Introduction to derivatives

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INTRODUCTION TO DERIVATIVES

Derivatives are the financial instruments which derive their value from the value of the underlying asset.

HISTORY:

Derivatives markets can be traced back to middle ages. They were developed to meet the needs of farmers and merchants. First future exchange was established in Japan in 16th century. The Chicago Board of Trade was established in 1848.The international Monetary market was established in 1972 for future trading in foreign currencies

Players in the derivatives market?

Hedgers

Speculators

Arbitrageurs

HEDGER

A hedger is someone who faces risk associated with price movement of an asset and who uses derivatives as means of reducing risk.

Definitions long position: an asset which is purchased

or owned

short position: an asset which must be delivered to a third party as a future date, or an asset which is borrowed and sold, but must be replaced in the future

Hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position.

SPECULATOR

Speculators use derivatives to bet on the future direction of the markets. Their objective is to gain when the prices move as per their expectation.

3 types based on duration

i. SCALPERS – hold for very short time (in minutes)

ii. DAY TRADERS- one trading day

iii.POSITION TRADERS- long period (week, month, a year).

ARBITRAGERS

Arbitrageurs try to make risk-less profit by simultaneously entering in to transactions in two or more market.

Arbitrageurs assist in proper price discovery and correct price abnormalities.

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TYPES OF FINANCIAL DERIVATIVEForward

Futures

Options

FORWARD CONTRACT

A forward is an agreement between two counterparties - a buyer and seller. The buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase.

FUTURES CONTRACT

A futures contract is an agreement that requires a party to the agreement either to buy or sell something at a designated future date at a predetermined price.

Futures contracts are categorized as either commodity futures or financial futures. Commodity futures involve traditional agricultural commodities (such as grain and livestock), imported foodstuffs (such as coffee, cocoa, and sugar), and industrial commodities.

WHO DO YOU USE FUTURES CONTRACTS MARKETS?

Hedgers

Speculators

MECHANICS OF FUTURES TRADING

A futures contract is a firm legal agreement between a buyer and an established exchange or its clearinghouse in which the buyer agrees to take delivery of something at a specified price at the end of a designated period of time.

The price at which the parties agree to transact in the future is called the futures price.

The designated date at which the parties must transact is called the settlement date.

LIQUIDATING A POSITION

Most financial futures contracts have settlement dates in the months of March, June, September, or December.

The contract with the closest settlement date is called the nearby futures contract.

The contract farthest away in time from the settlement is called the most distant futures contract.

Choices of liquidation

A party to a futures contract has two choices on liquidation of the position.

First, the position can be liquidated prior to the settlement date.

The alternative is to wait until the settlement date.

DAILY PRICE LIMITS

The exchange has the right to impose a limit on the daily price movement of a futures contract from the previous session's closing price.

RISK AND RETURN CHARACTERISTICS OF FUTURES CONTRACTS

Long futures: An investor whose opening position is the purchase of a futures contract

Short futures: An investor whose opening position is the sale of a futures contract.

The long will realize a profit if the futures price increases.

The short will realize a profit if the futures price decreases

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OPTIONS

Option is basically an instrument that is traded at the derivative segment in stock market. Option is a contract between the buyer and seller to buy or sell a one or more lot of underlying asset at a fixed price on or before the expiry date of the contract.

TYPES OF OPTIONS

There are mainly two types of option contact

that you can buy or sell at the stock market.

Call Option

Put Option

CALL OPTION

“ A call gives the holder the right to buy an asset at a certain price within a specific period of time or certain date of time.”

Certain price

Certain date

PUT OPTION

“A put gives the holder the right to sell an asset at a certain price within a specific period of time”.

OPTION PREMIUM

The premium is the price at which the contract trades. The premium is the price of the option and is paid by the buyer to the writer, or seller, of the option.

Option premium = intrinsic value + time value

INTRINSIC VALUE

The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option.

Put option=strike price-underlying asset

Call option=underlying asset-strike price

TIME VALUE

It is determined by the remaining lifespan of the option, the volatility and the cost of refinancing the underlying asset (interest rates).

Time value = option price - intrinsic value

OPTIONS CONTRACTSPRELIMINARIES

CALLS VERSUS PUTS

Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. When exercising a call option, you “call in” the asset.

Put options gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at prices agreed upon today. When exercising a put, you “put” the asset to someone

STRIKE PRICE TERMINOLOGY

The type of option and the relationship between the spot price of the underlying asset and the strike price of the option determine whether an option is in-the-money, at-the-money or out-of-the-money.

Call option Put option

In- the Money Spot.>strike Spot<strike

At-the-Money Spot=strike Spot=strike

Out-of the-Money Sport<strike Sport>strike

TRADING & PARTICIPANTS OF OPTIONS

Trading of option

Options are traded both on exchanges and in the over-the-counter market.

Participant of options

There are four types of participants in options markets.

Buyers of calls

Seller of calls

Buyer of puts

Seller of puts

DERIVATIVES MARKET IN PAKISTAN

Derivatives Market in Pakistan

Commodity futures contracts have recently been introduced from the platform of National Commodity Exchange Limited Karachi. Currently they only trade in Gold futures and plan to expand the contracts on agricultural commodities and interest rates.

SBP took initiative in 2004 by granting Authorized Derivative Dealers (ADD) license to five commercial banks.

Need & Scope of Derivatives in Pakistan

Volatile financial markets due to:

1. Political Uncertainty

2. Monetary Policy

3. Fiscal Policy

4. Foreign Investment

5. War On Terror

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