Derivatives, Futures and Options (4)

8/11/2019 Derivatives, Futures and Options (4)

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Derivatives, Futures and Options


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Risk

A probability or threat of damage,

liability, loss, or any other negativeoccurrence that is caused by external orinternal vulnerabilities, and that may be

avoided through preemptive action.

Financial Risk is defined as the chancethat an investment's actual return willbe different than expected. This includes

the possibility of losing some or all ofthe original investment.


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Types of Risk

FUNDAMENTAL TYPE OF RISK

Systematic Risk- It influences a large number of assets.This type of risk is both unpredictable and impossible tocompletely avoid.

Unsystematic Risk- This kind of risk affects a verysmall number of assets. An example is news that affects

a specific stock such as a sudden strike by employees.


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Types of Risk

Credit or Default Risk- Credit risk is the risk that a companyor individual will be unable to pay the contractual interestor principal on its debt obligations. This type of risk is ofparticular concern to investors who hold bonds in theirportfolios.

Country Risk- Country risk refers to the risk that a countrywon't be able to honor its financial commitments.Country risk applies to stocks, bonds, mutual funds,options and futures that are issued within a particular

country. This type of risk is most often seen in emergingmarkets or countries that have a severe deficit.


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Types of Risk

Foreign-Exchange Risk- When investing in foreign countriesyou must consider the fact that currency exchange ratescan change the price of the asset as well. Foreign-exchange risk applies to all financial instruments that are

in a currency other than your domestic currency.

Interest Rate Risk- Interest rate risk is the risk that aninvestment's value will change as a result of a change ininterest rates. This risk affects the value of bonds more

directly than stocks.


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Types of Risk

Political Risk- Political risk represents the financial risk that acountry's government will suddenly change its policies. This is amajor reason why developing countries lack foreign investment.

Market Risk- Also referred to as volatility, market risk is the day-to-day fluctuations in a stock's price. Market risk applies mainlyto stocks and options. As a whole, stocks tend to perform wellduring a bull market and poorly during a bear market - volatilityis not so much a cause but an effect of certain market forces.Volatility is a measure of risk because it refers to the behavior, or

"temperament", of your investment rather than the reason forthis behavior.


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Risk Reward Return

The risk-return tradeoff is the balance an investor must decide on

between the desire for the lowest possible risk for the highest possible

returns.


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Derivatives

Derivative is an instrument that

does not have a value of its own,

rather it derives its value/price

on the basis of some other

instrument, hence the name

Derivative.

In derivatives transactions, one

partys loss is always another

partys gain

The main purpose of derivatives is

to transfer risk from one person

or firm to another, that is, to

provide insurance


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Usage of Derivatives

To hedge risks

To speculate (take a view on the future direction 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 one portfolio and buying another

Derivatives improve overall performance of the economy


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Derivatives

Derivatives exchange is a market whereindividuals trade standardized contracts that havebeen defined by the exchange

The Chicago Board of Trade, established in 1948 isthe oldest exchange to trade derivatives

It brought farmers and merchants together andstandardized the qualities and quantities of the

grains traded Chicago Mercantile Exchange was established in

1919 in order to trade futures


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Major kind of Derivatives

1. Forwards and futures

2. Options

3. Swaps

These derivatives are traded on following markets

Over the counter

Exchange traded markets


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Kinds of Derivatives

Forwards and FuturesA forward, or a forward contract, is:

An agreement between a buyer and a seller to

exchange a commodity or a financial instrument for a

pre specified amount of cash on a prearranged future

date

Example: interest rate forwards

Forwards are highly customized, and are much less

common than the futures


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Kinds of Derivatives

Futures

Afuture is a forward contract that has been

standardized and sold through an organized

Exchange

Structure of a futures contract:

Seller (has short position) is obligated to deliver

the commodity or a financial instrument to thebuyer (has long position) on a specific date

This date is called settlement, or delivery, date


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Example of Futures


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Features of Forward contract

>Forward contracts are bilateral contracts and are are exposed tocounter party risk

> Each contract is custom design and is unique in terms of contract size,expiration date, asset type and quality

> The specified price in forward contract is referred to as delivery price.The forward price of particular forward contract at a particular time is

the delivery price that would apply if the contract would have entered at

that time. Both price are equal at the time the contract is entered into.

However, as the time passes the forward price changes while delivery

price remains same>The forward contract has to be settled by delivery of the asset onexpiration date

> If the party wishes to reverse the contract, then it has to deal with thesame counter party


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Forward contract Payoff

So in a long forward contract, you have a positive payoff only if the Spot Price (S) > Contract

Price (K) since in a long forward contract you have an obligation to buy. Hence, if S>K, then you

can buy it at lower cost and sell it into the market at a higher price and earn profits. In a short

forward contract, if S


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Features of Futures

>All futures contract have standardized specification i.e. quantity ofasset, quality of asset, date and month of delivery, unit of price quotation,

location of settlement.

>Clearing house acts as intermediary or middlemen in futures. It gives

guarantee for the performance of the parties to each transaction. It is thecountry party for every contract

>At the close of trading day, each contract is marked to market.Settlement price is established to calculate profit or loss of each member

>When a person enters into a futures contract, he is required to deposit

funds with broker called as margin. The basic objective of margin accountis to act as collateral security in order to minimize the risk of failure by

either party in the futures contract

>Most of the futures contract are settled in cash


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Futures contract


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Hedging and Speculating with

Futures

Agents hedge against adverse events in the market using futures

market

E.g. manager wishes to insure the firm against the rise in interest rates and

the resulting decline in the rise in interest rates and the resulting decline in the

value of bonds the firm holds value of bonds the firm holdsCan sell a futures contract and lock in a price

Producers and users of commodities use futures extensively to hedge

their risks extensively to hedge their risks

Farmers, oil drillers (producers) sell futures contracts for Farmers, oil drillers

(producers) sell futures contracts for their commodities and insure themselvesagainst price their commodities and insure themselves against price declines

Food processing companies, oil refineries (users) buy Food processing

companies, oil refineries (users) buy futures contracts to insure themselves

against price futures contracts to insure themselves against price increase


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Hedging and Speculating with

Futures

Speculators try to use futures to make a profit by betting on price

movements: profit by betting on price movements:

Sellers of futures bet on price decreases

Buyers of futures bet on price increasesFutures are popular because they are cheap


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Arbitrage and Futures Prices

On the delivery date, the price of the futures contract must equalthe price of the asset the contract the seller is obligated to deliver

If this were not true, it would be possible to earn instantaneous risk

free profit

If bond price were below the futures price, buy a bond, sell the

contract, deliver the bond, and earn the profit

Practice of simultaneously buying and selling financial instruments

to benefit from temporary price difference is called arbitrage

Existence of arbitrageurs ensures that at delivery date, the futures

price equals the market price of the bond


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Option Contracts

Optionis a contract entered between two parties whereby one party obtainsthe right and not the obligation, to buy or sell a particular asset, at a specified

price on or before the specified date

The person who acquires the right is known as option buyer or option holder

and the person is called option seller or option writer

The seller of the option for giving such option to the buyer charges an amountknown as option premium

TWO TYPES OF OPTION

Call options

Gives the holder an option to buy an asset at the specified price and time

Put options

Gives the holder an option to sell an asset at the specified price and time

The specified price in such contract is called Exercise price or strike price

the specified date is called expiration date or maturity date


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Option Contracts

American OptionIt can be exercised at any time before the expiration date

European Option

It can be exercised only on the expiration date


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Option Contracts


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Swap Contracts

A swap is an agreement between two counter partiesto exchange cash flows in the future.

Under the swap agreement, various terms like thedates when the cash flows are to be paid, the

currency in which to be paid and the mode of

payment are determined and finalized by the parties.

Usually the calculation of cash flows involves thefuture values of one or more market variables.


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Swap Contracts

Interest rate swapsprovide a way for businessesto hedge their exposure to changes in interest rates.

If a company believes long-term interest rates are likely to

rise, it can hedge its exposure to interest rate changes by

exchanging its floating rate payments for fixed rate payments.


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Swap Contracts

In case of currency swap, it involves in exchanging ofinterest flows, in one currency for interest flows in

other currency. In other words, it requires the

exchange of cash flows in two currencies. There are

various forms of swaps based upon these two, buthaving different features in general.

A B

E 40 Million

$ 50 MillionUS based company Euro based company

Dollar denominated interest rate is 8.25% and Euro denominated interest rate is 3.5%


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Swap Contracts

Currency swaps are over-the-counter derivatives that serve two mainpurposes.

1. They can be used to minimize foreign borrowing costs.

2. They could be used as tools to hedge exposure to exchange rate

risk. Corporations with international exposure will often utilize

these instruments for the former purpose while institutionalinvestors will typically implement currency swaps as part of a

comprehensive hedging strategy.


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Warrants and Convertibles

ConvertiblesThese are hybrid securities which combine the basic attributesof fixed interest and variable return securities. Most popularamong these are convertible bonds, convertible debentures

and convertible preference shares. These are also called equityderivative securities.

They can be fully or partially converted into the equity sharesof the issuing company at the predetermined specified termswith regards to the conversion period, conversion ratio and

conversion price.These terms may be different from company to company, asper nature of the instrument and particular equity issue of thecompany.


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Features of Forward Contracts

1. It is an agreement between the two counterparties in which one is buyer and

other is seller. All the terms are mutually agreed upon by the counterparties at the

time of the formation of the forward contract.

2. It specifies a quantity and type of the asset (commodity or security) to be sold

and purchased.

3. It specifies the future date at which the delivery and payment are to be made.

4. It specifies a price at which the payment is to be made by the seller to the buyer.

The price is determined presently to be paid in future.

5. It obligates the seller to deliver the asset and also obligates the buyer to buy the

asset.

6. No money changes hands until the delivery date reaches, except for a small

service fee, if there is.


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Classification of Forward ContractsHedge Contracts

The basic features of such forward contracts are that they are freely transferable anddo not specify any particular lot, consignment or variety of delivery of the underlying

goods or assets. Since in both hedge contracts and futures contracts, no specification

about the underlying asset/commodity is mentioned because such limits are set by

the rules of the exchange on which types can or cannot he delivered.

Transferable Specific Delivery (TSD) Contracts

These forward contracts are freely transferable from one party to other party. These

are concerned with a specific and predetermined consignment or variety of the

commodity.

Non-Transferable Specific Delivery (NTSD) Contracts

These contracts are of such nature which cannot be transferred at all. These may

concern with specific variety or consignment of goods or their terms may be highly

specific. The delivery in these contracts is mandatory at the time of expiration.

It may be generalized that every futures contract is a forward contract but every

forward contract may not be futures contract.


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Forward Rate Agreements (FRA) Sometimes, a customer (depositor) may also make a FRA contract with the bank

for his deposits for seeking a guaranteed rate of interest on his deposits.

If the market rate on his deposit turns out to be lower than that guaranteed

interest rate in the FRA, the bank will compensate him for the difference, i.e., FRA

rate minus market interest. Similarly, if the FRA is lower than the deposit rate then

the customer will pay difference to the banker. This transaction is known as sale of

a FRA to the bank. In this way, purchase of FRA protects the customer against a rise in interest in case

of borrowing from the bank. Similarly, sale of FRA will protect the customer from

deposits point of view. The bank charges different rates of interest for borrowing

and lending, and the spread between these two constitutes banks profit margin.

As a result, no other fee is chargeable for FRA contracts.

Range Forward

These instruments are very much popular in foreign exchange markets. Under this

instrument, instead of quoting a single forward rate, a quotation is given in terms

of a range, i.e., a range may be quoted for Indian rupee against US dollar at Rs 47

to Rs 49.


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Time Value of Money


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Time Value of Money

In option A, the total amount is invested at a simpleannual rate of 4.5%, the future value of your investmentat the end of the first year is $10,450Future value of investment at end of first year:= ($10,000 x 0.045) + $10,000= $10,450

At the end of two years, you would have $10,920:Future value of investment at end of second year:

= $10,450 x (1+0.045)= $10,920.25


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Time Value of Money

Present Value of a Future Payment

This shows that time literally is money - the value of the money now

is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money

so that one can distinguish between the worth of investments that offer

returns at different times.


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Forward Price

The Forward Price for Investment Asset (Securities)

1. Investment assets providing no income

2. Investment assets providing a known income

3. Investment assets providing a known dividend income


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Forward Price

1. Investment assets providing no income

These are usually non dividend paying equity shares and

discount bonds.

Eg: Consider a long forward contract to purchase a share (Non-

dividend paying) in three-months. Assume that the current

stock price is Rs 100 and the three-month risk free rate of

interest is 6% per annum.

1)Forward price to be Rs 105

2) Forward price to be Rs 99


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Forward Price

Scenario 1:

Borrow Rs 100 @ 6% for three months, buy one share at Rs 100and short a forward contract for Rs 105.

At the end of three months a profit of Rs 3.50 will be booked,

(Rs 105 - Rs 101.50).

Scenario 2:

An arbitrageur can sale one share, invest the proceeds of the

short sale at 6 percent per annum for three months, and a longposition in a three-month forward contract.

His net gain is Rs 101.50Rs 99 = Rs 2.5.


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Forward Price

F = Se(rT)

where F is forward price of the stock, S is spot price of the stock,

T is maturity period (remained), r is risk- free interest rate.

If F> Se(rT) then the arbitrageur can buy the asset and will go for

short forward contract on the asset.

If F < Se(rT) then he can short the asset and go for long forward

contract on it.


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Forward Price

2. Investment assets providing a known income

Forward contracts where in underlying asset are coupon

bearing bonds, treasury securities, known dividend.

Eg: Consider a long forward contract to purchase a coupon bond

whose current price is Rs 900 maturing in a year. Assume that

the coupon payment of Rs 40 are expected after six months

and 12 months, and six-month and one-year risk free interest

rate are 9 percent and 10 percent respectively.


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Forward Price

Scenario 1:

We assume that the forward price is high at Rs 930.

Arbitrageur can borrow Rs 900 to buy the bond and short aforward contract.

The arbitrageur will earn ( 40 + 930) 952.39 = Rs 17.61

Scenario 2:

we may assume the low forward price at Rs 905.

Arbitrageur can short the bond and outer into long forwardcontract.

The arbitrageur will earn 952.39(40 + 905) = Rs 7.39


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Forward Price

F = (SI)erT

In the earlier example, S = Rs 900, I = 40, r = 0.09 and 0.1 and T= 1.

If F > (S - I)erT, the investor can earn the profit by buying the asset

and shorting a forward contract on the asset.

If F < (S - I)erT, an arbitrageur can earn the profit by shorting theasset and taking a long position in a forward contract.


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Forward Price

3. Investment assets providing a known dividend income

A known dividend yield means that when income expressed as a

percentage of the asset life is known.

Eg: Let us consider a six-month forward contract on a security

where 4 percent per annum continuous dividend is expected.

The risk free rate of interest is 10 percent per annum. The

assets current price is Rs 25.

F = Se(r-q)T

= Rs 25.76


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Forward Price

If F> Se(r-q)T then an investor can buy the asset and enter into a

short forward contract to lock in a riskless profit.

If F< Se(r-q)T then an investor can enter into a long forward

contract and short the stock to earn riskless profit.


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Forward Price

Valuing Forward Contracts

f = (FK)e-rT

Where

f is value of a forward contract,

F is forward price (current) of the asset,

K is delivery price of the asset in the contract,

T is time to maturity of contract andr is risk free rate of interest.


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Forward Price

For example if S0 , the spot price, of the asset is

100. The time to delivery in the forward contract

is 6 months (or 0.5 years) and the annual risk

free rate is 5%, then the forward price of thesecurity will be:

100 e0.05 0.5= 102.53


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Forward Price

For example a security with spot price of 100,

pays a dividend whose present value as of today

(time 0) is 10. The risk free rate and tenor of the

forward contract are as mentioned earlier, i.e.5% and 0.5 years respectively. The forward price

will be:

(100-10) e0.05 0.5= 92.28


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Forward Price

For example a security with spot price of 100,

pays a 10% annual dividend. The risk free rate

and tenor of the forward contract are as

mentioned earlier, i.e. 5% and 0.5 yearsrespectively. The forward price will be:

100 e(0.05-0.1) 0.5= 97.53


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Forward Price

For example if the spot price is 30, the remaining term to

maturity is 9 months (0.75 years), the continuously compounded

risk free rate is 12% and the delivery price is 28, then the value

of the forward contract will be:

f = 3028e-0.120.75= 4.41


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The current spot price of an asset is 228 and

the interest rate is r = 6.75% per annum. Find

the one-month and six-month forward prices

for the asset.


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Forward Price

Consider a six-month long forward contract of a non-income-paying security. The risk free rate of interest is 6 percent perannum. The stock price is Rs 30 and the delivery price is Rs 28.

Compute the value of forward contract.

Answer: 2.84


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Forward Price

For example if the spot price is 30, the remaining term to

maturity is 9 months (0.75 years), the discretely compounded

risk free rate is 12.50% and the delivery price is 28, then the

value of the forward contract will be:

f = 3028(1+12.5%)-0.75= 4.37


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Examples

1. An investor enters into a short gold futures contract when the

futures price is 60 cent per pound. One contract is for delivery of

60,000 pounds. How much the investor gain or lose if cotton

price at the end of the contract is: (a) 58.20 cent per pound (b)

61 30 cent per pound?


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Examples

2. The current stock price is Rs 49 and a three-month call with astock price 50, losing Rs 3.90 (premium amount). You have Rs

9800 to invest. Identify alternative strategies.

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Derivatives, Futures and Options (4)

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