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FinancialDerivatives

HarshVardhan

Objective
What h isDerivative? ? WhyDerivativesareworthstudying? DerivativeMarkets, ,FutureProductsinIndia WaysDerivativesareused IndianDerivativesmarketanOverview Th t Three typesof ft traders d Hedger, H d S Speculator, l t A Arbitrageurs bit OTC&ExchangeTradedMarkets SpotandFutureContracts,LongandShortPositions FutureContract&ForwardContract OptionContractsPut&Call Long&ShortFutures, Futures ShortSelling HedgingusingForwardandOptions RoleofDerivativeMarket NumericalProblems
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TheNatureofDerivatives
A derivative is an instrument whose value depends on the values of other more basic underlying y g variables. It is an instrument that derives value from an underlying. underlying Derivative instruments are also known as contracts. Underlying is an instrument which lends value to the derivative instrument. Crude (underlying) y g Petrol(derivative) Milk (underlying) Curd(derivative) Derivatives have been very successful in brining i innovation i in i the h Capital C i l Market. M k
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ExamplesofDerivatives FuturesContracts ForwardContracts Options Swaps Theunderlyinginstrumentscouldbe stocks,indices,commodities,metal Veryoftenthevariablesunderlyingderivativesaretheprices oftradedassets. assets Examplestockoptionisa derivative, derivative itsvalue dependsonthepriceofthestock. Otherderivativeproductsrelatestointerestrate,foreign exchangeandequityderivatives. derivatives
Underlying Derivative CashMarket F&OMarket RelianceEQ Reliance Future& Reliance Option Stock Derivative NIFTY NIFTYFuture &NIFTY Option Index Derivative

NIFTYcannotbe tradedinthecash marketonitsown

WhyDerivativesareworthstudying?
The Bank of International Settlement of Basel, Switzerland ,estimated that at the end of 2010,the notional amount of overthe counter derivative contracts outstanding world wide is over $ 601 trillion. In comparison ,GDP in the US at the end of 2010 was about $15 trillion. According to Futures Industry magazine, the global listed derivative trading volume in 2010 was 22.3 billion contracts over 78 derivative d exchanges. h Of f which h h 11.2 billion b ll are futures and 11.1 billion are options. The top five volume categories 2010 for equity indices (7.4 (7 4 billion), individual equities (6.3 billion),interest rate (3.2 billion),foreign currency (2.4 billion) and agriculture commodities di i (1.3 (1 3 billion). billi )
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The notional amount is a measure of the size of a derivative contract stated in units of currency on which payment is calculated. While the notional amount reflects the size of the market on which derivatives are based, market value indicates amount of actual t l money under d exposure. Market value of contracts totals $ 21 trillion ,making the derivative market a sizeable force in the global market. market
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Notionalamountofoverthecounterderivative contracts19982010
Notional amount increased monotonically , but financial crisis has significant impact in 2008

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A derivative d exchange h is a market k where h individuals d d l trade standardized contracts that have been defined by the exchange. g Some of the oldest exchanges are: The Chicago Board of Trade (CBOT ,www.cbot.com) ,established established in 1884; started with grain trading and moved to dealing with futures in grain. The Chicago g Mercantile Exchange g (CME, www.cme.com) established in 1919. The Chicago Board Options Exchange (CBOE www.cboe.com) (CBOE, www cboe com) ,1973, 1973 started trading in Call option contracts on 16 stocks. Put option contracts started trading on exchange in 1997.Now around 1 000 stocks and many stock indices are traded. 1,000 traded
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ExchangeTradedMarkets

TopTenDerivativesExchangesworldwidetrading volumein2010inbillion

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DerivativeMarkets
Derivative markets are markets for contractual instruments whose performance is determined by the h way in i which hi h the h another h instrument i or asset perform. Instrument term is used to describe asset or liability. liability A contract is an enforceable legal agreement. A security is a tradable instrument representing a claim on a group of asset. Like all contracts derivatives are agreements b between two parties i buyer b and d seller ll in i which hi h each h party does something for other. These contracts price and buyer y try y to buy y as cheaply p y as have a p possible while seller try to sell as dearly as possible.
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IndianDerivativeMarketTimeline
Derivative market in India started in 2000 on both NSE & BSE with trading in Equity derivatives. June 2000 Index future June J 2001Index I d option ti July 2001Options in individual stocks November 2001 Futures in single stock derivatives 2008 Currency Future
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Indian experience with derivative market has b been positive. ii The derivative turn over on NSE surpassed equity market turn over. The turn over of derivatives on NSE increased from ` 23,654 million in 20002001 to ` 292,482,211 million in 20102011. Average daily turn over increased from ` 723,921 , , million in million in 20092010 to ` 1,151,505 201011 ,an increase of around 59%.
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FuturesProductsinIndia
1. 1 2. 3. 4. 5. EquityIndexFutures SingleStockFutures InterestRateFutures CommodityFutures CurrencyFutures

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NSE & BSE are the h exchanges h which h h offers ff trading d in Futures. Contracts are available for different tenures(expiry) ( p y) Typically contracts are available for 1,2 or 3 months Last working Thursday is the date of expiry for that month. If Thursday is holiday ,then then last Wednesday is considered. considered Buyers and sellers will not take or give delivery of the underlying. Profit fi & Loss are settled l d in i cash. h Since there is no delivery of the underlying ,we could trade in broad indices like NIFTY.NIFTY is most traded both for Futures & Options One can start trade in Futures by paying small % of contract co t act value a ue known o as margin. ag Contract size and margin are set by exchange.
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FuturesIndianMarketPerspective

TurnoverofIndianDerivativesMarkets
TURNOVER of INDIAN DERIVATIVES MARKET `(` Crore) Year Equity Derivatives Currency Derivatives Interest Rate Derivatives Interest Rate Swap

Index Futures

Index Options

Stock Futures

Stock Options

Forward

Swap

Exchange Traded Currency O ti Options and d Futures 8 3 11 389 3,11,389 37,27,262 84,06,307

1 2008-09 2009-10 2010-11

2 35 81 870 35,81,870 39,34,485

3 37 31 512 37,31,512 80,28,103

4 34 79 657 34,79,657 51,95,247 54,95,757

5 2 29 227 2,29,227 5,06,065 10,30,343

6 25 54 994 25,54,994 20,35,879 28,90,222

7 40 65 695 40,65,695 31,45,402 41,12,539

9 49 04 752 49,04,752 25,69,488 47,46,390

43,56,909 1,72,69,366

SourceRBI
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F&O Segment Index Future Index Option Stock Future Stock Option NSE 2010 2010-11 11

Turn over in Crore ` 4,356,909 , , 17,269,366 5,495,757 1,030,343

Theindexoptionistheleader with61%oftotalturnoverof F&OsegmentofNSEfollowed bystockfuture(20%)and indexfuture(15%).

Turnoverin%ofF&OsegmentofNSEfor201011
4% 20% 15%

IndexFuture IndexOption StockFuture StockOption 61%

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NumberofDerivativeStockstradedonNSE
Year Index futures Stock futures Index Stock optionsoptions Interest rate futures 1,60,68,559 Currency futures

2000 01 200001 200102 200203

90 580 90,580 10,25,588 21,26,763

19,57,856 10,67,683

1,75,90010,37,529 4,42,24135,23,062

2003041,71,91,688 3,23,68,84217,32,41455,83,07110,781 2004052,16,35,449 2005065,85,37,886 4,70,43,06632,93,53850,45,1120 8,09,05,4931,29,35,11652,40,7760

2006078,14,87,424 10,49,55,4012,51,57,43852,83,3100 20070815,65,98,579 20,35,87,9525,53,66,03894,60,6310 20080915,64,84,642 17,14,22,78213,79,49,48791,90,5380

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NiftyFutureon17/6/13at1:05pmfor27th J June expiry i

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Spot Contract An agreement to buy or sell an asset immediately (or within a very short period of time) for a certain price. Futures Contract A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price agreed upon today. Futures are traded in organized exchanges. They are standardized contracts, margin is required & th i settlement their ttl t is i done d b cash. by h
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SpotandFutureContract

FuturesPrice
The futures prices for a particular contract is the price at which you agree to buy or sell in the future. It is determined by supply and demand in the same way as a spot price.

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ExamplesofFuturesContracts
Agreementto: buy 100 oz. of gold @ US$600/oz. in December (NYMEX) sell 62,500 @ 1.9800 US$/ in March ( (CME) ) sell 1,000 bbl. of oil @ US$65/bbl. in April (NYMEX),(bbl =oil oil barrel =158.987 158.987 L)

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Forward d contracts are similar l to futures f except that h they trade in the overthecounter market usually between two financial institutions. A forward contract is a contract between two parties a buyer and a sellerto purchase or sell something at a latter l tt date d t at t a price i agreed d upon today. t d One of the parties in Forward contract assumes a long position and other short position. position Forward contracts are popular on currencies and interest rates. Forwards are traded over the counter, customized, margin is not required, stocks or goods are settled. settled
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ForwardContracts

The party that has agreed to buy the underlying asset on a certain specified future date for a specified price has a long position The party that has agreed to sell the underlying asset on a certain specified future date for a specified price has a short position Bid the price that a dealer is prepared to pay for an asset. Ask or Offer the price that a dealer is offering to sell an asset. BidAsk Spread the amount by which the ask price exceeds the bid price.
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Long&ShortPosition

An agreement that gives the right but not the obligation to buy or sell an asset at a certain time in the future for a certain price agreed upon today. The option buyer pays the seller a sum of money called the price or premium. premium The option seller stands ready to sell or buy according di to t the th contract t t term t if and d when h the th buyer so desires.
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OptionContract

Anoptiontobuysomethingisreferredtoas call ,anoptiontosellsomethingisknownas put. put Thepriceinthecontractisknownasthe exercisepriceorstrikeprice price.

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Optionsvs Forward/Futures
A forward/futures contract gives the holder the obligation to buy or sell at a certain price at a future date An option gives the h holder h ld the h right h but b not the obligation to buy or sell at a certain price at a future f d date

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Americanvs EuropeanOptions
An American option can be exercised at any time during its life. life A European option can be exercised only at maturity.

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ElectronicTrading
Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange. Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers. sellers

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OvertheCounterMarkets
The Overthe Counter Market is an important alternative to exchanges It is a telephone and computerlinked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers

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SizeofOTCandExchangeMarkets
$516.4 trillion OTC

$ 96.7 trillion Exchange t d d market traded k t

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market By June 2007, the OTC market had grown to $516.4 trillion and exchange traded market to $96.7 trillion

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RoleofDerivativeMarket
Derivative markets provide a means of adjusting the risk of spot p market investments to a more acceptable level. They make trading easier and less costly and spot markets more efficient. Th These markets k t also l provide id a means of f speculating. Operational Advantages First, First derivative markets entail lower transaction costs. Second, derivative greater liquidity q y than spot p markets often have g markets. And third, derivative markets allow investors to sell short in an easier manner.
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Risk
Risk results from exposure to uncertainty. Uncertainty is the doubt about our ability to predict future outcomes. When uncertainty exists outcomes cannot be forecasted with precision. precision Uncertainty is a function of circumstances in which hi h more than th one outcome t i possible. is ibl

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Risk in decision making relating to underlying nature of business which deals with matters such as uncertainty of future sales or the cost of inputs is known as business risk. Another class of risk deals with uncertainty such as interest rates, stock prices and commodity prices .These are known as financial risks. Derivatives D i ti serve a valuable l bl purpose in i managing i financial risk. By using derivatives companies and individuals can transfer for a price any undesired risk to other parties who either have risks that offset or want to assume that risk. risk
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TwoTypes yp ofRisk

WaysDerivativesareUsed
To Hedge risks. To Speculate l ( k a view on the (take h future f direction of the market) To lock in an Arbitrage profit. To change g the nature of an investment without incurring the costs of selling one portfolio and buying p y g another.

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CategoriesofTraders
Three broad category of traders are: H d Hedger, S Speculator l and d Arbitrageurs. A bi Hedgers use derivatives to reduce the risk due to potential future movements in the market variables. Speculators use them to bet on the future direction of market variables. Arbitrageurs take offsetting positions in two or more instruments to lock in profit.
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Hedging
Eliminating or reducing exposure to uncertainty Eliminating or reducing risk Hedger is risk averse This is not the same as eliminating or reducing uncertainty t i t A description of a risk averse investor who, when f d with faced ith two t i investments t t with ith a similar i il expected return (but different risks), will prefer the one with the lower risk. risk
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Speculation
Takeaviewonthefuturedirectionofan uncertain t i market k t Iftheviewturnsouttoberightinthefuture youmake k money Iftheviewturnsouttobewronginthefuture youlose l money Speculatorconsciouslytakesonriskbytaking exposureto t uncertainty t i t Speculatorisariskseeker
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Arbitrage
Riskfreeprofit Assuredprofitwithzerouncertainty Buylow l Sellhigh Buyandsellpricesknownwithzero y uncertainty

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Differencebetween Hedging, d Speculation l and dArbitrage b


A trader is hedging when he has an exposure to the price of an asset and takes a position in a derivative to offset the exposure. exposure In speculation the trader has no exposure to offset He is betting on the future movements offset. in the price of the asset. Arbitrage A bi i l involves taking ki a position i i in i two or more different markets to lock in a profit.
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Example
On July 20, 20 2007 the treasurer of a corporation enters into a long forward contract to buy 1 million in six months at an exchange rate of 2.0489 This obligates the corporation to pay $2,048,900 for 1 million on January 20, 2008 What Wh are the h possible ibl outcomes? ?

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ForeignExchangeQuotesforUSD/GBPonJuly 20 2007,Quote 20, 2007 Q in i number b of fUSDperGBP


Bid 2.0558 2.0547 2.0526 2.0483 Offer 2.0562 2.0552 2.0531 2.0489
Foreign g Contracts are used to hedge foreign currency risk. On July 20,2007 the treasurer of US corporation knows that they have to pay 1 million in 6 months. The treasurer buy 1 forward from bank at exchange rate 2.0489. The corporation has long forward contract on GBP ,it will buy 1 million from bank for $ 2.0489 million .The bank has short forward contract on GBP and will sell 1 million for $ 2.0489 million on Jan 2008.

Spot 1-month forward 3-month forward 6-month forward

Spot theBankispreparedtobuysterling()inthe spotmarketforimmediatedelivery.

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PayoffsfromForwardContracts
The forward contract help the corporation to buy 1 million for $2,048,900. Incase spot exchange h rate rose to 2.100,at the h end d of 6 months ,the forward contract will be worth $51,100(=$2,100,000 $51,100( $2,100,000$2,048,900) to the corporation. Thus it had enabled 1 million to be purchased at an exchange h rate t of f 2.0489 2 0489 instead i t d of f 2.100. 2 100 On the other hand if the exchange rate falls to 1 9000 at the end of 6 months ,the 1.9000 the forward contract will have negative value of $ 148,900 and corporation will pay $ 148,900 more than the market price of the .
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Profitfroma gForwardPosition Long


Profit

P i of Price f Underlying U d l i at Maturity, ST


K
Payoffforalongpositioninaforwardcontractonone unitofanassetisST - K, where K is the delivery price and ST is the spot price . Let K=2.0489,ST=2.1000,pay off =2.1002 0489 $0 0511/ 2.0489=$0.0511/, when ST =1.9000,payoff = - 0.1489/
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Profitfroma ShortForwardPosition Profit

Price of Underlying at Maturity, ST


K
Payoffforashortpositioninaforwardcontracton oneunitofanassetisKST , where K is the delivery price and ST is the spot price . Let K K=2.0489,S 2.0489,ST=2.1000,pay 2.1000,pay off =2.0489-2.1000= 2.0489 2.1000 -$0.0511/, when ST =1.9000,payoff = 0.1489/

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RelationshipbetweenForwardandSpotPrices Consider a stock which is not paying any dividend and is worth $ 60 today. You may borrow or lend at 5%.What should be the price of 1 year forward. If $60 invested for a year, it will be $60*1.05=$63. Let the forward price is more that $ 63 say $67. Borrow $ $60 , ,buy y a share of stock; ; sell it forward for $ 67.Pay loan interest =$3,Net gain =$(67 60)$3=$4
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If the forward price is less than $63 say $58 Investor owning the stock sell it for $60 and enters into a forward to buy at $58. Proceeds of the sales of $60 are invested for a year at 5%,interest earned =$3. Net N t gain i = $2+$3=$5. $2 $3 $5 Thus the investor would end up $5 more than if the stock is kept in the portfolio.

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Differencebetweenalongforward positionand dashort h forward f dposition


When the trader enters into a long forward contract ,he is agreeing to buy the underlying asset for a certain price at a certain time in the future. Where as when the trader enters into a short forward contract ,he is agreeing to sell the underlying asset for a certain price at a certain time in the future.
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US$` cCCurrency yFuturesQuote27/6/13

1$=`59.8538,on27/6/2013

F0=S0erT

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ExchangesTradingOptions
ChicagoBoardOptionsExchange(largestfor tradingstockoptions) AmericanStockExchange PhiladelphiaStockExchange InternationalSecuritiesExchange Eurex (Europe) ( p )

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ExampleCall&PutOption:IntelOptionPrices (S 12, (Sept 12 2006; 2006 Stock S kPrice=19.56) P i 19 56)


S trikeP rice ($) $15.00 $17.50 $20.00 $22.50 $2500 $25.00 O ct 2006 4.650 2.300 0.575 0.075 0025 0.025 C alls Jan 2007 4.950 2.775 1.175 0.375 0125 0.125 A pr 2007 5.150 3.150 1.650 0.725 0275 0.275 O ct 2006 0.025 0.125 0.875 2.950 5450 5.450 P uts Jan 2007 0.150 0.475 1.375 3.100 5450 5.450 A pr 2007 0.275 0.725 1.700 3.300 5450 5.450

Sourcewww.cobe.com

The price of call option decreases as the strike price increases. The price of put option increases as the strike price increases increases. Both option become more valuable as time of maturity increases. Chapter1/Harsh/2013

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CallOptionExercise
Investor instructs broker to buy one April call option on Intel at strike price $ 20. Price of the April call option at strike price $20 is $1.650 Option contract size is of 100 shares. Investor buys one contract of 100 Intel share at a strike price $20 for $165. The seller has received $ 165 and has agreed to sell 100 Intel shares for $20/share; incase investor chooses to exercise i option. i Expiration date is 21 April,2007. If the price before 21st April does not rise above $ 20 , the option is not exercised and investor looses $ 165 55

IftheIntelsharepriceiswellabove $20,say $30.Theinvestorisabletobuyshare$20 whichisfor$30. Thusgain=100*(3020)=$1000. Theinitialcostofoption$165 Thusnetgain=$(1000165)=$835

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1500 Profit($) 1000 500 10 0 500

PayOffprofitas afunctionoffinal stockprice

20 30

stockprice($)

Purchasingacontractconsistingof100 Aprilcalloptionwithstrikeprice$20

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PutOptionExercise
Investor instructs broker to buy one April put option on Intel at strike price $ 17.50. Price of the April put option at strike price $17.50 is $0.725 Option contract size is of 100 shares. Investor buys one contract of 100 Intel share @$0.725 /share for $72.50. The seller has received $ 72.50 and has agreed to sell 100 Intel shares for $17.50/share; incase investor chooses to exercise i option. i Expiration date is 21 April,2007. If the price before 21st April increase above $ 17.50 , the option is not exercised and investor looses $ 72.50

If the Intel share price is well below $ 17.50 ,say , y $ 15.The investor is able to sell share $ 17.50 while it is for $ 15. Thus gain =100*$(17.50 100 $(17.5015) = $ 250. The initial cost of put option is $72.50 Thus Th net t profit=$ fit $ (25072.50)=$177.50 72 50) $177 50

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1500 Profit($) 1000 500 10 0 500

PayOff

20

30 stockprice($)

Purchasingacontractconsistingof100April putoptionwithstrikeprice$17.50

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Therearefourtypesofparticipantsinthe optionmarket:
1. 2. 3. 4. BuyerofCalls SellersofCalls BuyersofPuts SellersofPuts

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LongFuture
If a trader buys a NIFTY future at 4625 what could be the profit or loss at various level of NIFTY closure. If NIFTY closes at 4500,trader loses (4625 4500)*50=125*50=` 6250[lot size =50] Similarly ,if NIFTY closes at 4700 , trader gains (47004625)*50=75*50= ( ) ` 3750

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Payoffgraph LongFutures
Spotclosingatexpiry Strike Instrument Action Price Future Buy 4625 Numberof Lots* Lots 4500 4600 4625 4700 4800 4900 1 125 25 Total Profit/Loss 6250 1250 LongFutures
275

0 0

75

175

275

3750 8750 13750

*(1lotof50)
300 250 200 Profito orLoss 150 100 50 0 50 100 150 125 4500 25 4600

175

75 0 4625 4700 4800 4900

SpotPrice

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ShortFutures
If a trader sells a NIFTY future at 4625 what could be the profit or loss at various level of NIFTY closure. closure If NIFTY closes at 4400,trader gains (4625 4000)*50=225*50= 4000) 50=225 50=` 11,250[lot 11 250[lot size =50] Similarly ,if NIFTY closes at 4700 , trader loses (47004625)*50=75*50= 4625)*50 75*50 ` 3,750 3 750

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ShortFutures
Spotclosingatexpiry Strike Numberof Instrument Action Price Lots 4400 4500 4600 4625 4700 4800 Future Buy 4625 1 225 125 25 Total Profit/Loss 11250 6250 1250 0 0 75 175

3750 8750

ShortFutures
250 200 150 Profit&Loss 100 50 0 504350 100 150 200 175 SpotPrice 4400 4450 4500 4550 25 4600 0 4650 4700 4750 75 4800 4850 125 225

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ShortSelling
If an individual anticipates the price of a stock falling, he can attempt to capture a profit by selling short. He would first borrow the stock from a broker and sell ll that h stock k in i the h marketplace. k l If the h price i of f the h stock then indeed fell, he would buy back the stock at a lower price. price This would allow him to capture a profit and repay the shares to the broker. Short selling creates a liability in the sense that the short seller is obligated to someday buy back the stock and return it to the broker; however, the short seller ll does d not know k h much how h he h will ll have h to pay to buy back the shares.
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HedgingUsingForwardContractsForeignExchange Q t of Quotes fUSDperGBPonJ July l 20th 2007

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Hedging g gUsing gForwardContracts


The purpose of hedging is to reduce risk. But it is uncertain that the outcome with hedging may be better with hedging or without hedging. On July 20,2007 an Import company based in US knew that i has it h to pay 10 million illi on October O b 2007 for f the h imports i from a British supplier. $ exchange h rate t quoted t d by b the th financial fi i l institution i tit ti are given in the Table(slide 67). Import Co can hedge by buying in 3 month forward market at 1=$2.0531 This will help in freezing the price and payment of $ 20,531,000 to the British exporter
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FortheImportCo. If the exchange rate is 1.9 on Oct 20th ( $ appreciates, earlier it was 2.0531)and the company has not hedged ,the 10 million that it has to pay will cost $ 19,000,000 instead of $20,531,000. On the other hand incase the exchange rate is 2.1000($ depreciates, import company will need more $s for sterling pound),it will cost $21 000 000 and $21,000,000 d the th company would ld have h thought if they have hedged.
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USexportcompanyExportCo,exportsgoodsto theUK.Itwillreceive30millionin3months. Thecompanymayhedgeitsforeignexchange riskbyselling30millionin3monthsforward marketatexchangerate1=$2.0526. This Thi will illhave h effect ff tin i locking l ki in i the th US$t tobe b realizedforthepoundsterlingat$61,578,000 Hedgemaymakecompanybetterorworse??

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For the Export company If the exchange rate in October is less than 2.0526( has depreciated) say 1.9,the export company will get less USDs, the company will think had it hedged. If the exchange rate is more that 2.0526 ,the p y would be better without hedging. g g company

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Hedging g gUsing gOptions p


An investor who is in May owns 1,000 Microsoft shares currently worth $28 per share. share There are chances that stock price may go down in the next two months. Investor wants protection. Investor could buy a twomonth put with a strike price of $27.50 costs $1. $1 The investor decides to hedge by buying 10 contracts each of 100 shares. price= $1 Quoted option price Cost of each option contract =$1*100=$100 Total cost of hedging =$100*10=$1 $100 10 $1,000 000
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The strategy costs $ 1,000 but ensures at least $ 27 50 during 27.50 d i the th life lif of f the th option. ti If the market price of Microsoft share is less th than 27 50 th option 27.50,the ti i exercised. is i d Thus Th $ 27,500 is realized irrespective of declined share price Less cost of option $ 1,000; price. 1 000; it will give $26,500. If the market price is above $27.50,the $27 50 the option is not exercised and it expires worthless. Thus the value of holding is always above $26,500 The dotted line in the figure indicates value of portfolio without hedging.
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ValueofMicrosoftShareswithandwithout Hedging d i
40,000 Value of Holding ($)

35,000

No Hedging

30,000

Hedging

25,000

Stock Price ($) 20,000 20 25 30 35 40

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SpeculationusingFutures US speculator p in February y thinks that will strengthen in comparison to $ in 2 months. Two possibilities1.To buy 250,000 in spot. or 2. To take long position on 4 April future contract, each contract of 62,500 Margin per contract $5000.There $5000 There are 4 future contracts. Margin amount $20,000. Assume current exchange g rate is 2.0470$/ / and April futures price is 2.0410$/
Profitsforbothbuyinginspotandbuyingfuturefor Aprilspotprice=2 =2.100 100and2 2.000 000arecalculated
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Speculators

The first alternative needs upfront of $511,750(=250000*2.0470 ); where as initial small margin required by the speculator for futures =4* $ 5000=$ 20,000.

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SpeculationusingSpotandFuturecontracts OneFuturecontractisof62,500.Initialmarginfor4contract=$4*5000=$20000 PossibleTrades Buy250,000 Buy4Futurescontracts SpotPrice=2.0470 =2 0470 FuturesPrice=2 =2.0410 0410 Investment $511,750 $20,000 ProfitifAprilspotis=2.1000 2 1000 $13,250 $13 250 $14 750 $14,750 ProfitifAprilspotis=2.0000 $11,750 $10,250
Itisseenfromthetablethatfuturesmarketprovides leverage,withrelativelysmallamountinvestormaytakea largespeculativeposition.
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ItisOctoberandspeculatorthinksthatstockwillriseinthenext2 months. CurrentPriceofstock=$20. 2monthscalloptionwith$22.50 22 50strikepriceiscurrentlysellingfor $1 Letthestockpricetouches$27byDecember. Speculatorwishestoinvest$2000 TwooptionsEitherpurchase100stocksor2000calloptions. Buyingstockyieldprofit=100*($27$20)=$700 Buyingoptionyieldsprofit=2000*$(2722.50)$2000=$7000,where $2000iscostofoption.ThusOptionbuyingis10timesmore profitable. Howeverifstockpricedeclinesto$15, Lossforbuyingstocks=100*($15$20)=$500. p isnotexercised,the , original g amountp paidforoption p is Thecalloption $2000,whichistheloss.
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SpeculationUsingOptions

Comparisonofprofit(losses)fromtwoalternative stategiesforusing$2000tospeculateonstockworth$20inOctober Decemberstockprice $15 $27 Investor'sstrategy Buy100shares $500 $2,000 Buy2000calloptions Profit/lossbyoption loss4time Optioncost $2,000

$700 $7,000 10timesprofitable

Thusoption p likefutureprovides p aleverage. g Good outcomesbecomeverygood,buttheinvestmentis lostinbadoutcomes


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Wh What t is i the th difference diff b t between entering t i into i t a long forward contract when the forward price is $50 and d taking t ki a long l position iti in i a call ll option ti with strike price of $50? In the first case the trader is obliged to buy the asset for $50.(He has no choice) Whereas in the 2nd case the trader has an option to buy the asset for $50(The trader does not have to exercise the option)

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A swap is a contract in which h h two parties agree to exchange cash flows. An agreement that can be modeled as a series of forward contracts. The agreement g specifies p a number of exchanges g of cash flows between two counterparties at different points in time in the future The quantum of cash flow exchanged at each point in time is determined by a formula specified in the agreement Interest rate swaps make up more than 60% of the $ 601 trillion notional principle over the counter derivative market in 2010. 2010
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SwapContract

PayoffsfromOptions
What is the Option Position in Each Case?

K =Strikeprice,ST =Priceofassetatmaturity Payoff Payoff K K Payoff K ST Payoff K ST ST ST

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VolumeWeighted Average Price (VWAP) is the ratio of the value traded to volume traded over a particular time horizon (usually one day). It is a measure of the average price a stock traded at over the trading horizon. The aim of using a VWAP trading target is to ensure that the trader executing the order does so inline with volume on the market. Open Interest The total number of long/short positions outstanding in a futures contract
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Terms

Tick Size a tick size is the smallest increment (tick) by which the price of stocks, stocks futures contracts or other exchange traded instrument can move. Tick sizes can be fixed (e.g., USD 0.01) or vary g to the current p price ( (common in according European markets) with larger increments at higher prices. Heavilytraded stocks are given smaller ll tick ti k sizes. i An instrument price is always a rational number and the tick sizes determine which numbers are permissible for a given instrument and exchange. g
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Open Outcry is the name of a method of communication i ti b t between professionals f i l on a stock t k exchange or futures exchange. It involves shouting and the use of hand signals to transfer information primarily about buy and sell orders. The part of the trading floor where this takes place is called a pit. Market Maker a trader who is willing to quote both bid and offer prices for an asset. Speculator p & GamblerThe word Speculator p comes from the Latin word specula or to see. This is the foremost difference between a gambler & a speculator. A Gambler is one who goes in blind taking a chance & a Speculator goes in to trade after 'seeing' the odds.

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