OFD Mini_Case_Chap_1 Introduction to Derivatives

8/11/2019 OFD Mini_Case_Chap_1 Introduction to Derivatives

http://slidepdf.com/reader/full/ofd-minicasechap1-introduction-to-derivatives 1/62

IntroductionChapter 1

1

Options, Futures, and Other

Derivatives, 7th Edition, Copyright ©John C. Hull 2008



Coverage

Payoff in futures contracts

Payoff in options contracts

Hedging with futures and options

Speculation with futures and options Arbitrage and the law of one price


Derivatives, 7th Edition, Copyright ©John C. Hull 2008 2



Indian Shipping Decided to buy 10 DB ships (Cap budgeting decision made!) Price agreed upon viz. $600 mil Timeline for payment

◦ No upfront payment $600mil 12-month later

Financing decision can be made now or in future

◦ USD price movement creating price risk till Dec-2014

◦ Future FCFF (2015 - ) decide the timing and amount of Debt CF ISL can have INR debt for 10 years or more at about 11% p.a.

ISL can have $debt – floating rate (IR risk and price risk) or fixed rate

Whether to hedge or not is a different issue altogether!

How to hedge is the issue to be discussed! (time, instrument)

◦ Do nothing (Don’t manage the currency risk) – a base case◦ Some or all with forward contracts LOCK INTO PRICE

◦ Some or all with options contracts BUY INSURANCE

◦ Money market hedge (using USD deposits and INR loans)



Layman’s view

BS on 26-Dec-2014

1. Risk can create problem of managing debt in future, if it arises

2. No price risk (transformed into a counterparty risk)

3. Gives best of both worlds (premium and interest on it has to be capitalized)

4. Mimics choice FORWARDS but costlier than FORWARDS (scope for arb!)

** premium capitalized is 60 * 2.50 * 1.09 = 13.50 + 150 = 163.50 crores

St = 56 St = 68 St = 56 St = 68

Loan in Dec-14 3,360 4,080 10 DB Ships 3,360 4,080




Do nothing

FORWARDS

OPTIONS

Money mkt.



Terminology of futures contract

Underlying

Delivery price (Forward price)◦ The price that would make the contract worth exactly zero)

◦ This may be different for contracts of different maturities

Spot price

Trade date

Delivery date

Delivery instructions





ISL in forward contract with HDFC



26-Dec-’13 26-Dec-’14

Negotiates qty, price,delivery instruction

ISL pays Rs.3,840 croreHDFC pays $600 mil

$ is the underlying asset

Delivery price today = 62;

Delivery price on 26-Dec-14 = 64

A contract got created but not a security!

ISL is holding LONG POSITION

RIGHT to receive $600M OBLIGATION to pay 3,840cr

HDFC has assumed the SHORT POSITION

RIGHT to receive 3,840cr OBLIGATION to pay $600M





Terminology

The LONG (a party!) receives UA

The SHORT (the other party)

delivers the UA



Contracts with USD as underlying

Forward contracts

Futures contracts

Options contracts

Interest rate swap contracts Currency swap contracts

Others





Other classes of derivatives

Credit derivatives

Electricity derivatives

Weather derivatives

Insurance derivatives





Other classes of traded assets

Commodities

Equity stocks and indices

Interest rate products (Bonds!)

Energy and other underlyings





Users of Derivatives

Banks and Financial Institutions

Fund managers (Asset management cos.)

Treasurers of manufacturing and service

companies



Any one who works in finance needs to understand how derivativeswork, how they are used, and how they are priced.





Ways Derivatives are Used

To hedge risks (to lock into price)

To speculate (take a view on the futuredirection 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 oneportfolio and buying another



Ways Derivatives are Used

To embed into securities to alter their payoffs (anapplication in corporate finance!)

◦ Convertible securities

Management compensation contracts with variablepay linked to the market

◦ ESOPs

Embedded in capital investment opportunities

◦ Option to expand

◦ Option to delay

◦ Option to abandon





Markets and their structure

The securities and financial institutions cameinto existence as natural responses of investor

needsThese markets evolve to meet investor

needs.

This is HOW markets evolved over time!

◦ Direct search markets

◦ Brokered market

◦ Dealer market

◦ Auction market



Direct search markets

Least organized◦ Buyers and sellers must seek each other out

directly. (Sale of used refrigerator )

Sporadic participation of players

◦ Trades does not get reported

Non-standard and low-priced goods

No one seeks to specialize in these goods

◦ Not worth the efforts and time involved



Brokered Market

Least organized! Populated by brokers. Sufficient liquidity viz. trading in goods (market) is

sufficiently active

Economies of scale in searches makes it worthwhile

to pay to the broker to conduct searches◦ Seeks out customers and maintain the database of needs

◦ Profits are worth the efforts and time involved

◦ Offers the search services for a fee!

◦ Doesn’t maintain any inventory

◦ Keeps track of prices at which trades had taken place◦ Brokers develop specialized knowledge.

Examples are real estate market, IPO market, blocktransactions in secondary market.



Dealer market (OTC market)

When trading activity in a particular type ofasset increases, Dealer markets arise. ◦ Sufficiently well-organized

◦ Many brokers transform into dealers to encash theirspecialized knowledge

Every dealer specializes in various assets◦ Assets are predominantly standardized

◦ Dealers bring in capital to maintain an inventory of assets

Purchases assets for their own inventory and selling

them for a margin Bid-ask spread is the profit margin.

Investors participate in this market because◦ saves the search costs and transaction costs



Auction market

Very well organized (most integrated)◦ Populated with brokers and dealers

◦ Highly standardized assets

◦

Transactions converge at one place◦ One need not search to find the best price

Best offer price and best quote price are known

Market is deep and thin bid-ask spreads

If all participants converge, they can arrive at mutually

agreeable prices saves bid-ask spread.

Continuous vs. Periodic auction markets

◦ 09.00 AM – 09.15 AM (periodic)



Continuous auction markets

Requires huge investment to set up thesystems for electronic trading

◦ Requires very heavy and frequent trading tocover the expense of maintaining the market

◦ Listing requirements is set to ensure above

◦ Separate section exhibits for BLOCK trades

◦ Real-time information is provided about the Recent trades taken place

Whole order book can be accessed



Many assets trade in more than one

type of market. In which Market doesthese trade?

Used Cars

Paintings

Rare Coins



Are derivative instruments tradable?Does active markets exist for them?



Active market does exist!

Derivative instruments are traded actively inOTC and ETC markets.

Institutions develop both spot and derivative

markets by acting as dealers◦ Provides two-ways quotes

◦ Bid price will always be less than ask price

Trades in OTC markets

◦ Easy to fill the order. If market is active, it will befilled at best price.

◦ Counterparty risk is a major issue in this market.



Size of OTC and Exchange-Traded Markets(Figure 1.1, Page 3)



Source: Bank for International Settlements. Chart shows total principal

amounts for OTC market and value of underlying assets for exchange

market

0

50

100

150

200250

300

350

400

450

500

550

Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

Size ofMarket

($ trillion)

OTCExchange



Amount outstanding of ETC derivatives

Notional amount outstanding March 2010 % share

Interest Rates 74,882.274 91.69%

Futures 23,529.345

Options 51,352.929

Currency contracts 400.998 0.49%

Futures 195.310

Options 205.688

Equity index 6,388.004 7.82%

Futures 1,040.004

Options 5,348.000

All markets 81,671.276 100.00%

Source: BIS survey



Amount outstanding of OTC derivativesNotional amount outstanding Dec. 2009 % share

Forwards and forex swaps 23,129.29

Currency swaps 16,509.01

Currency Options 9,558.07

Currency derivative contracts 49,196.37 8.00%

Forward rate agreements 51,749.26

Interest rate swaps 349,235.83

Interest rate options 48,807.61

Interest rate contracts 449,792.70 73.18%Forwards and swaps 1,829.87

Options 4,761.58

Equity-linked contracts 6,591.45 1.07%

Gold 423.18

Other commodities: Forwards & swaps 1,674.91

Other commodities: Options 845.92Commodity contracts 2,944.01 0.48%

Multi-name instruments 10,775.64

Single-nname instruments 21,917.06

Credit default swaps 32,692.70 5.32%

Unallocated 73,456.37 11.95%

Total contracts 614,673.60 100.00%

$billionsSource: BIS survey



RECAP!

Futures/forward contracts are obligationsthat must be fulfilled at maturity.

Options contracts are rights, not obligations,

to either buy (call) or sell (put the underlyingfinancial instrument.

Swaps are the multi-period contracts

Derivatives are traded in auction markets

◦ Institutions make spot and derivative markets

◦ Develops new instruments to fill the gaps

◦ Trading volumes in OTC are much higher



Role of Derivative Instruments

Protect against different types of investment risks,◦ Purchasing power risk, interest rate risk, currency risk.

Advantages:

◦ Lower transactions costs

◦ Faster to carry out transaction

◦ Greater liquidity





Foreign Exchange Quotes for € in INR,March 01, 2013 09.30 AM

OTC (Mumbai) NSE

Bid Offer Bid Offer

1-month

forward

66.4500 66.4800 66.4225 66.4575

2-monthforward

66.7600 66.8000 66.7450 66.7850

3-month

forward

67.0800 67.1300 67.0575 67.1025

6-monthforward

67.9300 68.0400 67.9045 67.9985

Spot 66.2500 66.2800





Profit from aLong Forward Position (SBI)

Profit

Price of Underlying

at Maturity, S T

K

Long forward = Agreeing to buy the Underlying





Profit from aShort Forward Position (SL)

Profit

Price of Underlying

at Maturity, S T

K

Short forward = Agreeing to SELL the Underlying



Payoff on forward contract

ST ISL HDFC

56 -8 8

58 -6 6

60 -4 4

62 -2 2

64 0 0

66 2 -2

68 4 -4-10

-8

-6

-4

-2

0

2

4

6

8

10

56 58 60 62 64 66 68

Blue line is payoff of ISL (long position)

Pink line is payoff of HDFC (Short!)

They are mirror images!

Payoff table Payoff diagram

ST - F

F - ST

ST



A-2 is base-case PLUS forwardcontract (perfectly hedged!)

ST ISL HDFC Do nothing Forward Total

56 -8 8 -3,360 -480 -3,840

58 -6 6 -3,480 -360 -3,84060 -4 4 -3,600 -240 -3,840

62 -2 2 -3,720 -120 -3,840

64 0 0 -3,840 0 -3,84066 2 -2 -3,960 120 -3,840

68 4 -4 -4,080 240 -3,840 -3,900

-3,850

-3,800

56 58 60 62 64 66 68



Questions

Why a forward contract can be usedfor either speculation or hedging?

◦ Hedging: An exposure shall be present

such that gains in it will be offset by theloss in the forward contract and vice versa

◦ Thus a short position or a long positioncan be entered into for hedging purposes

◦ If trader has no exposure to UA, thenentering a forward is SPECULATION!



Questions

ISL is hedging its exposure. Does HDFC isspeculating in USD?

◦ In proprietary transactions, Yes

◦ In dealer transaction, HDFC would hedge theacquired exposure either in

Futures market by taking long position

Forward market by taking long position in USD withInfosys

Gains the bid-ask spread

Counterparty risk exists in ISL or Infosys moves out

A FORWAD contract in BINDING on BOTH parties



QUESTION

You have to receive C$ 5million in 6months. Explain how XR risk can behedged using forward ?



Ex 1.26 (8e) GOLD forwards

A: Long in 12-m contract F@1000 B: Long in 12-m call option contract

with F@1000. Call premium is $100





Futures Contracts

Agreement to buy or sell an asset for acertain price at a certain time

Similar to forward contract Whereas a forward contract is traded OTC,

a futures contract is traded on an exchange

◦ Tick size

◦ Delivery date◦ Contract size

◦ Margining



Forward vs. Futures contracts

Forward Contract Futures contract

Private contract betweentwo parties

Traded on an exchange

Contract terms notstandardized Standardized contract

Usually one specific deliverydate

Range of delivery dates

Settled at the end ofcontract period Settled daily

Delivery or final cashsettlement usually happens

Contract is usually closedout prior to maturity

Some credit risk Virtually no credit risk





Exchanges Trading Futures

Chicago Board of Trade Chicago Mercantile Exchange

LIFFE (London)

Eurex (Europe) BM&F (Sao Paulo, Brazil)

TIFFE (Tokyo)

and many more (see list at end of book)





Exchanges Trading Futures

Bombay Stock Exchange National Stock Exchange

MCX Stock Exchange

MCX NCDEX

United Stock Exchange

CCIL





Examples of Futures Contracts

Agreement to:

◦ Buy 100 oz. of gold @ US$1,280/oz. in Oct (NYMEX)

◦ Sell £62,500 @ 1.6500 US$/£ in June (CME)

◦ Sell 1,000 bbl. of oil @ US$114/bbl. in April (NYMEX)◦ Buy 100 shares of Infosys Limited at Rs.3,973 in 25-

Sep-2014 (NSE)





Types of Traders

• Hedgers : offset the exposure to price of UA.

• Speculators: No exposure to offset.

• Arbitrageurs: To lock in a arbitrage profit

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 (See

for example Barings Bank , Business Snapshot 1.2, page 15)





Are spot and forward prices related?

If the spot price of gold is S and the forward pricefor a contract deliverable in T years is F , then

F = S (1+r )T

where r is the 1-year (domestic currency) risk-freerate of interest.

FT = S0 [(1+r INR)/(1+r $)]T

12-m USD price = 62 * 1.09/1.012 = INR 66.7787





Solve Ex 1.30 on Gold arb

You are a US citizen!

S = $1,000

12-m F = $1,200

1yr interest rate in USD = 10%





Does any arb opportunitypresent in ISL data?

Fair price of 12-m USD = 66.7787 vs. quoted price 64:

◦ 12-month forward contract is underpriced

Today: Take LONG position in 12-m F @ 64Borrow USD and sell them in currency mkt

Deposit the INR at 9% for 1 year

Dec-94: RECEIVE $ from counterparty at 64

Deliver them to the USD lender





Market efficiency

If more dealers are taking long position in USD than forshort position, what would happen to price? Vice versa?

O





Options

A call option is an option to buy a certainasset by a certain date for a certain price(the strike price)

◦ For a long, it is right to BUY

A put option is an option to sell a certainasset by a certain date for a certain price(the strike price)

◦

For a long, it is right to SELL

O i T i l





Options Terminology

Call option (c) Put option (p) 1.3795

Price of underlying (S) 66.25

Strike Price (K) 67.00 Expiry Date (T) 31-May

At-the-money Option (ATM)

In-the-money Option (ITM) Out-of-money Option (OOM)

Covered option; Naked option

O ti Ri ht & Obli ti





Options: Rights & Obligations

Holder (long position) Writer (Short position)

Right to receive UA Obligation to deliver UA

Obligation to pay K Right to receive K Obligation to deliver UA

Receive K

Obligation to receive UA

Pay K

Forward Exercises it only when

beneficial

Call

option

Put

option

Exercises it only when

beneficial

ON maturity date or expiration rate, do the following:

I t d E t ith



Importers and Exporter withcomplete hedging

F @ 64 c @ 64 p @ 64 -ST + F -ST + C ST - F ST + P

56 -8 0 8 -64 -56 64 64

58 -6 0 6 -64 -58 64 64

60 -4 0 4 -64 -60 64 64

62 -2 0 2 -64 -62 64 64

64 0 0 0 -64 -64 64 6466 2 2 0 -64 -64 64 66

68 4 4 0 -64 -64 64 68

70 6 6 0 -64 -64 64 70

ST

Payoffs from contracts Importer Exporter

-10

-8

-6

-4

-2

0

2

4

6

8

10

56 58 60 62 64 66 68 70

Blue line is LONG in Forward

Pink line is LONG in Call option

Yellow Line is LONG in Put

I t d E t fil



Importers and Exporter profilewith 50% hedging-ST + F -ST + C ST - F ST + P

56 -64 -56 64 64

58 -64 -58 64 64

60 -64 -60 64 64

62 -64 -62 64 64

64 -64 -64 64 64

66 -64 -64 64 66

68 -64 -64 64 68

70 -64 -64 64 70

ST

Importer Exporter

-ST + F -ST + C ST - F ST + P

56 -60 -56 60 60

58 -61 -58 61 61

60 -62 -60 62 62

62 -63 -62 63 63

64 -64 -64 64 64

66 -65 -65 65 66

68 -66 -66 66 68

70 -67 -67 67 70

ST

Importer: 50% hedge Exporter: 50% hedge

-6 8

-6 6

-6 4

-6 2

-6 0

-5 8

-5 6

-5 4

5658606264666870

IMPORTER: 50% vs. 100% hedge

58

60

62

64

66

68

70

72

5 6 5 8 60 62 6 4 6 6 6 8 7 0

EXPORTER: 50% vs. 100% hedge







Exchanges Trading Options

Chicago Board Options Exchange American Stock Exchange

Philadelphia Stock Exchange

Pacific Exchange LIFFE (London)

Eurex (Europe)

and many more (see list at end of book)



Questions

Long F at $50 vs. long call at 50 Selling a CALL vs. buying a PUT

Suppose you have 500 shares of YES

bank. How to obtain insurance againsta decline in share value over 4 months

Payoff for [Long forward + long put]

Exercise 1.24





Is it naked or covered option

Covered option OOM option

Long Term Equity AnticiPation Security

◦

Options on long term until expiry than others◦ Available on approximately 2,500 equities and

20 indices

◦ LEAPS were created relatively recently and

typically extend for terms of 2 years out.◦ Equity LEAPS always expire in January.

◦ When LEAPS were first introduced in 1990, theywere derivative instruments solely for equities

Mi ft ff ith d ith t

http://en.wikipedia.org/wiki/Derivative_(finance)

http://en.wikipedia.org/wiki/Ownership_equity

http://en.wikipedia.org/wiki/Ownership_equity

http://en.wikipedia.org/wiki/Derivative_(finance)





Microsoft payoff with and withoutHedging (LONG PUT OPTION CONTRACTS)

20,000

25,000

30,000

35,000

40,000

20 25 30 35 40

Value of Holding($)

Stock Price ($)

No Hedging

Hedging





Infosys Option Prices (March 01, 2013; S =2925)



StrikePrice

28-MarCall

25-AprCall

30-MayCall

28-MarPut

25-AprPut

30-MayPut

2,850 107.30 200.00 - 30.65 - -

2,900 78.50 150.00 - 48.00 120.00 -

2,950 53.00 - - 70.70 128.65 -

3,000 34.20 - - 103.00 - -

3,050 21.00 - - 151.40 - -





Options vs Futures/Forwards

A futures/forward contract gives the holderthe obligation to buy or sell at a certainprice

An option gives the holder the right to buyor sell at a certain price





Hedge Funds (see Business Snapshot 1.1, page 9)

Hedge funds are not subject to the same rules asmutual funds and cannot offer their securitiespublicly.

Mutual funds must◦ disclose investment policies,

◦ makes shares redeemable at any time,

◦ limit use of leverage

◦ take no short positions.

Hedge funds are not subject to these constraints.

Hedge funds use complex trading strategies; arebig users of derivatives for hedging, speculationand arbitrage





Hedge Funds strategies

Convertible Arbitrage Distressed Securities

Emerging Markets

Macro or global

Market neutral



SUMMARY



SUMMARY

OFD Mini_Case_Chap_1 Introduction to Derivatives

Documents