BASICS OF BASICS OF DERIVATIVESDERIVATIVES

by by ERUMERUM

RiskRisk Goal of risk management : to maximize the Goal of risk management : to maximize the

value of the firm by reducing the negative value of the firm by reducing the negative potential impact of forces beyond the potential impact of forces beyond the control of management.control of management.

four basic approaches to risk management: four basic approaches to risk management: risk avoidance, risk retention, loss risk avoidance, risk retention, loss prevention and control, and risk transfer.prevention and control, and risk transfer.

Derivatives- financial instruments whose value Derivatives- financial instruments whose value depends on/derives from some underlying depends on/derives from some underlying variable(asset).variable(asset).

Used for changing the risk exposureUsed for changing the risk exposure..

HedgingHedging When the firm reduces its risk exposure with the When the firm reduces its risk exposure with the

use of derivatives, it is said to be hedging.use of derivatives, it is said to be hedging.

Derivatives as a leveraging tool.Derivatives as a leveraging tool.

It’s increased use for speculation.It’s increased use for speculation.

Word of CautionWord of Caution : Barrings Bank, : Barrings Bank, Orange County, P&C, LTCM etc.Orange County, P&C, LTCM etc.

Types of derivatives.Types of derivatives.

FuturesFutures

Forwards Forwards

OptionsOptions

SwapSwap

Forward contractForward contract

an agreement to buy or sell an an agreement to buy or sell an asset (of a specified quantity) at asset (of a specified quantity) at a certain future time for a certain future time for a certain a certain price.price.

FuturesFutures

Futures contracts areFutures contracts are a variant of a variant of the forward contract that take place the forward contract that take place on financial exchanges.on financial exchanges.

Future v/s FORWARDFuture v/s FORWARD

the seller can choose to deliver the the seller can choose to deliver the commodity on any day during the commodity on any day during the delivery monthdelivery month

futures contracts are traded on an futures contracts are traded on an exchange whereas forward contracts exchange whereas forward contracts arearegenerally traded off an exchange.generally traded off an exchange.

the prices of futures contracts are the prices of futures contracts are marked to the market marked to the market onona daily basis.a daily basis.

OTC Vs ExchangeOTC Vs Exchange

OPTIONSOPTIONS

Options are special contractual Options are special contractual arrangements giving the owner arrangements giving the owner the right to buy or sell an asset the right to buy or sell an asset at a fixed price anytime on or at a fixed price anytime on or before a given date.before a given date.

they give the buyer the right, they give the buyer the right, but not the obligation to but not the obligation to exercise the contract.exercise the contract.

Two types of options contractTwo types of options contract

Call optionCall optionPut optionPut option

CALL OPTIONSCALL OPTIONS

A call option gives the owner the right to A call option gives the owner the right to buy an asset at a fixed price during a buy an asset at a fixed price during a particular time periodparticular time period

The Value of a Call Option at ExpirationThe Value of a Call Option at Expiration If the stock price is greater than the If the stock price is greater than the

exercise price, we say that the call is in exercise price, we say that the call is in the moneythe money

The payoff of a call option at expiration isThe payoff of a call option at expiration is

1.If Stock Price Is Greater Than Strike price1.If Stock Price Is Greater Than Strike price

Call-option value=Stock price-Strike priceCall-option value=Stock price-Strike price

If Stock Price Is If Stock Price Is Lesser Than Lesser Than Strike Price Call-Strike Price Call-option value=0option value=0

Put OptionsPut Options

a put gives the a put gives the holder the right holder the right to sell the stock to sell the stock for a fixed for a fixed exercise price.exercise price.

The Value of a Put The Value of a Put Option at Option at ExpirationExpiration

SELLING OPTIONSSELLING OPTIONS An investor who sells (or writes) a An investor who sells (or writes) a

call on common stock promises to call on common stock promises to deliver shares of the common stock if deliver shares of the common stock if required to do so by the call-option required to do so by the call-option holderholder

the seller loses money if the stock the seller loses money if the stock price ends up above the exercise price ends up above the exercise price and he merely avoids losing price and he merely avoids losing money if the stock price ends up money if the stock price ends up below the exercise pricebelow the exercise price

Why would the seller of a call place Why would the seller of a call place himself in such a precarious position?himself in such a precarious position?

sell-a-callsell-a-call

sell-a-putsell-a-put

VALUING OPTIONSVALUING OPTIONS

determine the value of options determine the value of options when you buy them well before when you buy them well before expiration.expiration.

Bounding the Value of a CallBounding the Value of a Call

Arbitrage profitArbitrage profit

Upper bound:Upper bound:It turns out that the It turns out that the upper boundary is the price of upper boundary is the price of the underlying stock.the underlying stock.

Upper and Lower Boundaries Upper and Lower Boundaries of Call-Option Valuesof Call-Option Values

The Factors Determining The Factors Determining Call-Option ValuesCall-Option Values

1)Exercise Price 1)Exercise Price 2)Expiration Date 2)Expiration Date 3)Stock Price3)Stock Price 4)The Key Factor: The Variability 4)The Key Factor: The Variability

of the Underlying Assetof the Underlying Asset

Factors Determining Put-Factors Determining Put-Option ValuesOption Values

1. The put’s market value decreases 1. The put’s market value decreases as the stock price increasesas the stock price increases

2. The value of a put with a high 2. The value of a put with a high exercise price is greater than the exercise price is greater than the value of an otherwise identical put value of an otherwise identical put with a low exercise pricewith a low exercise price

4. The value of a put with a distant 4. The value of a put with a distant expiration date is greaterexpiration date is greater

5. Volatility of the underlying stock 5. Volatility of the underlying stock increases the value of the put.increases the value of the put.

SWAPS CONTRACTSSWAPS CONTRACTS

Swaps are arrangements Swaps are arrangements between two counterparts to between two counterparts to exchange cash flows over timeexchange cash flows over time

two basic types are two basic types are

interest-rate swaps interest-rate swaps

currency swapscurrency swaps..

Currency swapsCurrency swaps

Currency swaps are swaps of Currency swaps are swaps of obligations to pay cash flows in obligations to pay cash flows in one currency for obligations to one currency for obligations to pay in another currencypay in another currency