Using derivatives

Susan Thomas

26 February, 2009

Susan Thomas Using derivatives

Recap: Types of derivatives

Linear – derivatives where the payoff is linearly related to

the price of the underlying asset.
When the spot price, the price of the derivative also rises,
and when the price falls, the derivatives price falls.
1 Forwards – Contracts that give the right to buy/sell an asset
at a future date (maturity or exercise date), but at a price
that is fixed today (futures price).
2 Futures – Forwards contracts with contract features that are
standardised and is traded only at an exchange.
Non–linear – derivatives where the payoff is non–linearly
related to the price of the underlying.
1 Options – Contracts which gives the buyer right to
purchase/sell an asset at a pre–determined price (strike
price) at or before a pre–determined time (maturity or
exercise date).

Susan Thomas Using derivatives

Recap: Payoffs
Graph of profits/losses that accrue (y-axis) as the
underlying price changes (x-axis).
Forwards/futures have a linear payoff.
Since the (long) forwards contract is a future claim on the
underlying, as the price of the underlying goes up, the
value of the futures go up.
The payoff diagram looks like:
200
Payoff to futures buyer (Rs.)

100

0
4000 4200 4400 4600

-100

-200

Futures price on expiration (Rs.)

Susan Thomas Using derivatives

Recap: Payoffs to holding options

Options have a non-linear payoff structure.

The options contract is a future claim on the underlying
only under certain conditions about the price of the
underlying.
These conditions can be favourable to the owner of the
option under different price movements.
Call options give the buyer benefits if the price of the
underlying goes up.
Put options give the buyer benefits if the price of the
underlying goes down.

Susan Thomas Using derivatives

Recap: Payoff to a call option buyer

The payoff diagram of a call option looks like:

200

Payoff to call option buyer (Rs.) 100

0
1000 1100 1200 1300 1400 1500

-100

-200

Spot price on expiration (Rs.)

Susan Thomas Using derivatives

Recap: Payoff to a put option buyer

The payoff diagram of a put option looks like:

200

Payoff to put option buyer (Rs.) 100

0
1000 1100 1200 1300 1400 1500

-100

-200

Spot price on expiration (Rs.)

Susan Thomas Using derivatives

Recap: Payoff diagrams of options
200 200

Payoff to call option buyer (Rs.)

Payoff to put option buyer (Rs.)

100 100

0 0
1000 1100 1200 1300 1400 1500 1000 1100 1200 1300 1400 1500

-100 -100

-200 -200

Spot price on expiration (Rs.) Spot price on expiration (Rs.)

200 200
Payoff to call option seller (Rs.)

Payoff to put option seller (Rs.)

100 100

0 0

1000 1100 1200 1300 1400 1500 1000 1100 1200 1300 1400 1500

-100 -100

-200 -200

Spot price on expiration (Rs.) Spot price on expiration (Rs.)

Susan Thomas Using derivatives

Uses of derivatives

Susan Thomas Using derivatives

Why are derivatives so useful?

The advantage of derivatives are two: leverage and

liquidity.
The uses are three: speculation, hedging and arbitrage.

Susan Thomas Using derivatives

Leverage with derivatives

Leverage using a small base of capital to take exposure on a

larger base of capital.
Example, when a group starts with Rs.100 of
equity capital and can borrow Rs.900 of debt from
a bank to create a firm worth Rs.1000. The base
capital of Rs.100 access an exposure of Rs.1000.
With derivatives:
No payment is required upfront, when
buying/selling futures,
The price of an option is typically a fraction of
the underlying value.
Little capital is required to trade derivatives: this
makes it accessible to a much larger audience.

Susan Thomas Using derivatives

Liquidity with derivatives

Liquidity : trading derivatives is cheaper than trading the

underlying asset.
This typically leads to higher liquidity in derivatives
on underlyings.

Susan Thomas Using derivatives

Uses of derivatives
Speculation Putting money on knowledge/forecasts of future
price behaviour. Typically, this is a short-term
trade.
Long term “speculative” behaviour becomes more
like investment.
Hedging Modifying the risk (and therefore, return) profile of
a portfolio. Once again, this tends to be temporary.
Arbitrage By definition, derivatives price ought to be strongly
linked with the underlying price. Any unexpected
discrepancy between the two requires trades in
both.
Beyond these three, there is also the investment motivation to use
derivatives but this is rare. For example, an index fund management
firm will typically use index futures when fresh investments come into
their fund. However, it is cheaper to eventually trade the underlying
equity itself.
Susan Thomas Using derivatives
 Speculation

Susan Thomas Using derivatives

Speculation using derivatives

Speculation is putting money on your knowledge about

future movements in an asset price.
For example, you are convinced that Nifty will rise by the
end of March. What do you do to prove your conviction?
You want to take a position of “100 units of Nifty”.
Different ways:
1 Go long Nifty spot, with the intention of selling on 29th
March.
Pay on (T + 2) – how much?
2 Go long Nifty 29th March futures.
Zero money upfront, other than Initial Margin for NSCCL.
3 Go long Nifty 29th March call at a strike of 3650.
Pay the call option price.
Principle: choose the strategy that is the cheapest.

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LOB for Nifty 29th March futures

Susan Thomas Using derivatives

LOB for Nifty 29th March call at 3650

Susan Thomas Using derivatives

The underlying value involved in the speculation

The position we want to take is 100 units of Nifty, current value

of 3650. Underlying value = Rs.365,000.
Assume the brokerage fees are the same for all trades.

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Cost of each speculative strategy

Spot transaction:
1 impact cost = 9 bps of value on buy+sell side = Rs.401.5
2 STT = 12.5 bps of value on buy+sell side = Rs.456.25
3 Interest on borrowing to buy Nifty = 365,000*0.005 = 1825
4 Total = Rs.2,682.75
Futures transaction:
1 impact cost = 3.67 bps of value on buy side = 134.97
2 STT = 1.33 bps of value = 48.91
3 Interest on IM = 29,420.60*0.005 = 147.10
4 Need to make arrangement for paying mark-to-market
margins, x, if the position becomes negative.
5 Total = Rs.330.98 + x
Options transaction:
1 impact cost = 9.28% of call value = 1,150.72
2 STT = 1.33 bps of call value = 1.65
3 Interest on call value = 12,400*0.005 = 62
4 Total = Rs.1,224.37

Susan Thomas Using derivatives

Analysing the speculative strategies

Both futures and options are cheaper in total cost than the
spot.
However, the potential loss in the options payoff is capped.
Therefore, the different strategies are not readily
compareable on the cost dimension alone.
Fundamental reasoning : Each person has his own U(),
his own speculative view about the pdf of future returns,
and based on that, chooses the position which gives the
highest EU.
A risk averse individual would choose the options (cheap
and with known loss).
A risk loving individual would choose the futures (cheap at
the cost of a potentially large loss).

Susan Thomas Using derivatives

 Hedging

Susan Thomas Using derivatives

Defining hedging

Defn: A perfectly hedged portfolio is one where the price

risk of the portfolio is zero.
If the hedging is done using (say) a futures contract, it
typically involves having a portfolio of the spot asset, and
an equal and opposite position in a related futures contract.

Susan Thomas Using derivatives

Alternative hedging methods

The traditional way of reducing price risk was to reduce

price exposure.
What is new about derivatives are that these are a way of
reducing risk, while retaining the inherent underlying
exposure.
Derivatives are useful to hedge risk
1 over short periods of time, or
2 of a specific magnitude.
There is more control on managing risk.
Derivatives also have the advantage of leverage: the
hedge can be acheived with little capital.

Susan Thomas Using derivatives

Types of hedges
The principle of hedging rests on the idea that risk is of two
types: systematic and unsystematic.
Therefore, hedges can be differentiated by whether you
are trying to reduce (or enhance!) systematic or
unsystematic risk.
Systematic risk is best captured by the index. Therefore,
these are implemented using the index futures.
Unsystematic risk is captured by a portfolio of (long asset
and short index) futures.
The more sophisticated type of hedges are structured
hedges: reducing the loss in a particular direction (buying
“price insurance”) or to a certain fixed amount (limiting
prices to move within a pre-determined range).
Structured hedges are more easily done by options.
But in either of the above, the final hedging strategy you
choose depends upon the liquidity of the contracts in the
market.
Susan Thomas Using derivatives
Operationalising systematic risk hedging using futures

Given the linearity of spot and future payoffs, hedging

using futures is simple: for every unit of the spot held, sell
a unit of the futures. This becomes like a portfolio, where
the characteristics of the portfolio, rp , is given by:

rp = rj − rfut
σr2p = σr2j − 2cov (rj , rfut ) + σr2fut

The reduction in the risk of the “spot-futures” portfolio

depends upon the correlation between the spot and the
futures contract.
If correlation is 1, then σp2 = 0 because cov (rj , rfut ) = σj σfut .

Susan Thomas Using derivatives

Operationalising unsystematic risk hedging using
futures

If an asset has a futures contract trading on it, then the

correlation is 1 and there is perfect risk hedging in the
combined portfolio of J − F .
Typically, the underlying and the asset with the futures
contract need not be not the same.
For example, SAIL does not have futures trading on it.
To remove systematic risk in SAIL we short Nifty futures.
To remove unsystematic risk in SAIL we try (say) short
Tata Steel futures.
We can do this using futures that has the highest
correlation with the risk component in the asset.

Susan Thomas Using derivatives

Operationalising unsystematic risk hedging using
futures

In the above case, the risk is reduced but cannot be

eliminated.
The amount by which the hedge is imperfect is called the
basis and is defined as:

basis = futures returns − spot returns

The extent to which the hedge is imperfect is measured by

σbasis .

Susan Thomas Using derivatives

Creating minimum variance hedges

The most commonly used method of creating minimum

variance hedges is where the amount of hedging is done
so that the variance of the hedged portfolio is as small as
possible. This is called minimum variance hedging.

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Portfolio with minimum variance hedges

If
the value of the spot being hedged is V , and
h units of the futures position is taken at F0 ,
then,
the MTM value of the hedged portfolio at t is

MTMt = V − (Ft − F0 )h
2
σMTM t
= σV2 + 2hσ(V
2 2 2
,Ft ) + h σFt
2
σ(V ,Ft )
where h = − and
σF2t
2
σ(V
2 ,Ft )
σMTM = σV2 −
t
σF2t

Susan Thomas Using derivatives

Maximising utility
Alternatively, we can create optimal hedging portfolios,
where the utility of the spot asset holder is maximised.
Here, the objective function becomes:
maximizeh EU[V + h(Ft − F0 )]

For example, a typical utility function used is the quadratic

utility function of the form:
b
U(MTMt ) = MTMt − MTMt2
2

Often, the preference parameters being maximised are

typically the mean and the variance of the profits/losses of
the hedged portfolio.
Then, the solution could be the same as that reached for
the minimum variance optimisation problem.
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Hedging using options

The linearity of futures makes the risk low and the

expected returns low.
Options offer more directional hedges.
For example: I have a portfolio which has a 95% correlation
with the market index. For every one unit move in the
market, my portfolio moves by 0.95 in the same direction.
I want to limit the expected loss on this portfolio till the end
of March to less than 2%.
If my portfolio had options trading on it, I would implement
this protection by
1 long end-March portfolio put options
2 with strike of 98% of the value of my portfolio

Susan Thomas Using derivatives

Hedging using options

But there are no options available on my portfolio.

I have to use Nifty options.
Suppose the correlation between my portfolio and Nifty is
0.95%.
I could:
Go long 29th March Nifty put options with strike of 3600
(98% of 3650 is 3577; thus, 3600 is a bit better than
dropping to 98% of the portfolio value).
If Nifty should reach 3600, my portfolio would probably
reach 98% of it’s original value.
For every move down in Nifty, the put option would pay me
0.95% of the move value.
This should adjust for the loss in my portfolio!
This is why long a put option is called buying “portfolio
insurance”.

Susan Thomas Using derivatives

LOB for 29th March Nifty puts

Susan Thomas Using derivatives

Arbitrage using derivatives

Susan Thomas Using derivatives

Some ground rules for arbitrage

There ought to be a close link between the price of the

derivative (F/C/P) and the price of the underlying asset (S).
Let’s assume that we know the link:

E(F) = f (S)

Let’s define the difference between the price of the

derivative and the model as basis.

basis = F − E(F)

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Defining arbitrage

Deviations in the basis between derivative and underlying

price can lead to arbitrage opportunities as follows:
1 If the basis becomes too small (or negative), the arbitrage
strategy would be

Long futures, Short spot

2 If the basis becomes too large, the arbitrage strategy would
be the opposite:

Long spot, Short futures

At maturity of the futures, unwind both positions.

If your arbitrage calculation was correct, you have profit at
the end of the unwind.
Arbitrage can be found in any set of these:
spot/futures/options

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Example: Arbitrage using gold futures

The price of gold is Rs.8000/tola.

What should be the least price at which anyone ought to
be willing to sell a 20 April gold futures contract?
As a conservative short, I take the following approach:
1 Start with no capital.
2 Buy gold today at Rs.8000.
3 Borrow the money from the bank.
Tfhe bank at 6% needs repayment per month on the
borrowed Rs.8000.
4 If I have to settle on the 20th April, that’s 25 days of interest,
which is approximately Rs.40 and exactly Rs.34.58.
Therefore, I’d be willing to become a 20th April gold futures
short if the futures market price was anything above
Rs.8035.

Susan Thomas Using derivatives

The full arbitrage position

If the spot market price S = 8000 and

the 20th April futures market price F = 8050
this is an arbitrage opportunity.
The arbitrage (riskless/certain) profit is

8050 − 8035 = Rs.15

The sole position “short 20th April futures 8050” is risky.

What if the price on 20th April rises to 8070?
Therefore, position = “short 20th April futures 8050 and
long gold 8000 today”.
This gets the “arbitrage profit of Rs.15” regardless of what
happens to the market price of gold on 20th April.

Susan Thomas Using derivatives

Market price is different from the seller’s price

The market price can be legitimately different from the

E(F ) = f (S) price” as computed above.
It does not take other factors into account (brokerage fees,
STT, impact cost, etc).
However, the entire arbitrage approach gives us an idea of
what to expect as a “fair price” in the market.
Therefore, arbitrage is the first step to pricing derivatives
using the spotprice.

Susan Thomas Using derivatives

HW: Hedging puzzle

Puzzle: What is the payoff for this combined portfolio of

(long portfolio + long Nifty put options)?
What is the combination to adopt for a “better hedge”?

Susan Thomas Using derivatives