You are on page 1of 37

Introduction

1.1

The Nature of Derivatives

A derivative is an instrument whose value depends on the values of other more basic underlying variables

1.2

Examples of Derivatives

Futures Contracts Forward Contracts Swaps Options

1.3

Derivatives Markets


Exchange traded


Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading. CBOT in 1848. CME (futures xch) in 1919. CBOE (options xch) in
1973 Open outcry vs electronic trading

Contracts are standard there is virtually no credit risk A computer- and telephone-linked network of dealers at financial institutions, corporations and fund managers Contracts can be non-standard and there is some small amount of credit risk. Taped. Larger than xch traded in volume.
1.4

Over-the-counter (OTC)
   

Size of OTC and Exchange Markets


550 500 450 400 350 300 250 200 150 100 50 0 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

Size of Market ($ trillion)

OTC Exchange

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market 1.5

Factors driving growth of fin. deriv


 

Increased volatility in asset prices Integration of national markets with international markets Improvement in communication facilities and reduction in their costs Development of wide risk management tools Innovations in derivatives market (new
products, lower transaction costs.)
1.6

Ways Derivatives are Used


 

  

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
1.7

Economic functions of derivatives mkt




Price reflects mkt perception of future and lead underlying price to perceived futures price. Helps in price discovery (through
convergence on expiry)

  

Help in risk transfer from those who have it to those who will take it. Increased market participation from more players Speculative trades shift to a controlled deriv. mkt. In Cash market, margining, monitoring and surveillance difficult. 1.8

Forward Contracts
 

Forward vs spot contract Traded OTC (between two FI or FI & its clients) 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
1.9

OTC vs Exchange traded markets


   

Management of counter party risk is decentralized and managed by indiv. Insti. No centralized limits on indiv. positions, leverage or margining. No formal rules for risk and burden sharing. No formal rules to ensure market stability and integrity and safeguard mkt participants interest. Not regulated by the regulatory authority and the exchanges Self Regulatory Orgn.
1.10

Foreign Exchange Quotes for GBP June 20, 2010


Bid Spot 1-month forward 3-month forward 6-month forward 1.2358 1.2347 1.2326 1.2283 Offer 1.2362 1.2352 1.2331 1.2289

1.11

Forward Price


The forward price for a contract is the delivery price that would be applicable to the contract if 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
1.12

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


Can be used to hedge forex risk.

1.13

Example


On Jun 20, 2010 the treasurer of a corporation enters into a long forward contract to buy 1 million in six months at an exchange rate of 1.2289 This obligates the corporation to pay $1,228,900 for 1 million on December 20, 2010 What are the possible outcomes?
1.14

Profit from a Long Forward Position


Profit

Price of Underlying at Maturity, ST

Spot rate can be 1.252 (company gains) or 1.204 (company loses). Payoff = S-K 1.15

Profit from a Short Forward Position


Profit

Price of Underlying at Maturity, ST

Payoff = K-S

1.16

Forward price and delivery price




Forward price and spot price




Forward price is agreed price today for delivery in future. Delivery price (1.2289) does not change till expiry. But forward price may change daily.

Spot price is for todays delivery. Forward price is for future delivery. Spot price for Gold $900/ounce. Risk free interest rate = 5%. What is the forward rate? What will you do if the forward price is
 

$960 $920
1.17

Futures Contracts
     

Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Forward contract is traded OTC, Futures contract is traded on an exchange Standardized features Exchange/Clearing house guarantees to reduce counter party risk.
 

Commodities like live cattle, orange juice, sugar, wool, copper, aluminium gold, tin. Financial assets like stock indices, stocks, currencies, treasury bonds.
1.18

Exchanges Trading Futures


     

Chicago Board of Trade Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) TIFFE (Tokyo) NSE/BSE/NCDEX/MCX


and many more


1.19

Examples of Futures Contracts


Agreement to:  buy 100 oz. of gold @ US$900/oz. in December (NYMEX)  sell 62,500 @ 1.2350 US$/ in March (CME)  sell 1,000 bbl. of oil @ US$ 60/bbl. in April (NYMEX)
1.20

1. Gold: An Arbitrage Opportunity?


Suppose that: The spot price of gold is US$900 The 1-year forward price of gold is US$960 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?
1.21

2. Gold: Another Arbitrage Opportunity?


Suppose that: - The spot price of gold is US$900 - The 1-year forward price of gold is US$920 - The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?
1.22

The Forward Price of Gold


If the spot price of gold is S and the forward price for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S = 900, T = 1, and r =0.05 so that F = 900(1+0.05) = 945
1.23

1. Oil: An Arbitrage Opportunity?


Suppose that: - The spot price of oil is $ 45 - The quoted 1-year futures price of oil is $ 49.5 - The 1-year US$ interest rate is 5% p.a. - The storage costs of oil are 2% p.a. Is there an arbitrage opportunity?

1.24

2. Oil: Another Arbitrage Opportunity?


Suppose that: - The spot price of oil is $ 45 - The quoted 1-year futures price of oil is $ 44.5 - The 1-year US$ interest rate is 5% p.a. - The storage costs of oil are 2% p.a. Is there an arbitrage opportunity?

1.25

Options


Options traded OTC/Exchange  A call option is an option to buy a certain asset by a certain date (expiration date or maturity) for a certain price (strike price/exercise price)  A put option is an option to sell a certain asset by a certain date for a certain price
1.26

American vs European Options




An American option can be exercised at any time during its life A European option can be exercised only at maturity

1.27

Reliance Option Prices (June 08, 2010


Stock Price=1050
Strike Price 1020 1050 1080 1110 1140

)
Jun Call 54 43 35 25 16 Jul Call 64 49 37 33 23 Aug Call 71 61 47 44 32 Jun Put 15 21 25 32 47 Jul Put 22 28 33 41 53 Aug Put 30 33 41 46 59

1.28

Exchanges Trading Options


      

Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) NSE/BSE (India)


and many more


1.29

Options vs Futures/Forwards


 

A futures/forward contract gives the holder the obligation to buy or sell at a certain price. It costs nothing to enter into futures trans. An option gives the holder the right to buy or sell at a certain price The buyer of options pays a price (option premium)
1.30

Option positions
 

Option Buyer Option Seller (writer) Value of Option


   


Call Put

Call buyer Call seller Put buyer Put seller

Max(S-K,0) -Max(S-K,0) or Min(K-S,0) Max (K-S,0) -Max(K-S,0) or Min(S-K,0)

S is the spot price on expiration and K is the exercise price


1.31

Types of Traders
Hedgers Speculators Arbitrageurs
Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators.

1.32

Hedging Examples


 

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 @ 1.2053 A US exporter receiving 25 million 6 months hence from a dealer. Hedge by selling in forward market @ 1.2048 now. If you dont hedge, what happens? Are you better off or worse off? An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts
1.33

Value of Microsoft Shares with and without Hedging


40,000 Value of Holding ($)

35,000

No Hedging

Hedging

30,000

25,000

Stock Price ($) 20,000 20 25 30 35 40

1.34

Speculation Example


An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of 22.50 is $1 What are the alternative strategies?

1.35

Speculation Example


Buy 100 shares @ 20. Price increases to $30. Profit is 100* (30-20) = 1000 Buy 20 lots of 22.5 Call option. Price increases to $30. Profit is 2000*(3022.5)-2000 = 13,000. What happens if the price falls to $15?
Investor Strategy Buy shares Buy option $30 1000 13000 $15 -500 -2000 1.36

Arbitrage Example


 

A stock price is quoted as 100 in London and $125 in New York The current exchange rate is 1.24 What is the arbitrage opportunity?

1.37