Nuts And Bolts Of Derivatives.Pdf

Nuts and Bolts of

Derivatives

Understanding Derivatives

Derivatives Defined

Derivatives are instruments whose

value is ‘derived’, in whole or in part,

from the value of one or more underlying

assets.

*Financial Market

The Underlying in a Derivative

Commodity

An Index

StockBond

The value of the derivative instrument is

DERIVED from the underlying asset

An Exchange Rate Another Derivative

Key features of Derivatives

� The value of a derivative instrument is derived from the value of the underlying

� A derivative contract is priced separately from the asset

� The derivative contract is traded not the underlying asset

� No ownership rights associated with the asset sold

Classification of Derivatives

Based on the underlying:

Commodity Derivatives

Financial Derivatives

Origin of Derivatives

� Originated as hedging devices against fluctuation in commodity prices

� Chicago Mercantile Exchange

� Chicago Board of Trade

� Financial derivatives emerged post 1970

� Volatility of financial market an important reason

� Index based and stock based are most popular today

� Today the volumes of financial derivatives trade is many times more than volumes in commodity derivatives trade.

Derivatives in India

� In India, derivative trading commenced on Jun 09, 2000 (BSE) & Jun 12, 2000 (NSE) with index futures and subsequently index options (Jun 2001), stock options (Jul 2001) and stock futures (Nov 2001) were introduced

� Commodity derivatives started much later in 2003 and are also popular but the market is smaller in comparison

� Futures & Options are the more popular forms

� Separate segment for derivatives (NEAT- F&O on NSE and DTSS on BSE)

� Today the trading volumes on derivative segment are in excess of INR 15,000 crores per day

� In 2004-05, 77+ crores trades with volumes of 25 lakh-crores were done.

Popularity of Derivatives

Hedging:

• Interest rate volatility • Stock price volatility • Exchage rate volatility • Commodity prices volatility

VOLATILITY

Derivative markets have attained an overwhelming popularity for a variety of reasons...

To hedge or insure risks; i.e., shift risk.

Popularity of Derivatives

Speculation:• Leverage opportunity• Huge returns

EXTREMELY RISKY

Derivative markets have attained an overwhelming popularity for a variety of reasons...

To reflect a view on the future direction of the market, i.e., to speculate.

Popularity of Derivatives

Derivative markets have attained an overwhelming popularity for a variety of reasons...

Arbitrage: • Take advantage of price differential by taking offsetting positions

PRICE DIFFERENTIAL

To lock in an profit on the basis of price differential in the market i.e. an arbitrage opportunity

!STOP!!CHECK!

� The following could be an underlying in a derivative?� ITC Stock

� Coffee

� USD/GBP rate

� All the above

� The price of a derivate is separate from but dependent on the price of the underlying � TRUE

� FALSE

� While Commodity based derivatives started before financial derivatives, the trading volumes in financial derivatives across the world are higher than commodity derivatives� TRUE

� FALSE

� Which of the following was the 1st financial derivative traded in India?a. Index Option

b. Index Future

c. Stock Future

d. Stock option

� The strategy that involves taking advantage of price differential between two markets is called:� Hedging

� Speculating

� Arbitraging

� Diversifying

Types of Derivatives

Futures

Swaps

OptionsForwardsTypes of Derivative

Instruments

Option

Swap

Forward

Future

The owner of an option has the OPTION to buy or sell

something at a predetermined price on or before a

predetermined date.

The owner of a forward has the OBLIGATION to sell or buy

something in the future at a predetermined price. The difference

to a future contract is that forwards are customized, not

standardized. These are bilateral contracts between 2

private parties.

The owner of a future has the OBLIGATION to sell or buy

something in the future at a predetermined price. A future

contract has standardized conditions.

A swap is an agreement between two parties to

exchange a sequence of cash flows.

Types of Derivatives

OTC vs. Exchange-Traded Derivatives

� Primarily, Forwards and Swaps are OTCderivatives

� Considered risky because:

–There is no formal margining system

–These are not settled on a clearing house

–These do no follow any formal rules or mechanisms

� Futures and Options are exchange-traded, a safer option.

!STOP!!CHECK!

� If I commit to sell gold to you in the month of Dec and we agree to a price of Rs. 12,000 per 10 gm, we have just entered into a:� Future contract

� Option contract

� Forward contract

� Swap agreement

� All derivatives are obligatory on both buyer and seller, except:� Futures

� Forwards

� Options

� Swaps

� The following are OTC derivatives, hence have higher element of risk involved:� Swaps and options

� Options and futures

� Futures and forwards

� Swaps and forwards

� The following is not true about exchange-traded derivatives?� There is a settlement mechanism

� There is a margining system

� there is no loss of margin money ever

� There are formal rules or mechanism

Understanding Futures

Future The owner of a future contract

has the OBLIGATION to sell or

buy something in the future at

a predetermined price.

Future Contract

Future Contract

Standardized Items in Future

� Quantity of the underlying

� Quality of the underlying

� The date and month of delivery

� Location of settlement

Future Contract

Future Terminology� Spot Price

� Future Price

� Contract Cycle

� Expiry Date

� Contract Size

� Basis

� Cost of Carry

� Initial Margin

� Marking to Market

� Maintenance Margin

Futures Terminology

� Spot Price – the price at which an asset trades in the spot market

� Future Price – the price at which the future contract trades in the futures market

� Contract Cycle – the period over which the contract trades. The index futures contracts on the NSE have a one-month, two-month and three-month expiry cycles which expire on the last Thursday of the month. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.

� Expiry Date – the date specified in the futures contract.

� Contract Size – the amount of asset that has to be delivered under one contract. For instance, the contract size on NSE futures market is 100 Nifties.

Futures Terminology

� Basis – the future price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futureprices normally exceed spot prices.

� Cost of Carry – the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

� Initial Margin – the amount that must be deposited in the margin account at the time the future contract is first entered into

� Marking to Market – the adjustment made at the end of each trading day to the investor’s margin account to reflect the investor’s gain or loss depending upon the future closing price.

� Maintenance Margin – somewhat lower than the initial margin; the balance in the margin account must never become negative and in case it does, the investor receives a margin call who must top-up the account to the initial margin level before trade commences the following day

A long position is an agreement to buy

LONG => BUY

A short position is an agreement to sell

SHORT => SELL

Futures Payoffs

� Future contracts have linear pay-offs –unlimited profits or losses

� Payoff for buyer of future: long future

� An obligation to take delivery at a future date

– Similar to that of a person who holds an asset

– Example - A speculator buys a two-month nifty index futures contract when the nifty stands at 3250. when the index starts moving up, the long futures position makes profits and when the index moves down the future starts making losses.

NIFTY

3250

Pro

fit

Lo

ss

Long Future

Futures Payoffs

� Future contracts have linear pay-offs –unlimited profits or losses

� Payoff for seller of future: short future

� An obligation to give/make delivery at a future date

– Similar to that of a person who sells/shorts an asset

– Example - A speculator sells a two-month nifty index futures contract when the nifty stands at 3250. when the index starts moving down, the short futures position makes profits and when the index moves up the future starts making losses.

NIFTY

3250

Pro

fit

Lo

ss

Short Future

Futures PayoffsP

rofit

Current

PricePurchase Price

of Contract

Gain

Loss

Sold

Future

Gain/Loss =

Sale Price – Purchase Price

Pro

fit

Current

PricePurchase Price

of Contract

Gain/Loss =

Purchase Price - Sale Price

Bought

FutureGain

Loss

General Rule for Hedgers:

• If you are going to sell something in the near future but

want to lock in a secured price, you take a short position.

• If you are going to receive/buy something in the future but

want to lock in a secured price, you take a long position.

Futures Contracts

The Role of Speculators:

• As the name implies, speculators are involved in price betting and take the risk of price movements against them.

Application of Futures

� Hedging – a risk management tool

� long security, short future

� Example – an investor holds a security but gets uncomfortable with the movements in the short run. Sees prices falling from 450 to 390. in the absence of stock futures, he either live with it or sells the security.

� With security futures he can minimize the price risk. He can enter into an off-setting short futures position.

� Assuming spot price is 390. He sells a two-months future for 400, for which he pays an initial margin. If prices fall, so does the price of futures. As a result, his short futures position starts making profits. The loss incurred on the security will be made up by the profit on his short futures position.

� N.B. Hedging does not always make money! It removes unwanted exposure i.e. unnecessary risk.

Application of Futures

� Speculation – bullish security, buy (long) future

� Case 1 – a speculator believes a security at 1000 is undervalued; in the absence of a deferred product, he has to buy it and hold on to it till his hunch proves correct. assume he buys 100 shares which cost him one lakh rupees. Two-months later, say the security closes at 1010. He makes a profit of 1000 on an investment of 100,000 for a period of two-months. This works out to be an annual return of 6% .

� Case 2 – the security trades at 1000 and the two-month future at 1006. for the sake of comparison, assume the minimum contract value is 100,000. he buys 100 security futures for which he pays a margin of Rs. 20,000. two months later, the security closes at 1010. Assuming, on the date of expiration, the future price converges to the spot price, he makes a profit of Rs. 400 on an investment of Rs. 20,000. this works out to an annual return of 12 percent. There lies the power of leverage.

Application of Futures

� Speculation – bearish security, Sell (Short) future

� Example – take a trader who expects to see a fall in price of X. he sells one two-month contract of futures on X at Rs. 240 (each contract for 100 underlying shares). He pays a small margin on the same, say 48,000. Two months later, when the futures contract expires, X closes at Rs. 220. on the day of expiration, the spot and futures price converge. He has made a clean profit of Rs. 20 per share. For the one contract that he bought, this works out to Rs. 2000.

Application of Futures

Arbitrage

� Overpriced futures: buy (long) spot, sell (short) future

� Cash-and-carry arbitrage opportunity

� The cost-of-carry ensures that futures price stay in tune with the spot price. Whenever futures price deviates from its fair value, arbitrage opportunities arise.

� Say X trades at 1000. one month future trades at 1025 and seems overpriced. As an arbitrageur, you can enter into the following trade to make riskless profit:

– Borrow funds to buy the security in cash/spot market for 1000.

– Take delivery of the security and hold for a month.

– Simultaneously, sell the security future for 1025.

– On futures expiration date, spot and future prices converge. Unwind the position.

– Say the security closes at 1015. sell the security.

– Futures position expires with a profit of Rs. 10

– The result is also a riskless profit of Rs. 15 on the spot position.

– Return the borrowed funds.

Application of Futures

Arbitrage

� Underpriced futures – buy (long) future, sell (short) spot

� A reverse cash-and-carry arbitrage – where the riskless return is more than the arbitrage trades

� A security X trades at 1000. a one-month future trades at 965 and seems underpriced. You can make riskless profit by entering into the following transaction.– on day 1, sell the security in cash/spot for 1000.

– make delivery of the security.

– simultaneously, buy the futures on the security at 965.

– on the futures expiration date, the spot and the future prices converge. Now unwind the position.

– say, the security closes at 975.

– buy back the security. the result is a riskless profit of Rs. 25 on the spot position

– And, the futures position expires with a profit of Rs. 10.

Index Arbitrage

- Buy NIFTY Futures- Sell Stock Futures on the composition stocks

Open Interest

The outstanding open long or short positions in the market

230-505-155100-25125

-5020-45100-7550Day 3

125-15-1105075

-15-1050-25Day 2

100-100100Day 1

Open

InterestS3S2Seller1B3B2Buyer1INFY

!STOP!!CHECK!

� Ram sold a Nov ABB futures contract at Rs. 1000. Each contract is for delivery of 200 shares. Current Spot Price is Rs. 995. On future expiry date the spot price has slipped to Rs. 950. Ram’s profit/loss in the transaction is:� Profit of Rs. 5,000

� Loss of Rs. 5,000

� Profit of Rs. 10,000

� Loss of Rs. 10,000

� Ganesh bought a Dec ITC futures at Rs. 650. Each contract is for delivery of 400 shares. Current Spot is Rs. 660. on Futures expiry date, ITC has moved down to 625. Ganesh’s profit/loss on the transaction is:� Profit of Rs. 10,000

� Profit of Rs. 7,000

� Loss of Rs. 10,000

� Loss of Rs. 7,000

� The adjustments made to the margin account at the end of each trading day to reflect the investor’s gain/loss is called:� Maintenance margin

� Marking to market

� Margin call

� Initial margin

� Hedge using futures involves:� Have underlying, buy futures

� Have underlying, sell futures

� Sell underlying, buy futures

� Sell underlying, sell futures

Understanding Options

Option The owner of an option has the OPTION

to buy or sell something at a

predetermined price

Right to BUY – CALL OPTION

Right to SELL – PUT OPTION

Options Contracts

Options Contracts

Option Terminology� Stock options

� Buyer of an option

� Writer of an option

� Call Option

� Put Option

� Option price/premium

� Expiration date

� Strike Price

� American Options

� European options

� In-The-Money Option (ITM)

� At-The-Money (ATM)

� Out-Of-The-Money Option (OTM)

Options Contracts

Option Terminology

� Stock options – options on individual stocks. A contract gives the buyer the right to buy or sell shares at the specifiedprice

� Buyer of an option – the one who by paying price (premium) buys the right but not the obligation to exercise his/her option on the seller/writer

� Writer of an option – the one who by receiving premium, is obliged to sell/buy the asset if the buyer exercises on him

� Call Option – gives the buyer the right but not the obligation to buy an asset by a certain date for a certain price

� Put Option – gives the buyer the right but not the obligation to sell an asset by a certain date for a certain price

Options Contracts

Option Terminology

� Option price/premium – the price that the buyer pays to the seller/writer

� Expiration date – the date specified in the options contract; also called exercise date or strike date or maturity date

� Strike Price – the price specified in the options contract; also called exercise price

� American Options – options that can be exercised at any time upto the expiration date. Most exchange-traded options are American

� European options – options that can be exercised only on the expiration date

Options Contracts

� In-The-Money Option (ITM) – an option that would lead to a positive cash-flow to the holder if it were exercised immediately.

� A call option on the index is said to be ITM if the current index stands higher than the strike price (Spot Price > Strike Price).

� A put option is ITM if the index is below the Strike price (SpotPrice < Strike Price).

� At-The-Money (ATM) – an option that would lead to zero cash flows to the holder if it were exercised immediately.

� Out-Of-The-Money Option (OTM) – an option that would lead to a negative cash-flow to the holder if it were exercised immediately.

� A call option on the index is said to be OTM if the current index stands at a level which is less than the strike price (Spot Price < Strike Price).

� A put option is OTM if the index is above the Strike price (SpotPrice > Strike Price).

� The option premium has two components – intrinsic value and time value.

� The intrinsic value of an option - is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.

– Intrinsic value of a call is Max [0, (St – K)]

– Intrinsic value of a put is Max [0, (K – St )]

where, K= Strike Price and St = spot price

� Time value of an option – the difference between the option premium and its intrinsic value. Both calls and puts have time value. An option that is ATM or OTM only has time value. Usually, the maximum time value exists when option is ATM. The longer the expiration, the greater the time value of an option, all else being equal. At expiration, an option should have no time value.

Options Contracts

Call Option Contracts

� A call option is a contract that gives the owner of the call option the right, but not the obligation, to buy an underlying asset, at a fixed price (K), on (or sometimes before) a pre-specified day, which is known as the expiration day.

� The seller of a call option, the call writer, is obligated to deliver, or sell, the underlying asset at a fixed price, K on (or sometimes before) expiration day (T).

� The fixed price, K, is called the strike price, or the exercise price.

� Because they separate rights from obligations, call options have value.

Options Contracts

Put Option Contracts

� A put option is a contract that gives the owner of the put option the right, but not the obligation, to sell an underlying asset, at a fixed price, on (or sometimes before) a pre-specified day, which is known as the expiration day (T).

� The seller of a put option, the put writer, is obligated to take delivery, or buy, the underlying asset at a fixed price (K), on (or sometimes before) expiration day.

� The fixed price, K, is called the strike price, or the exercise price.

� Because they separate rights from obligations, put options have value.

Options Contracts

Call Option

Put Option

Write (SHORT)

Buy (LONG)

Write (SHORT)

Buy (LONG)

The four basic positions:

Options Contracts

Profit Diagram for a Long CallPosition, at Expiration

Profit

0K ST

call premium

Profit Diagram for a Short Call Position, at Expiration

K

0

ST

Profit

Call premium

Covered Call- Your Short call position is covered if you have the underlying asset

Profit Diagram for a Long Put Position, at Expiration

ST

Profit

0K put premium

Protective Put- Your Long Put Position is protective if you have the underlying asset

Profit Diagram for a Short Put Position, at Expiration

ST

0

Profit

K

Payoff

Price

Current

Stock

Price

Stock Payoffs

Payoff

Price

Option

Exercise

Price

Call Option Payoffs

Out of

the Money

In

the Money

Call Option Payoff = Max[ 0 , S - X ]

Call Option Payoffs

Payoff

Price

Current

Stock

Price

Stock Payoffs

Payoff

Price

Option

Exercise

Price

Put Option Payoffs

In

the Money

Out of

the Money

Put Option Payoff = Max[ 0 , X - S ]

Put Option Payoffs

Application of Options

� Hedging – have underlying, buy (go LONG on) puts (Protective Puts)

� One way to protect your portfolio from potential downside due to market drop is to buy insurance using put options

� Buy the right no. of puts at the right exercise price –when the stock prices fall, your stock will lose value and the put options bought by you will gain, effectively ensuring that the portfolio value does not fall below a particular level.

� Portfolio insurance by buying put options is a hedging tool for funds who own well-diversified portfolios

� By buying puts, funds can limit the downside in case of a market fall.

Application of Options

� Speculation – bullish security, buy (LONG) calls or sell (SHORT) puts

� Buying a call option

� The downside is limited to the option premium

� The upside is potentially unlimited

� Selling a Put Option

� The upside is the option premium

� The downside is potentially unlimited

!STOP!!CHECK!

� A call writer could have:

� Limited profit; unlimited losses

� Unlimited profit, unlimited losses

� Unlimited profit, limited losses

� Limited profit, limited losses

� Spot S&P CNX Nifty is Rs. 3200. An investor bought a one-month S&P CNX 3220 call option for a premium of Rs.10. As on date the option is: � In the money

� At the money

� Out of the money

� None of these

� In a rising market, the right strategy would be to go:

� long puts and/or long calls

� long puts and/or short calls

� Short puts and/or short calls

� Short puts and/or long calls

� When Spot<Strike, which of the following positions will be ITM?

a. Long Call and Short Put

b. Long Call and Long Put

c. Short Call and Long Put

d. Short Call and Short Put

� Purchasers of options have rights but no obligations and Sellers have obligations, no rights. Whereas, both purchasers and sellers of futures have obligations.

� Options also lock in a future price, but do not have to be exercised. Futures lock in prices and must be executed at specified future date.

� To enter into a future contract one must maintain a margin, while option buying requires an up-front payment (premium).

Futures vs. Options

Futures vis-à-vis Options

Futures Options

Exchange traded Same as futures

Exchange defines the product Same as futures

Price is zero, strike price moves Strike price is fixed, price moves

Price is zero Price is always positive

Linear payoff Non-linear payoff

Both long and short at risk Only short at risk

Remember

• Future and Option markets have a short-term investment horizon ONLY.

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