UNIT-3

The Concept of Derivatives

 Financial derivatives

• The term “ Derivatives” indicates that it has no

independent value ie., its value is entirely
derived from the value of the underlying
asset.
• The Underlying asset can be securities,
commodities ,bullion, currency or anything
else.,
• Derivatives means forwards, futures, swaps, options
or any other hybrid contract of predetermined fixed
duration, linked for purpose of contract fulfillment
of the value of a specified financial asset.
• The Securities contracts Act,1956 defines derivative
as
 Security derived from a debt instrument, share,
loan whether secured or unsecured risk instrument
for differences or any other form of security.
 Types of Derivatives
• Forwards
• Futures
• Options
• Swaps
• Warrants
• LEAPS
 Role of derivatives

• Hedging
• Synthetic Asset exposure
• Speculation
• Arbitrage
Role of derivative securities to manage risk

• Firms and individuals must avoid risks that are

not profitable so that they can take on more
risks that are advantageous.
• Derivatives enable them to shed risk and take in
risks cheaply.
• Derivatives are useful not only to manage risks
corporations have already taken but they also
enable firms to change what they do, to think of
new profitable stratagies
 Features of forward contract
• No down payment
• Settlement of maturity
• No secondary market
• Necessity of a third party
• Delivery
 Main terms
• Long position- who agrees to buy
• Short position- who agrees to sell
• underlying asset- commodity, currency
• Spot price
• Future spot price
• Delivery price
• Forward price
 Pricing of forward contracts
• Securities providing no income
• Securities providing a known cash income
• Securities providing known yield
 Securities providing no income

F= So.ert
F= Forward price
So= spot price
R=rest free rate of interest per annum
T=time of maturity
• A forward contract on a non dividend paying
share which is available at ₹70 to mature in 3
months time. If rest free rate of interest be
8% per annum. find the price of the contract
• A forward contract on a non dividend paying a
share which is available at ₹100 to mature in 2
months time and the rest free rate of interest
7.5%.find the price of the contract.
Securities providing a known cash income

• F= So. e(r-y)t
• y= yield rate
• P] The shares underlying a index provide a
dividend yield of 4% per annum. The current
value of index is 520 and has the continously
compounded rests free rate of interest is 10%
per annum. find the value of 3 months forward
contract.
 problems
• A stock index is currently at 820 the
continuously compounded rests free rate of
return is 9%per annum and the dividend is on
the index is 3% per annum. What should be
future price for a contract with 3 months to be
expression.
 Securities providing known yield

• F = So. e(r-q)t
• q= constant dividend rate
• A six months forward contract on a security
where 4% annum continuous dividend is
expected. The risk free rate of interest is 10% per
annum. The assets current price is 25. What is
the forward price?
 Calculation of payoff from the forward
contract
• Long position( BUYER)
• Gain or positive payoff = (Future spot price-forward
price) * No of units
• Loss = (Forward price- future spot price)* n of units
or size of the contract
• Short position (Seller)
• Gain = ( forward price –future spot price) * No of
units
• Loss=(Future spot price –Forward price) * No of units
 Problems on forward contract for arbitrage
opportunity
• Consider a long forward contract to purchase
a non dividend paying stock in 3 months.The
current stock price is 40 and 3 months risk
free rate 5%. What is the forward contract. If
the future forward price if a) 43/- per share b)
39/- per share who the arbitrer try to get
profit.
• On march 1 two parties enter into a forward
contract for delivery of 200 ounce of gold in
august 1 at a price of 550 dollars per ounce.
What would be the gain or loss for long
forward and position and short position . If the
price of gold on August 1 will be 700 dollars
per ounce.
• Consider a six months long forward contract of
non income saying security. the risk rate of
interest is 6% per annum. The stock price is
30/- and delivery price is 28/-.Compute the
value of forward contract when the investor
hold 500 shares of particular company.
• Sol: Given :
• Spot price =30/-,r=6%=0.06,t=6/12=0.5
• On Jan 1 price of Reliance share is 450/- and
two parties enter into a forward contract for
delivery of 1000 shares of reliance on April 15
at a price of 460/-.Find out the profit or loss
profile of seller and buyer if the price of
reliance share is expected to be a) 470/-
b) 400/- on 15 april.
 FUTURES CONTRACTS
• A future contract is a form forward contract in
that it conveys the right to purchase or sell a
specified quantity of a foreign currency at a
fixed exchanged rate on a specified future
date. Whereas in a forward contract the
quantum of foreign currency and the due
date are determined by the customer, in a
futures contract these are standardized.
 Features of Future Contract
• Futures exchange-IMM,LIFFE
• Size of contract
• Delivery dates
• Price movements
• Trading by members
• Dealing with clearing house
• Marking to market
• Delivery
Basis and convergence of future price to spot
price
• Basis= spot price ( cash)–future price
• Spot price = cash market
• Future price= futures market
• Basis price can be negative , zero and positive
• When spot price is < future price = positive
and is termed as Normal market.
• When spot price > future price =negative and
is termed as Inverted market
• When spot market= 45/- and futures
market=50/- arbitraguer makes a profit of 5/-
• Spot market =80/- and future market =70/-
• CONVERGENCE:
 Problems on future contracts
• Determination of future price:
• 1. For stock index future and stocks
F=S.ert
2. When yield on underlying asset is estimated
during future period
F= S.e(r-q)t
3. For commodities
a) When storage or holding cost is not estimated
F=S.ert
• B) When storage or holding cost is estimated
• F= (S+U).ert,
• Where U= Carrying cost or holding cost
 Problems
• Consider a 3 month future contract on the S
&P 500 market suppose that the stocks
underlying the index provides dividend yield of
1% per annum that the current value of the
index is 800 and the continuously
compounding risk free interest rate is 6% per
annum determine the future price for the
stock index.
• F=S.e (r-q) t
• S=800,t=3/12=0.25,r=6%, q=1%
• 800.e(.06-.01).25
• 800.e.05*.25
• 800*e0.0125
• 800 *1.0125
F= 810
• Consider the 3 months future contracts on
S&P500 suppose that the stock underlying
index provides a dividend yield of 1% per
annum the current value of index is 400 and
risk free interest is 6% per annum. Calculate
the future price

• F= S.e(r-q)t
 Problems on Commodity Future

• Consider one year future contract investment

that produces no income it cost ₹2 per unit to
store the asset with the payment made at the
end of 1 year. Assume that spot price is 450 per
unit and risk free rate is 7% per annum. Calculate
future price for particular asset.
• F= (S+U)*ert
• 450+2*e0.07*1=450+2*1.0725=450+2.1450
• F = 452.1450