Introduction to

Derivatives

1
What are derivatives?

Derivatives are financial instruments

whose prices depend on, or are
derived from, the prices of other
assets.
What are the assets on which
their prices depend?
 Underlying is financial in nature
 Stock prices
 Credit rating
 Interest rates
 Exchange rates
 Also..
 Electricity
 The weather
 Insurance
 Cattle prices

In sum, if you can price the underlying asset, there can

always be a derivative on it.
Why are derivatives useful?

 Hedging
 Speculation
 Arbitrage profit-making
 Balance sheet changes
 To change the nature of a liability
 To change the nature of an
investment/assets
The various kinds of derivatives

There are three principal classes of

derivative securities:

 Options
 Futures and Forwards
 Swaps

In addition, it is possible to have options

on futures, futures on options,
swaptions.. Infinite complexity.
Forward Contracts

 An agreement to buy or sell an asset

at a certain time in the future for a
certain price
 No daily settlement. When the
contract expires, one party buys the
asset for the agreed price from the
other party.
 The contract is an over-the-counter
(OTC) agreement between 2
institutions.
 Profit from Forward Positions

Profit
Profit
Price of Underlying Price of Underlying
at Maturity at Maturity

Long position Short position

7
Working of a forward contract

Exchange Rate Bid Ask

(INR/USD)

Spot 39.94 40.11

1-month 39.78 40.02

3-month 39.55 39.94

8
Working of a forward contract
 Suppose Reliance has to make a
payment of $25 M to Total 3 months
from now and wish to lock in an
exchange rate.
 They would enter a 3-month forward
contract to buy $ at the 3-month
forward exchange rate.
 What happens if the exchange rate 3-
months from now is different from
39.55?
9
Futures Contracts

 An agreement to buy or sell an

asset at a certain time in the
future for a certain price.
 They are exchange-traded, and
hence, are standardized contracts.
 Important futures exchanges:
CBOT, CME, NYMEX etc.
 In India: BSE, NSE, MCX, NCDEX.
Examples of Futures Contracts

 Agreement to:

 Buy 1000 shares of Reliance at

Rs. 2500 in May (BSE)
 Sell $1 million at 1.5000 US$/£
in april (CME)
Futures Arbitrage
Suppose that:

 The spot price of Reliance is

Rs. 1500
 The quoted 1-year futures
price is Rs. 2000
 1-year interest rate is 10%

 Is there an arbitrage
opportunity?
Futures Arbitrage
Solution:
 Borrow Rs. 1500 at 10%
 Go long spot
 Short futures

 End of year profit

 = 2000 – 1500*(1+10%)

 What if the futures price

is Rs. 1600?
 Non-arbitrage futures price
If the spot price is S and futures price is F for a
contract deliverable in T years, then

F = S (1+r )T

If F > S (1+r )T, go short on futures and long

on spot and vice versa.

 What is the value of the futures

contract?
Daily settlement and margins
 Margin is cash or marketable
securities deposited by an investor
with the broker
 Marking to market: Balance in the
margin account is adjusted to reflect
daily settlement
 Margins guard against default
 How are margins set?
Forward Contracts vs Futures
Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at maturity Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Options
 An option is a security that gives the holder the
right but not the obligation to buy or sell a
security for a specified price at a specified
date.

 Basic classification of options:

 Call options/Put options
 American options/European options

 How are options different from

futures/forwards?
Intrinsic and Time Value
 Option premium = Intrinsic Value + Time Value

 Intrinsic value: payoff if option is exercised

immediately, always greater than or equal to zero.

 Usually the price of an option in the marketplace

will be greater than its intrinsic value. The
difference between the market value of an option
and its intrinsic value is called the time value of an
option.

 What are in-the-money, out-of-the-money and

at-the-money options?
Long Call

Profit from buying European call option: option price =

$5, strike price = $100, option life = 2 months

30 Profit ($)

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130
Short Call

Profit from writing a European call option: option price =

$5, strike price = $100

Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30
Long Put

Profit from buying an European put option: option price

= $7, strike price = $70

30 Profit ($)

20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7
Short Put

Profit from writing an European put option: option price

= $7, strike price = $70

Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10

-20

-30
Effect of Variables on Option
Pricing
Variable c p C P
S0 + – + –
X – +? – +
T ? + +
 + + + +
r + – + –
D – + – +
• What is the relation between price of an American
option and a European option?
Put-Call Parity; No Dividends

 Consider the following 2 portfolios:

 Portfolio A: European call on a stock + PV of
the strike price in cash
 Portfolio C: European put on the stock + the
stock
 Both are worth Max (ST , X) at the maturity of the
options
 They must therefore be worth the same today
 This means that

c + Xe -rT = p + S0
 Valuation using Black
Scholes equation
c  S0 N (d1 )  X e  rT N (d 2 )
p  X e  rT N (  d 2 )  S0 N (  d1 )
ln( S0 / X )  (r   2 / 2)T
where d1 
 T
ln( S0 / X )  (r   2 / 2)T
d2   d1   T
 T
•What happens if S is a) very large? b) very small?
What is Risk-Neutral
Valuation?

1. Assume that the expected

return from an asset is the
risk-free rate
2. Calculate the expected
payoff from the derivative
3. Discount at the risk-free
rate
Naked and Covered Positions

Naked position
Take no action

Covered position
Buy 100,000 shares today

 Both strategies leave the bank

exposed to significant risk.
How?
Stop-Loss Strategy

This involves:
 Buying 100,000 shares as soon
as price reaches $50
 Selling 100,000 shares as soon
as price falls below $50

 What is the problem with

this strategy?
The Greeks: Delta
 Delta () is the rate of change of the option price with
respect to the underlying

Option
price

Slope = 
B
A Stock price
Delta…
 Delta = sensitivity of an option's theoretical
value to a change in the price of the underlying
contract.

delta = change in the option price

change in the stock price

 What is the range of deltas for calls and

puts?

 Why is delta also called the hedge ratio?

Theta
 Theta () is the rate of change of the value with respect
to time.

 Gamma () is the rate of change of delta () with

respect to price of the underlying asset.

 Vega () is the rate of change of the value of a

derivatives portfolio with respect to volatility.

 Rho is the rate of change of the value of a derivative

with respect to the interest rate.
Managing Delta, Gamma, &
Vega
 Delta, , can be changed by
taking a position in the
underlying asset
 To adjust gamma,  and vega, 
it is necessary to take a position
in an option or other derivative
Hedging in Practice

 Traders usually ensure that their

portfolios are delta-neutral at least
once a day
 Whenever the opportunity arises,
they improve gamma and vega
 As portfolio becomes larger hedging
becomes less expensive
Exotic Options
 Bermudan option - non-standard American option in which
early exercise is limited to certain dates during the life of
the option. Also referred to as "hybrid-style" exercise.

 Forward start option is an option that is paid for now, but

does not begin until some later date.

 Compound option is an option on an option. Compound

options have two strike prices and two expiration dates. For
example, a call on a call is purchased. At some specified
date in the future, a person will have the right but not the
obligation of purchasing a call option.
Exotic Options
 Chooser option, also called an "as you like it" option, allows
the holder to choose after a specified period of time
whether the option is a call or a put.

 Barrier option is an option in which the payoff depends on

whether the underlying asset's price reaches a certain level
during the life of the option.
 Up-and-out option becomes worthless once the underlying asset price
reaches a specified boundary price.
 Up-and-in option requires the underlying asset price to reach the
boundary price before the option can be activated.

 Rainbow option is an option involving two or more risky

assets.
Exotic Options
 Lookback option - payoffs depend on the maximum or
minimum the stock price reaches over the life of the option.

 Asian option (average price option) - payoff depends on the

average price of the asset (not the stock price itself) over a
specified amount of time during the life of the option.

 Spread option - strike price is the spread between two

underlying assets. For example, crack spreads on the
spread between the price of crude and its by-products.

 Basket option - payoff depends upon a portfolio of assets.

Terms to watch out for
 Volatility trading, correlation trading
 Delta hedging, Gamma Hedging
 Long, short, spread
 Basis risk
 Libor, yield curve
Butterfly Spread Using Calls
 Butterfly Spread: buying a call option with a relative
low strike price, K1, buying a call option with a
relative high strike price. K3, and selling two call
options with a strike price halfway in between, K2.

Stock price Payoff Payoff from Payoff from Total

Range from First Second Short Calls Payoff
Long Call Long Call
Option Option
ST ≥ K3 ST - K1 ST - K3 -2(ST - K2) 0
K2 < ST < K3 ST - K1 0 -2(ST - K2) K3 - ST
K2 < ST < K3 ST - K1 0 0 ST - K1
ST ≤ K1 0 0 0 0
Butterfly Spread Using Calls
 Example: Call option prices on a $61 stock are: $10 for a $55 strike, $7
for a $60 strike, and $5 for a $65 strike. The investor could create a
butterfly spread by buying one call with $55 strike price, buying a call
with a $65 strike price, and selling two calls with a $60 strike price.

Stock price Payoff Payoff from Payoff from Total

Range from First Second Short Calls Payoff
Long Call Long Call
Option Option
ST ≥ $65 ST - $55 ST - $65 -2(ST - $60) 0
$60 < ST ST - $55 0 -2(ST - $60) $65 - ST
<$65 ST - $55 0 0 ST -$55
$55 < ST 0 0 0 0
<$60
ST ≤ $55
Butterfly Spread Using Calls

Profit

K1 K2 K3 ST
Butterfly Spread Using Puts

Profit

K1 K2 K3 ST
Introduction to financial
swaps
 An asset-liability management technique which permits
a borrower (investor) to access one market and then
exchange the liability (asset) for another type of
liability (asset).

 Swaps are not a funding instrument; they are a device

to obtain the desired form of financing indirectly which
otherwise might be inaccessible or too expensive.

 Swaps may also be used purely for hedging purposes.

Major Types of Swap
Structures

 Swaps involve exchange of a series of periodic

payments between two parties, usually through an
intermediary which is normally a large international
financial institution which runs a “swap book”.

 The two major types are Interest Rate Swaps (also

known as Coupon Swaps) and Currency Swaps.

 Major classification of swaps:

 Liability swaps
 Asset swaps
 A Three Year Fixed-to-Floating Interest
Rate Swap

Notional principal P = $50 million

Trade Date : August 30, 2004
Effective Date : September 1, 2004
Fixed Rate : 9.5% p.a. payable semiannually, Actual/360
Floating Rate : 6 Month LIBOR
 The fixed payments are as follows :
__________________________________________________
Payment Date Day Count Fraction Amount
_________________________________________________
_
1/3/2005 181/360 $2388194.40
1/9/2005 184/360 $2427777.80
1/3/2006 181/360 $2388194.40
1/9/2006 184/360 $2427777.80
1/3/2007 181/360 $2388194.40
1/9/2007 184/360 $2427777.80
 Suppose the floating rates evolve as
follows :

Reset Date LIBOR (% p.a.)

30/8/2004 9.80
28/2/2005 9.20
30/8/2005 9.50
27/2/2006 8.90
30/8/2006 9.70
27/2/2007 10.20
 This will give rise to the following
floating payments :

Payment Date Amount ($)

1/3/2005 2477222.20
1/9/2005 2351111.10
1/3/2006 2388194.40
1/9/2006 2274444.40
1/3/2007 2438472.20
1/9/2007 2606666.70
Normally, the payments would be netted out with only the net
payment being transferred from the deficit to the surplus party.
A TYPICAL USD IRS
A FIXED-TO-FLOATING INTEREST RATE SWAP

6.75% Fixed 6.5% fixed

SWAP BANK

Prime-25bp Prime-25bp

XYZ CORP. ABC BANK

Prime+75bp 6.5% Fixed

To Floating to Fixed
Rate Lenders Rate Lenders
Major Types of Swap
Structures

 A number of variants of the standard structure are

found in practice
• Varying notional principal – Amortizing,
Accreting and Roller-Coaster Swaps
 A Zero-Coupon Swap has only one fixed
payment at maturity
 A Basis Swap involves an exchange of two
floating payments, each tied to a different
market index
 In an Extendable Swap, one of the parties has
the option to extend the swap beyond the
scheduled termination date
 Index maturity not equal to reset frequency
Major Types of Swap Structures

 In a Forward Start Swap, the effective date is

several months even years after the trade date
so that a borrower with a future funding need
can take advantage of prevailing favourable
swap rates to lock in the terms of a swap to be
entered into at a later date
An Indexed Principal Swap is a variant in which the
principal is not fixed for the life of the swap but
tied to the level of interest rates - as rates
decline, the notional principal rises according to
some formula
 In a Callable Swap the fixed rate payer has the
option to terminate the agreement prior to
scheduled maturity while in a Putable Swap the
fixed rate receiver has such an option
Credit Default Swaps

Protection
Premium
Default protection Default protection
buyer seller
Credit Default Swaps

Tranche 1
1st 5% of loss
35% return

Bond 1 Tranche 2
Bond 2 2nd 10% of loss
Bond 3 Trust 15% return
…
Bond n
Tranche 3
Residual loss
6% return