price of the 6 month futures contract?

F0  S 0 e rT
F0  68e.045.50
F0  $69.55
CASE 2:The price of a non interest bearing asset futures contract.
The price is merely the future value of the spot
price of the asset, less dividends paid.
I= present value of dividends
F0  ( S 0  I )e rT

CASE 3: If an asset provides a known % yield, instead of a specific cash

yield, the formula can be modified to remove the yield.
( r  q )T
F  S 0 e
q = the known continuous0 compounded yield
USES OF FUTURES CONTRACTS
 Hedgers
 Speculators
 Arbitrageurs
OPTIONS
 An option establishes a contract between two parties
concerning the buying or selling of an asset at a reference price.
 The buyer of the option gains the right, but not the obligation,
to engage in some specific transaction on the asset, while the
seller incurs the obligation to fulfil the transaction if so
requested by the buyer.
 Is traded on both the exchange market and over the counter
market.
 Option to buy is a call option
 Option to sell is the put option
 Types:
 European Option: exercised only on the expiration date
 American Option: on or before the expiration date
Options maybe : (for call option)
 ATM (At the money):
 Exercise price = Market price
 ITM (In the money):
 Exercise price <Market price
 OTM (Out of the money):
 Exercise price > Market price
LONG CALL
 A trader who believes that a stock's price will increase might buy
the right to purchase the stock (a call option) rather than just
purchase the stock itself. He would have no obligation to buy the
stock, only the right to do so until the expiration date. If the stock
price at expiration is above the exercise price by more than the
premium (price) paid, he will profit. If the stock price at expiration
is lower than the exercise price, he will let the call contract expire
worthless, and only lose the amount of the premium. 
LONG PUT
 A trader who believes that a stock's price will decrease can buy
the right to sell the stock at a fixed price (a put option). He will be
under no obligation to sell the stock, but has the right to do so
until the expiration date. If the stock price at expiration is below
the exercise price by more than the premium paid, he will profit.
If the stock price at expiration is above the exercise price, he will
let the put contract expire worthless and only lose the premium
paid.
SHORT CALL
 A trader who believes that a stock price will decrease, can sell the
stock short or instead sell, or "write," a call. The trader selling a
call has an obligation to sell the stock to the call buyer at the
buyer's option. If the stock price decreases, the short call position
will make a profit in the amount of the premium. If the stock price
increases over the exercise price by more than the amount of the
premium, the short will lose money, with the potential loss
unlimited.
SHORT PUT
 A trader who believes that a stock price will increase can buy the
stock or instead sell, or "write", a put. The trader selling a put has
an obligation to buy the stock from the put buyer at the put
buyer's option. If the stock price at expiration is above the
exercise price, the short put position will make a profit in the
amount of the premium. If the stock price at expiration is below
the exercise price by more than the amount of the premium, the
trader will lose money, with the potential loss being up to the full
value of the stock.
BLACK-SCHOLES MODEL
 The Black-Scholes formula calculates the price
of European put and call options.
 The value of a call option for a non-dividend paying
underlying stock in terms of the Black–Scholes
parameters is:

 Also,
 The price of a corresponding put option based on put-call
parity is:

  N() is the cumulative distribution function of the standard

normal distribution
 T − t is the time to maturity
 S is the spot price of the underlying asset
 K is the strike price
 r is the risk free rate (annual rate, expressed in terms
of continuous compounding)
 σ is the volatility of returns of the underlying asset
SWAPS
 Swaps are private agreements between two parties to
exchange cash flows in the future according to a
prearranged formula. They can be regarded as portfolios
of forward contracts.
 The two commonly used swaps are :
• Interest rate swaps: These entail swapping only the
interest related cash flows between the parties in the
same currency.
• Currency swaps: These entail swapping both principal
and interest between the parties, with the cash flows in
one direction being in a different currency than those in
the opposite direction.
AN EXAMPLE OF INTEREST RATE SWAP
 A is currently paying floating, but wants to pay fixed. B is currently
paying fixed but wants to pay floating. By entering into an interest
rate swap, the net result is that each party can 'swap' their
existing obligation for their desired obligation. Normally the
parties do not swap payments directly, but rather, each sets up a
separate swap with a financial intermediary such as a bank.
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