Derivatives

P.Harika

Derivatives(Introduction)A derivative is a financial instrument, whose value depends on the value of basic underlying variable The value of derivative is linked to risk or volatility in either financial asset, transaction, market rate, or contingency, and creates a product

Underlying Assets

T-BillStocks

Interest Rates

Index & Bonds

Agro Commodities

Precious Metals

Foreign Exchange Rate Crude Oil

Features of Derivatives•Traded on exchange• No compulsory physical trading of underlying assets All transactions in derivatives take place in future specific date •Hedging Device-Reduces risk• Derivatives has low transaction cost •Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative.

Derivatives

Over the counter(OTC)

EXCHANGE RELATED

Futures

Stock options

Commodity futures

Credit

Options

Swaps

Forward rate agreements

Forward contractTypes of Derivatives

Over-the-Counter Contracts:

OTC derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding notional amount is USD 516 trillion (as of June 2007)

ForwardsA forward contract is a customized contract

between two entities, where settlement takes place as a specific date in the future at predetermined price.

Ex: On 10th Novem, Ram enters into an agreement to buy 100 kgs of wheat on 1st May at Rs.10000 from Shyam, a farmer. It is a case of a forward contract where Ram has to pay Rs.10000 on 1st May to Shyam and Shyam has to supply 100 kgs of wheat. Ram has taken a long position assuming the price of the wheat will rise in the future six months . Normally traded outside exchange.

Forward Pricing:Forward Price The forward price

for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)

The forward price may be different for contracts of different maturities

Forward Pricing:The Forward Price of Gold If the spot

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

F = S (1+ r )twhere r is the 1-year (domestic

currency) risk-free rate of interest. In our examples, S = 300, T = 1,

and r =0.05 so that F = 300(1+0.05) = 315

Futures A financial contract obligating the buyer to purchase an asset, (or

the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.

Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange.

Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.

Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency.

FC –commodity (OTC) Kissan co wants to procure 500 kg of tomatoes after 3 months. Prevailing 1 kg @Rs 6. View of the company– Expected to go up to Rs 8 per kg. View of the farmer- Price @ Rs 5.50. So FC between Company & Farmer.Agreed price @ Rs 6.50 . Delivery after 3 months. Situation after 3 moths – Price may be same I.e @ Rs 6 or more or less than strike price.

SwapsSwaps are private agreement between two parties

to exchange cash flows in the future according to a pre-arranged formula.

They can be regarded as portfolio of forward contracts.

The two commonly used Swaps are- i) Interest Rate Swaps: - A interest rate swap

entails swapping only the interest related cash flows between the parties in the same currency.

ii) Currency Swaps: - A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and after a specified period of time, to give back the original amount swapped.

OPTIONS “ An Options contract confers the right but not the

obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price – the Strike or Exercised price up until or an specified future date – the Expiry date. ” The Price is called Premium and is paid by buyer of the option to the seller or writer of the option.

Types of option: Call Option Put option

Option Jargons

Infosys (2800)

In-The-Money (ITM)

At-The-Money (ATM)

Out-The-Money (OTM)

CALL S > K 2800 > 2700

S = K 2800 = 2800

S < K 2800 < 2900

PUT S < K 2800 < 2900

S = K 2800 = 2800

S > K 2800 > 2700

S = Spot price K = Strike price

OPTION PREMIUM

INTRINSIC VALUE

TIME VALUE

Intrinsic Value : When option is in-the-money we have maximum Intrinsic Value. If the option is out of the money or at the money its Intrinsic Value is zero. For a call option intrinsic value : Max (0, (St – K) ) and For a put option intrinsic value : Max (0, (K - St ) )

TYPE EXPIRY

CALL/PUT

STRIKE

SPOTTYPE OF OPTION

PREMIUM

INTRISIC VALUE

TIME VALUE

OPTSTK

25/6/2006 CA 1170 1200 ITM 37 (1200

-1170=30)

7

OPTSTK

25/6/2006 CA 1200 1200 ATM 24

(1200-1200=0)

24

OPTSTK

25/6/2006 CA 1230 1200 OTM 11

(1200-1230=-30 or 0)

11

Eg. Stock ONGC

Terminology:• Spot price- the price at which an assets trades in a spot markets. •Future price- the price at which the future contracts trades in future markets. •Strike price- the price specified in the option contract •Expiry date- the date specified in future and option contracts. •Contract size- the amount of assets that has to be delivered under one contract. •Basis= Future price- Spot Price •Initial Margin- the amount that must be deposited at the future contract is first entered into. •Marking to market •Maintenance Margin- A set minimum margin per outstanding future contract that a customer must maintain in his margin account .

PARTICIPANTSSpeculators - willing to take on

risk in pursuit of profit. Hedgers - transfer risk by taking

a position in the Derivatives Market.

Arbitrageurs - aim to make a risk less profit by taking advantage of price differentials and thus bring about an alignment in prices by participating in two markets simultaneously.

Stock Index futuresStock Index futures have

revolutionized the art and science of equity portfolio management as practiced by:

◦ mutual funds◦ pension plans◦ endowments◦ insurance company◦ other money managers.

• A futures contract on a stock market index represents the right and obligation to buy or to sell a portfolio of stocks characterized by the index.

Stock index futures are cash settled.That is, there is no delivery of the underlying stocks. The contracts are marked to market daily.On the last trading day, the futures price is set equal to the spot index level and there is a final mark to market cash flow.

An interest rate future is a financial derivative (a futures contract) with an interest-bearing instrument as the underlying asset. Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures. Interest rate futures are used to hedge against the risk of that interest rates will move in an adverse direction, causing a cost to the company.For example, borrowers face the risk of interest rates rising. Futures use the inverse relationship between interest rates and bond prices to hedge against the risk of rising interest rates. A borrower will enter to sell a future today. Then if interest rates rise in the future, the value of the future will fall (as it is linked to the underlying asset, bond prices), and hence a profit can be made when closing out of the future (i.e. buying the future).