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Derivatives, Futures and Options

Risk
A probability or threat of damage,
liability, loss, or any other negative
occurrence that is caused by external or
internal vulnerabilities, and that may be
avoided through preemptive action.

Financial Risk is defined as the chance
that an investment's actual return will
be different than expected. This includes
the possibility of losing some or all of
the original investment.
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 to
completely avoid.

Unsystematic Risk - This kind of risk affects a very
small number of assets. An example is news that affects
a specific stock such as a sudden strike by employees.

Types of Risk
Credit or Default Risk - Credit risk is the risk that a company
or individual will be unable to pay the contractual interest
or principal on its debt obligations. This type of risk is of
particular concern to investors who hold bonds in their
portfolios.

Country Risk - Country risk refers to the risk that a country
won'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 emerging
markets or countries that have a severe deficit.

Types of Risk
Foreign-Exchange Risk - When investing in foreign countries
you must consider the fact that currency exchange rates
can 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 an
investment's value will change as a result of a change in
interest rates. This risk affects the value of bonds more
directly than stocks.


Types of Risk
Political Risk - Political risk represents the financial risk that a
country's government will suddenly change its policies. This is a
major 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 mainly
to stocks and options. As a whole, stocks tend to perform well
during a bull market and poorly during a bear market - volatility
is 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 for
this behavior.


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.
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
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
Derivatives
Derivatives exchange is a market where
individuals trade standardized contracts that have
been defined by the exchange
The Chicago Board of Trade, established in 1948 is
the oldest exchange to trade derivatives
It brought farmers and merchants together and
standardized the qualities and quantities of the
grains traded
Chicago Mercantile Exchange was established in
1919 in order to trade futures

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
Kinds of Derivatives


Forwards and Futures
A 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
Kinds of Derivatives


Futures
A future 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 the
buyer (has long position) on a specific date
This date is called settlement, or delivery, date
Example of Futures


Features of Forward contract


> Forward contracts are bilateral contracts and are are exposed to
counter 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 on
expiration date
> If the party wishes to reverse the contract, then it has to deal with the
same counter party

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<K , you can buy from the market at a lower price and sell it to the other
party at K and hence, earn profits.
Features of Futures


> All futures contract have standardized specification i.e. quantity of
asset, 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 the
country 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 account
is 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

Futures contract


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 holds
Can 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 themselves
against 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


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 increases
Futures are popular because they are cheap





Arbitrage and Futures Prices
On the delivery date, the price of the futures contract must equal
the 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
Option Contracts


Option is a contract entered between two parties whereby one party obtains
the 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 amount
known 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


Option Contracts


American Option
It can be exercised at any time before the expiration date

European Option
It can be exercised only on the expiration date


Option Contracts


Swap Contracts
A swap is an agreement between two counter parties
to exchange cash flows in the future.

Under the swap agreement, various terms like the
dates 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 the
future values of one or more market variables.
Swap Contracts
In the interest rate swap one party agrees to pay the other
party interest at a fixed rate on a notional principal amount,
and in return, it receives interest at a floating rate on the
same principal notional amount for a specified period. The
currencies of the two sets of cash flows are the same.

A B
LIBOR + 1%
1.5%
At no point does the principal change hands, which is why it is referred to
as a "notional" amount.
LIBOR: London Interbank Offered Rate is a benchmark rate that some of
the worlds leading banks charge each other for short-term loans.

Swap Contracts
Interest rate swaps provide a way for businesses
to 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.
Swap Contracts
In case of currency swap, it involves in exchanging of
interest 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, but
having different features in general.

A B
E 40 Million
$ 50 Million
US based company Euro based company
Dollar denominated interest rate is 8.25% and Euro denominated interest rate is 3.5%
Swap Contracts
Currency swaps are over-the-counter derivatives that serve two main
purposes.
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 institutional
investors will typically implement currency swaps as part of a
comprehensive hedging strategy.
Warrants and Convertibles
Warrants
Warrant is just like an option contract where the holder has
the right to buy shares of a specified company at a certain
price during the given time period.
If the holder exercised the right, it increases the number of
shares of the issuing company, and thus, dilutes the equities
of its shareholders.
Warrants are usually issued as sweeteners attached to
senior securities like bonds and debentures so that they are
successful in their equity issues in terms of volume and price.
Warrants are highly speculative and leverage instruments,
so trading in them must be done cautiously.
Warrants and Convertibles
Convertibles
These are hybrid securities which combine the basic attributes
of fixed interest and variable return securities. Most popular
among these are convertible bonds, convertible debentures
and convertible preference shares. These are also called equity
derivative securities.
They can be fully or partially converted into the equity shares
of the issuing company at the predetermined specified terms
with regards to the conversion period, conversion ratio and
conversion price.
These terms may be different from company to company, as
per nature of the instrument and particular equity issue of the
company.
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.
Classification of Forward Contracts
Hedge Contracts
The basic features of such forward contracts are that they are freely transferable and
do 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.
Forward Rate Agreements (FRA)
Forward contracts are commonly arranged on domestic interest-rate bearing
instruments as well as on foreign currencies.
A forward rate agreement is a contract between the two parties, (usually one
being the banker and other a bankers customer or independent party), in which
one party (the banker) has given the other party (customer) a guaranteed future
rate of interest to cover a specified sum of money over a specified period of time
in the future.
In forward rate agreement, no actual lending or borrowing is affected. Only it fixes
the rate of interest for a futures transaction. At the time of maturity, when the
customer actually needs funds, then he has to borrow the funds at the prevailing
rate of interest from the market.
If the market rate of interest is higher than the FRA interest then the banker will
have to pay to the other party (customer) the difference in the interest rate.
However, if market interest is lesser than the FRA rate then the customer will have
to pay the difference to the banker.
This transaction is known as purchase of FRA from the bank.
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.
Time Value of Money
Time Value of Money
In option A, the total amount is invested at a simple
annual rate of 4.5%, the future value of your investment
at the end of the first year is $10,450
Future 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

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.

Notations
T = Time remained upto delivery date in the contract

S = Price of the underlying asset at present, also called as spot or cash or
current

K = Delivery price in the contract at time T

F = Forward or future price today

f = Value of a long forward contract today

r = Risk free rate of interest per annum today

t = Current or today or present period of entering the contract
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
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


Forward Price
Scenario 1:
Borrow Rs 100 @ 6% for three months, buy one share at Rs 100
and 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 long
position in a three-month forward contract.
His net gain is Rs 101.50 Rs 99 = Rs 2.5.


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.

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.

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 a
forward 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 forward
contract.
The arbitrageur will earn 952.39 (40 + 905) = Rs 7.39

Forward Price
F = (S I)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 the
asset and taking a long position in a forward contract.

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
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.


Forward Price
Valuing Forward Contracts
f = (F K)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 and
r is risk free rate of interest.

Forward Price
For example if S
0 ,
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 the
security will be:

100 e
0.05 0.5
= 102.53

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) e
0.05 0.5
= 92.28
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 years
respectively. The forward price will be:

100 e
(0.05-0.1) 0.5
= 97.53
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 = 30 28e
-0.120.75
= 4.41


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.

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






Answer: 2.84

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 = 30 28(1+12.5%)
-0.75
= 4.37
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?
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?





Ans:
a) 1080 pound
b) 780 pound
Examples
2. The current stock price is Rs 49 and a three-month call with a
stock price 50, losing Rs 3.90 (premium amount). You have Rs
9800 to invest. Identify alternative strategies.