8. Introduction to DERIVATIVES
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Transcript of 8. Introduction to DERIVATIVES
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Introduction toDERIVATIVES
Himanshu PuriAssistant Professor (Finance)IILM CMS
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INTRODUCTION
According to the Securities ContractRegulation Act, (1956) the termderivative includes:
(i) a security derived from a debt instrument,share, loan, whether secured or unsecured, riskinstrument or contract for differences or any
other form ofsecurity;(ii) a contract which derives its value fromthe prices, or index of prices, of underlyingsecurities.
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INTRODUCTION
Derivatives are financial instrumentswhose value is derived from the value ofunderlying assets. These underlying
assets can be equities, commodities,currency, etc.
The origin of derivatives can be tracedback to the need of farmers to protectthemselves against fluctuations in the
price of their crop.Hedging
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PARTICIPANTS
Hedgers
They use derivatives to reduce the
risk
Speculators
They wish to bet on futuremovements in the price of an asset
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Economic Function of theDerivative MarketDerivatives help in discovery of
future prices. derivatives marketreflect the perception of the
market participants about the futureand lead the prices of underlying tothe perceived future level
The derivatives market helps totransfer risks from those who havethem but do not like them to those
who have an appetite for them.
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Economic Function of theDerivative MarketSpeculative trades shift to a more
controlled environment withMargining, monitoring and
surveillance of the activities
With the introduction of derivatives,the underlying cash market
witnesses higher trading volumes.This is because of participation bymore players who would not
otherwise participate for lack of an
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TYPES OF DERIVATIVES
DERIVATIVES
FORWARD
FUTURE OPTIONS SWAPS
CALL
PUT CURRENY
INTERST
RAT
E
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Forwards
OVER THE COUNTER
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Forwards
These are promises to deliver anasset at a pre- determined date infuture at a predetermined price.
The contracts are traded over thecounter (i.e. outside the stockexchanges, directly between the two
parties) and are customizedaccording to the needs of the parties.
contracts do not fall under the
purview of rules and regulations of an
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Features of forwardcontracts
The salient features of forwardcontracts are as given below:
They are bilateral contracts andhence exposed to counter-party risk.
Each contract is custom designed,
and hence is unique in terms ofcontract size, expiration date and theasset type and quality.
The contract price is generally not
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FUTURES
A futures contract is an agreement to buy orsell an asset at a certain time in the future for acertain price
Similar to forward contract, except that forwardcontract is traded OTC and futures contract istraded on an exchange.
Standardized (Terms are not negotiable)
Quantity (Contract size)
Expiration Date
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Futures
The exchange stands guaranteeto all transactions and counterpartyrisk is largely eliminated
The buyers of futures contracts areconsidered having a long positionwhereas the sellers are considered
to be having a short position
Futures contract may be offset priorto maturity by entering into an
equal and opposite transaction
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Purposes of Futures Markets
Meets the needs of four groups offutures market users:
1. Those who wish to discover information
about future prices of underlying (suppliers)2. Those who wish to speculate(speculators)
3. Those who wish to transfer risk to someother party (hedgers)
4. Those who wish to make riskless profit(arbitragers)
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Futures Price
The futures prices for a particularcontract is the price at which you
agree to buy or sell
It is determined by supply anddemand in the same way as a spotprice
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Examples of FuturesContractsAgreement to:
buy 100 oz. of gold @ US$600/oz.in December
sell 1,000 bbl. of oil @ US$65/bbl.in January
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Types of Futures
Commodity Futures
Index and Stock Futures
Interest Rate Futures
Currency Futures
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Profit from a LongForward/Futures Position
Profit
Price of Underlying
at Maturity
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Profit from a ShortForward/Futures Position
Profit
Price of Underlying
at Maturity
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Pricing Futures
The cost of carry model used forpricing futures is given below:
F = Se^rTwhere:
r Cost of financing (using continuously
compounded interest rate)T Time till expiration in years
e 2.71828
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Pricing Futures
XYZ Ltd.s futures trade on NSE asone, two and three-month contracts.Money can be borrowed at 10% per
annum. What will be the price of aunit of new two-month futurescontract on XYZ Ltd. if no dividends
are expected during the two-monthperiod?
Assume that the spot price of XYZ
Ltd. is Rs. 228.
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Answer
futures price F = 228e^ 0.1*(60/365)
= Rs. 231.90
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Pricing index futures givenexpected dividend yieldF = Se^(r-q)T
where:
F futures price S spot index value
r cost of financing
q expected dividend yield
T holding period
Example: A two-month futures
contract trades on the NSE. The cost
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Pricing stock futures whendividends are expectedThe net carrying cost is the cost of
financing the purchase of the stock,minus the present value of dividends
obtained from the stock
XYZ Ltd. futures trade on NSE as one,two and three-month contracts. What
will be the price of a unit of new two-month futures contract on XYZ Ltd. ifdividends are expected during the
two-month period?
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Pricing stock futures whendividends are expectedTo calculate the futures price, we
need to reduce the cost-of-carry tothe extent of dividend received. The
amount of dividend received is Rs.10.The dividend is received 15 dayslater and hence compounded only for
the remainder of 45 days.
Thus, futures price
= ^ ^
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Strategy for futures
Hedging: Long security, sell futures
Speculation: Bullish security, buy
futuresSpeculation: Bearish security, sell
futures
Arbitrage: Overpriced futures: buyspot, sell futures (Spot 1000, OPFuture1025)
Arbitrage: Underpriced futures: buy
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DIFFERENCE IN FORWARDS ANDFUTURES
Forwards
OTC.
Terms structured to suitboth contracting parties.
Counterparty risk. NoClearing House.
No compulsion to makedeposits.
No such provision. Quite difficult to do so.
Regulation not as tight.
No such adjustments
carried out.
Futures
Exchange Traded.
Terms highly standardized.
Clearing House guaranteesthe performance of thecontract.
Initial Margin to be
deposited.
Daily Settlement.
Easy to close positions.
Monitored and regulated.
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OPTIONS
An Option is a contract in which the seller grants the buyer : A Right but not an Obligation
To Buy or Sell ( Call or Put)
An Underlying Asset
On Some Future Date ( Exercise Date)
At a Price Fixed today (Exercise Price)
Calls give the buyer the right but not the obligation tobuy a given quantity of the underlying asset, at agiven price on or before a given future date.
Puts give the buyer the right, but not the obligation tosell a given quantity of the underlying asset at a givenprice on or before a given date.
But if the Bu er wants to exercise his o tion
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Why Options ???
v Risk management
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Identifying an Option
Reliance May 580Call
Expiration (Last Thursdayin May)
Type ofoption
Underlying asset(Reliance common
stock)
Strike price(580 pershare)
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Types of Option
Option can be exercised at the expiry of the contract period(which is known as European option contract) or anytime up to
the expiry of the contract period (termed as American optioncontract)
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Generic Terms
vExercise Date The Date at which the contract Matures
v Strike Price The predetermined price at which the option is to be exercisedregardless of market price of the asset at the time of exercising.
v Expiration Period At the time of introducing an option contract, the exchange
specifies the period during which the option can be exercised or traded. Beyondthis the contract expires.
v Option Premium or Option Price Amount which the buyer of the option paysto the writer of the option to induce him to accept the risk associated with thecontract. It can also be regarded as price paid to buy the option.
Index options: Have the index as the underlying. They are alsocash settled.
Stock options: They are options on individual stocks and givethe holder the right to buy or sell shares at the specified price
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Money-ness
Money-ness Put Options Call Options
Out-of-the-MoneySpot Price >
Exercise PriceSpot Price