l2-introduction to derivatives

8/2/2019 L2-Introduction to Derivatives

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DERIVATIVES

- An Introduction

By

Prof. A. G. Mendhi


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AGENDA FOR TODAY

What are derivatives?

Types of derivatives:

Forward Contracts & Types,

Futures Contracts,Options & Types,

Swaps,

Basis & Spread

Pricing of Derivatives (Futures only)

Risk Management (through hedging)

Profits through speculation


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What are Derivatives?

Definition:

Depending on what the underlying asset is, thederivative could be named differently:

Stock Derivative,Commodity Derivative,

Currency Derivative,

Index based Derivative, etc.

Thus a Commodity Derivative is a contract to either

sell or buy a commodity at a certain time in future at a

price agreed upon at the time of entering into such a

Contract.


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INTRODUCTION

DERIVATIVES ORIGIN

Uncertainties in fluctuations of assetprices

Presence of risk-averse economic agents

Started with commodities in ChicagoFarmers and grain merchants were the

initiators


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NEED FOR DERIVATIVES

Commodity markets like any other

market for financial instruments, involve

risks associated with frequent pricevolatility.

Hedging is therefore required with the

objective of transferring the risk relatedto the possession of physical assets due to

any adverse movement of price.


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FUNCTIONS OF

DERIVATIVES

Reflecting Market Perception

Discovering Future as well as Current PriceTransferring Risk from those who are

averse to those who have an appetite

Speculation in more controlled environmentInvolving more participants and increasing

volumes


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Advantage - Derivatives

Derivatives are useful

when individuals or companies wish to buy asset or commodity in

advance to insure against adverse market movements;

As effective tools for hedging risksdesigned to enable market

participants to partially eliminate risk.

For business dealings in respect of a good that faces risk associated with

price fluctuations.

Examples:

A farmer can fix price for crop even before planting, partially eliminating

price risk

An exporter can fix a foreign exchange rate even before beginning to

manufacture a product for exports, eliminating foreign exchange risk.


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Contracts / agreements

Cash(Ready delivery contract)

Futures(Standardised)

NTSD TSD

Merchandising,Customised

CALL PUT

Options

Forward Others (SWAPS) etc.

Derivatives

Contracts / agreements


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FORWARD CONTRACT

A Forward Contract is one of the simplest formsof derivatives. It is an agreement to buy or sell anasset (in our case a commodity) at a certain time in

future for a certain price mentioned in the contract.It is different from the spot contract

Is usually traded in over the counter (OTC) mode.(Exception of selected overseas exchanges)

Buyers and Sellers would usually know each other.No institutional set up like an exchange isnecessary.


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FORWARD CONTRACT

Forward contract is specified by a legal document, the terms of which are

binding on two parties involved in a specific transaction in the future.

on a priced asset, it is a financial instrument, since it has an intrinsic

value determined by the market for underlying asset

on a commodity, it is a contract to purchase or sell a specific amount

of commodity at specific time in future at a specific price agreed upon

today

Contract is between two parties, buyer and seller.

buyer (long ): is obliged to take delivery of asset & pay agreed-uponprice at maturity

seller (short): is obliged to deliver asset & accept agreed-upon price

at maturity

Forward price applies at delivery and is negotiated so that there is little or no

initial payment.


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POSITIVE & NEGATIVE SIDES

OF FORWARD CONTRACTS

Advantages:

Each party fixes the purchase or sale price

in advance.Little or No money changes hands on

date 0

Drawbacks:Liquidity

Credit Risk.


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In Nutshell:

A forward contract is an agreement today to

buy or sell an asset on a fixed future date

for a fixed price.It is different from a spot contract which is an

agreement to buy or sell immediately,

The fixed future date is called the maturity date,

The fixed price is called delivery / strike price

(DP / SP) ,

The delivery price is to be paid at maturity.


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TERMINOLOGY

Please note that in a forward contract:

Agreement date is different from the

delivery date.The spot price (SP) is different from thedelivery price (DP) at least till maturity.

The date of initiation is always taken asdate 0

The date of maturity will always berepresented by time to maturity (T).


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Commodity Futures

A Commodity Futures contractis an agreement between two

parties to buy or sell a specifiedquantity of a commodity ofdefined quality at a certain time in

future at a price agreed upon at thetime of entering into the contracton a Commodity Exchange.


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TRADING IN FUTURES

MAJOR OBJECTIVES:

- PRICE DISCOVERY

- PRICE RISK MANAGEMENT


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FUTURES PAY OFF

LONG FUTURES

PROFIT

LOSS

STRIKEPRICE

PRICE

0


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FUTURES PAY OFF

SHORT FUTURES

PROFIT

LOSS

STRIKEPRICE

PRICE

0


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Advantages of

Commodity Futures

Liquidity and price discovery to ensure base

minimum volume in trading of a commodity

through market information and demand supply

factors that facilitate a regular and authentic

price discovery mechanism.

Liquidity in the contracts of the commodities

traded also ensures that the equilibrium indemand and supply is maintained. Price

stabilization is possible.


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Advantages (Contd.)

Hedging

Maintaining just adequate buffer

stocks - Resources can then bediversified for other investments.

Flexibility, certainty andtransparency facilitate bank

financing.


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Special Features of

a Futures Contract:

To ensure Liquidity:

Futures contracts are Exchange traded

andHave standardized contract terms

To cover the Credit Risk:

Futures contracts are guaranteed by theconcerned clearing house and

Are settled on daily basis by Marking toMarket


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Futures contracts & Delivery

A very small percentage of Futures contracts

would normally result into delivery of

underlying commodities. In most cases traders

would offset their futures positions before the

contracts mature.

The difference between the initial purchase or

sale price and the price of offsetting thetransaction would represent the realized profit /

loss.


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Forward V/S Futures Contract

Forward Contract:

It is unique and hence non-standardized

Not traded on exchanges. OTC is the preferred route.

Usually buying & Selling parties would know eachother

Futures Contract:

Have standardized contract terms (Quantity, Quality,

Time)Are Exchange traded and

Buyers & Sellers need not know each other


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OPTIONS


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Meaning and types of options:

An option is a formal futures contract whichgives the holder the right, without the

obligation, to buy or sell a certain quantity ofan underlying asset at a stipulated price withina specific period of time.

Commodity Options are allowed in

practically all commodity exchangesworld-over except in some countries like

India.


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Forward Contracts V/S Options

The holder offorward contract is obliged to trade at the maturity

of the contract.

Unless the position is closed before maturity, the holder must take

possession of the commodity, currency or whatever is the subject

of the contract, regardless of whether the asset price has risen or

fallen.

An option gives the holder the right to trade in the future at a

previously agreed price but takes away the obligations.

Ifstock / commodity price falls, you do not have to buy it after all.

An option is a privilege sold by one party to another that offers the

buyer the right to buy or sell a security at an agreed-upon price

during a certain period of time or on a specific date.


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Types of options

There are two types of options

Call Option and Put Option.

A Call OptionGives holder the right, but not the obligation to buy the underlyingasset. Upon exercise of that right, the option seller is obliged to sell theunderlying product under the specified conditions to the option buyer.

A Put Option gives the owner of the put option the right, but not theobligation to sell the underlying asset. Upon exercise of that right, the

option seller has the obligation to sell the underlying product to theoption buyer under the specified conditions.

THESE OPTIONS ARE ALSO CALLED VANILLA OPTIONSAND ARE THE SIMPLEST FORM OF OPTIONS TRADED ON

EXCHANGES.


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Call Option

The right to buy a particular commodity

for an agreed amount at a specified time

in the future.

Call option is exercised at expiry if the

commodity price rises above the strike

price and not if it is below.

Buyer has a bullish outlook


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Put Option

The right to sell a particular asset for

an agreed amount at a specified time in

the future.Put option is exercised if the

commodity / stock price falls below the

strike price and not if it rises above the

strike price.

Buyer has a bearish outlook


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More about options:

The purchase of an option limits the maximum

loss and at the same time allows the buyer to

take advantage of favorable price movements.

Options are called options since they are not

obligatory!

The process by which the option holder uses

the right conveyed by the option is known asexercise and the time by which exercise has to

have taken place is expiry.


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OPTION PAYOFF

FOR BUYER OF CALL OPTION

Premium=20

Strike Price=185

Break-even = 205

LOSS RESTRICTED TO PREMIUM, PROFIT UNLIMITED, IF PRICES RISE


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OPTION PAYOFF

FOR WRITER OF CALL OPTION

Premium=20

Break-even = 205,

Strike Price=185

INCOME RESTRICTED TO PREMIUM,

LOSS UNLIMITED IF PRICES RISE


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OPTION PAYOFF

BUYER OF PUT OPTION

Strike Price=185

LOSS RESTRICTED TO PREMIUM PAID, PROFIT UNLIMITED, IF PRICES DECLINE

Premium=20Break-even = 165


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OPTION PAYOFF

SELLER OF PUT OPTION

Premium=20

Strike Price=185

Break-even = 165

INCOME RESTRICTED TO PREMIUM, LOSS UNLIMITED IF PRICES DECLINE

PAY OFF SUMMARY FOR FUTURES & OPTIONS


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LongFutures

Short Futures Long Call Short Call Long Put Short Put

Traders

rights andobligations

Right and

obligationto buy

Right and

obligation to sell

Right but not

the obligation tobuy

Obligation to

deliver

Right but not the

obligation to sell

Obligation

to buy

Premiumpaid orreceived

- - Paid Received Paid Received

Marginrequirement

Yes Yes None Yes None Yes

Risk (loss) Unlimitedin case of adecline in

prices

Unlimited incase prices rise.

Loss and risklimited to thepremium paid

upfront.

Unlimited incase prices

rise

Loss and risklimited to thepremium paid

upfront

Unlimitedin case ofa declinein prices

Return(Profit)

Unlimited,if prices

rise

Unlimited incase of a declinein prices

Unlimited incase prices rise

Return limitedto the

premiumreceivedupfront

Unlimited, in caseprices decline

Returnlimited tothe extentof thepremiumreceivedupfront

PAY OFF SUMMARY FOR FUTURES & OPTIONS


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OPTIONS PREMIUM

An option premium is made up of two componentsitsintrinsic value and time value.

Intrinsic value is the difference between the exercise price andthe current price. The intrinsic value is that part of the premiumwhich could be realized as profit if the option were exercised.Such an option is referred to as "in-the-money".A call option has intrinsic value only if the underlying productprice is above the option price. Conversely, a put option hasintrinsic value only if the underlying product price is below theoption price.

Time valueis the amount, if any, by which an optionspremium exceeds its current intrinsic value. Time value reflectsthe willingness of buyers to pay for the right offered by theoption and the willingness of sellers to incur the obligations ofthe options.


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Types of Options (Exercise Mode)

American style options:

The buyer of the option can choose to exercise hisoption at any given period of time between the purchase

date and the expiry dateEuropean style options:

The buyer of the option can choose to exercise hisoption only on the expiry date

WHY?The premium paid to buy an American style option is

normally equal to or greater than the European style

option for the same underlying commodity futures

contract.


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Some more options!!

Bermudan options Exercise on specific

days or periods only

Asian Options Payoff depends on averageprice of underlying asset over a certain

period of time

Exotic Options

More complex cash flowStructures. EXAMPLES :Barrier, look-back,

Shout, Exchange, & so on


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PRICING OF FUTURES

Spot prices and Futures prices are different mainly because

of the Cost of Carry

Cost of carry in case of commodities would include

following elements of cost :Cost of storage (Food Grains / perishable commodities,

crude),

Cost of insurance,

Cost of financing,Cost of feeding (Live stock), and

Other undefined on unquantifiable costs such as

security risks (Gold).


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PRICING FUTURESCOST OF CARRY MODEL

PRICING FOR STOCKS AND COMMODITIES

F = S + C

F = FUTURES PRICE

S = SPOT PRICE

C = HOLDING COSTS/

COST OF CARRY

OR

F = S ( 1 + r )Tr = FINANCING COST

T = TIME PERIOD


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Pricing Futures Contract

F = S (1+r)n

Where,

F=Futures price

S=Spot pricer= percentage cost of financing (annuallycompounded)

n= Time till expiration of the contract

If the value of 'r' is compounded m times in a year,the formula to calculate the fair value will be

F = S (l+r/m)mn

Where m = no. of times compounded in a year


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NUMERICAL ON PRICING

The cost of 100 grams of gold in the spot market is Rs.220,000 & the cost of financing is 12% p.a., compoundedmonthly, the fair value of a 100 grams 4 month futuresgold contract will be

F = S * (l+r/m)mn

F = 220,000 (1+0.12/ 12)12*4/12

F = 220,000(1.01)4

F = 220,000 * 1.0406

F = Rs. 228,932

ARBITRAGE OPPORTUNITY EXISTS IF VALUE OF F IS LESS ORMORE THAN RS. 228,932/-


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Daily / continuous compounding

The fair value of a futures price with continuous / dailycompounding can be expressed as:

F=Sern Where:

r=percentage cost of financingn = Time till expiration of the contract e = 2.71828

The above formula is used to calculate the futures price ofa commodity when no storage costs are involved.

The futures price is equal to the sum of money 'S' investedat a rate of interest 'r' for a period of n years.


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NUMERICAL ON PRICING

If the cost of 100 grams of gold in the spot marketis Rs. 220,000 & the cost of financing is 12% p.a.,the fair value of a 100 grams 4 month futures gold

contract on continuous compounding basis will be:F = 220,000 *e (0.12* 0.333) ,

F = 220,000 * 2.71828 (0.0399)

F = 220,000 * 1.0407

F = Rs. 228,954/-

ARBITRAGE OPPORTUNITY EXISTS IF VALUE OF F IS LESS ORMORE THAN RS. 228,954/-


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SWAPS

After studying Forward Contracts and

Futures and Options, we would also study

another class of contract / financial

instrument called Swap.

A swap is an agreement / contract between

two parties to exchange different streams of

cash flows in the future according to a pre-

determined formula.


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SWAPS (CONTD.)

Usually swaps are used more often in case of cash

flows related to interest rates and exchange rates.

The first ever swap contract was negotiated and

entered into between IBM and the World Bank in

1981. Ever since then the market for swaps

(particularly in interest rates and exchange rates)

has increased very rapidly. The swaps are

however, still very rarely used in case of

commodities.


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EXAMPLE OF SWAP

The company X :

Pays 5.5% to its lender

It pays at the LIBOR under the SWAP with Y

It receives 5% under the SWAP with Y

The company Y :

It pays interest at (LIBOR + 0.30) to Lenders. It pays at 5% under the SWAP with X.

It receives at LIBOR under the SWAP with X.


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AFTER THE SWAP IS IN PLACE!

Effective or net outflow for X will be LIBOR + 0.5

Company X Company Y

LIBOR

5%

5.5% LIBOR +0.3%

Effectiveor net outflow for Y will be 5.3%


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Meaning of Basis and Spreads

Basis is the difference between the cash / spotprice of a commodity and its futures price

Basis = Spot or Cash PriceFutures price

If cash price is less than the futures price, basis isnegative and the market is said to be in contango

A strong basis is indicative of short supply. Assoon as supply needs are met, basis levels

(offerings) will weaken. Short supply in a givenperiod for a commodity, will result in strong basisofferings until supply needs are met.


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Basis (Contd.)

If the spot price of an asset is more than the

futures price of the underlying asset, the

basis is positive and the market is said to be

in backwardation.

When the futures contract approaches

expiry, the spot price and futures price

converge with each other. (WHY?)

PARTICIPANTS IN THE


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PARTICIPANTS IN THE

FUTURES MARKET

Hedgers: Producers or users of physical commodities whoseek protection against adverse price changes by initiatinga position in the futures market as a temporary substitutefor the sale or purchase of the actual commodity. They usethe futures or options marketsto reduce if not totallyeliminate the risk associated with adverse changes in

price.

Speculators: Private investors who attemptto profit fromanticipated commodity price changes. They do not usuallyown or use the underlying product.

Arbitragers: People who attemptto profit fromtemporary distortions,discrepancies or inconsistencies inprices usually in different markets by making purchasesand sales in these (two or more) markets at the same time.


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SPREADS

Spread is the difference in prices of two futures contracts.

If the price of the far month futures contract is higher thanthe price of the near month futures contract, the market issaid to be normal. Otherwise, it is called an inverted

market.In normal markets, if the spreads do exceed the cost ofstorage, it could be termed as a storage market and astorage hedge could be a profitable option.

Inverted market offers an opportunity to sell a futurescontract in near month and buy the same futures contract infar month.


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Intra & Inter commodity Spreads

An intra commodity spread is the difference

in prices of two futures contracts of the

same commodity having different expiry

months.

An inter commodity spread is the difference

in prices of two futures contracts of two

different commodities having the same

expiry month.


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RISK MANAGEMENT

Many Corporate Companies are increasingly

resorting to Risk Management Strategies if they are

using commodities as their raw materials.

This is immensely important because commodityprices can fluctuate wildly thus jeopardizing the

profitability.

For such companies hedging on commodityexchanges is one of the most important and effective

tools of risk management.


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H d i


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Hedging:

Example of Cotton Contract

Spot Market

December 2006

Current market price is

Rs. 5000/- per quintal

------------------------------April 2006:

Sells at Rs. 4800/- per quintal

Cotton Futures

Sells April 2007 cotton

contract at Rs. 5300/- perquintal

-----------------------------------Buys cotton contract at Rs.4800/- per quintal

Profit made by X is

Rs. 500/- per quintalNet price locked:


H d i


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Hedging:

Example of Cotton Contract

Spot Market

December 2006

Current market price is


------------------------------

April 2006:

Sells at Rs. 5400/- per quintal

Cotton Futures

Sells April 2007 cotton

contract at Rs. 5300/- perquintal

-----------------------------------

Buys cotton contract at Rs.5400/- per quintal

Loss incurred by X is


Net price locked:Is still Rs. 5300/- per

quintal


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Example of Speculation

Chartered Accountant A is anticipating rise in prices ofgold in November 2007. He has surplus / idle cash ofapproximately Rs. 98,000/- by which he can buy only 100gms of gold in open market at the ruling price of Rs.

9800/- per ten gm. Instead, he decides to trade in Goldfutures contract. He buys two contracts (1Kg. Each) ofNovember 2007 gold futures from the CommodityExchange in April 2005 @ Rs. 9,900/- per ten gram. Hehas to pay say 5% margin i.e. Rs. 99,000/- as margin for

two contracts. Gold price moves according to Asexpectation and rules at Rs. 10,000/- per ten gram inNovember 2007.

Let us see how A is benefited by speculation.


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Profit through speculation

Buy in Spot Market

April 2007 Buys 100 gms of

gold at Rs. 98,000/-

---------------------------------------

Sells 100 gms of gold in spotmarket in November 2007 forRs. 100,000/-@ Rs. 10,000/-per ten gm.

---------------------------------------

Makes a profit of Rs. 2000/-

Returns 2.04%

Buy in Futures Market

Buys two contracts

(2Kg.) of November

2005 gold valued at Rs.

19,80,000/- @Rs. 9,900/-

per ten gm. Margin money paid

= Rs. 99,000/-

------------------------------

Sells two contracts at

Rs. 20,00,000/- @ Rs. 10,000/- per

ten gms.------------------------------

Makes a profit of Rs.20,000/-

Returns 20.20%


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REVIEW QUESTIONS

Explain the difference between:

Forward Contract and a Futures Contract

Forward Contract and Option

State whether the following statement is true. Explain with an example.

A call option has intrinsic value only if the underlying commodityprice is above the option price. Conversely, a put option hasintrinsic value only if the underlying commodity price is below theoption price.

Explain briefly the concepts of the following and draw pay offdiagrams:

Long forward position in commodity futures and

Short forward position in commodity futures.

How would a speculator use them to make profit on a commodityexchange?


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REVIEW QUESTIONS

State whether the following statement is true. Explain withan example, when you would use which option.

Materially speaking, buying a call option may be the same asselling a put option; but financially they have differentimplications

Current price of gold in the spot market is Rs. 12,000/- perten grams. What should be the fair value of four monthsone Kg. Gold Futures contract assuming that storage orother costs associated with gold are in-built into the cost offinancing.

If the cost of financing is 12% per annum compounded on monthlybasis?

If the cost of financing is 12% per annum compounded oncontinuous basis?


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Thank You

l2-introduction to derivatives

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