Introduction to Derivatives

Prof. Sudhakar Reddy

 What is a Derivative Security?
• A Derivative Security is a security whose value depends on the
values of other, more basic underlying variables.

Example:
• An Indian exporter is likely to receive USD 1000 after one month
goes to a bank and contracts to sell the USD money for Rs.41 per
USD.
• This contract is an example of derivative contract where the
underlying is the foreign currency (USD)

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 Derivatives Markets
• Two types:
– Exchange traded
– Over-the-counter (OTC)
• Exchange traded
– Traditionally exchanges have used the open-outcry system, but
increasingly they are switching to electronic trading.
– Contracts are standard, so there is virtually no credit risk
– Example:
• Futures, Options

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 Derivatives Markets – contd.
• Over-the-counter (OTC)
– A computer- and telephone-linked network of dealers at financial
institutions, corporations, and fund managers
– Financial institutions often act as market makers.
– Contracts can be non-standard and there is some amount of credit risk
– Example:
• Swaps, Forward Rate Agreement, Exotic options

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 Exchange Traded Market
• Open outcry: A method of communication
between professionals on exchange which
involves shouting and the use of hand signals to
transfer information primarily about buy and
sell orders

• Electronic trading: A mode of trading that

uses information technology to bring together a
buyer and a seller through electronic media to
create a virtual market place

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 Advantages of OTC & Exchanged Traded
market
• Advantage of OTC market:
– In OTC market participants are free to undertake any mutually
attractive deal.
• Advantage of Exchange traded market:
– In OTC market there is a small risk that the contract will not be
honored, which is eliminated in exchange traded market.
– Secondary trading in the security is possible.

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 Types of Derivatives
• Forward Contracts
• Futures Contracts
• Swaps**
• Options

** Swaps can be considered as summation of forward contracts

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 Forward Contract
• A forward contract is an agreement to buy or sell an asset at a
certain future time for a certain price.
• It can be contrasted with a spot contract, which is an agreement to
buy or sell an asset today.
• The contract is between two financial institutions or between a
financial institution and one of its corporate clients.
• It is not traded on an exchange.
• Forward contracts are particularly popular on currencies and
interest rates.

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 Terminology
• Long position agrees to buy the underlying asset on
a certain specified future date for a certain specified
price.

• Short position is the other party and agrees to sell

that asset on same future date for the same price.

• The specified price in a forward contract is referred to

as the delivery price.

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 Example of Forward Contract
• Suppose on April 01,2007 the treasurer of an export
company in India knows that it will receive USD 1
million in 6 months (i.e. on October 01,2007) and
wants to become indifferent against exchange rate moves.
– He can undertake currency forward contract with a bank now to
sell USD 1 million in 6 months at a particular INR/USD forward
rate.

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Spot and Future Quotes for INR/USD (Not Actual
Values)

Bid Price Offer Price

Spot 56.85 57.10
6 month 58.80 59.15
Forward

• INR/USD means Rs. per USD

• Bid – price at which one is prepared to buy
• Ask – price at which one is prepared to sell
• These quotes are for inter-bank transactions, for retail investors spread
(difference between bid and ask) is more

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Payoffs From Long Forward Contracts
Payoff from
Long Position

K
Price of Underlying
at Maturity, ST

The payoff from a long position in a forward contract on one

unit of an asset = ST – K (K = delivery price, ST = Price of
the underlying security at maturity )

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Payoffs From Short Forward Contracts
Payoff from
Short Position

Price of Underlying
at Maturity, ST
K

The payoff from a short position in a forward contract on one

unit of an asset = K – ST (K = delivery price, ST = Price of the
underlying security at maturity )
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 Futures Contract
• Agreement (obligation) to buy or sell an asset for a
certain price at a certain time
• Similar to forward contract but futures contracts are
traded on an exchange

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 Swaps
• A swap is an agreement to exchange cash flows
at specified future times according to certain
specified rules.

• Examples:
• Converting a liability from
– fixed rate to floating rate
– floating rate to fixed rate

• Converting an investment from

– fixed rate to floating rate
– floating rate to fixed rate

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 Options
• A call option is an option to buy a certain asset by a
certain date for a certain price.
• A put option is an option to sell a certain asset by a
certain date for a certain price.

• The price of the contract is known as strike

price/exercise price.
• The date in the contract is known as expiration
date/maturity.
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 Options – contd.
• An American option can be exercised at any time during its life.
• An European option can be exercised only at maturity.
–The terms American or European do not refer to the location of the option.

• Examples:
–Index options traded in NSE are of European type
–Stock options traded in NSE are of European type

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 Difference Between Options and
Forward/Futures Contracts
• The holder of the option is not obliged to honor the
contract, whereas the holder of Forward/Futures
Contract is obliged to buy or sell the underlying asset.

• It costs nothing to enter into Forward/ Futures

Contracts, but for buying options, upfront payment is
required.

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 Example of European Long Call Option
• Suppose an investor purchases 1 NIFTY-May-4000-Call at
premium 45
– One contract consists 50 index share.
– The contract is cash settled.

• If at the end of this option life NIFTY value is more than 4000
– He exercises the option and receives the amount by which NIFTY exceeds
4000 for one index share times Rs. 50.

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Example of European Long Call Option – contd.
• Suppose the final day value of NIFTY is 4100.
– By exercising he gets (4100 – 4000) = 100 per index share or Rs. 50X100
= Rs. 5,000 for one contract
• However, if the final day value is below 4000
– He will not exercise the option.

• For this privilege, he pays a fee of Rs.2250 (Rs.45 a share for 50

shares).

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 Example of American Option – Long Call
• Suppose an investor purchases 1 Reliance-May-1590-Call at premium
Rs.55.
– Lot size is 150
– The contract is cash settled

• This contract allows him to buy 150 shares of Reliance at Rs.1590

per share at any time between the current date and the option
expiry date of May.

• If the price goes above Rs. 1590 he can exercise the option.

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 Example of American Option – Long Call –
contd.
• Suppose the price goes to 1650 and he exercises the option.
– This is equivalent to buying the option @ 1590 and selling it @ 1650.
– He will get Rs. (1650 – 1590) = Rs. 60 per share or Rs. 60 * 150 = Rs. 9,000 for one
contract

• If the price remains below Rs. 1590 over the life of the option.
– He will not exercise the option.

• For this privilege, he pays a fee of Rs.8250 (Rs.55 a share for 150 shares).

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 Example of American Option – Short Call
• Suppose an investor writes/shorts 1 Reliance-May-1590-Call at premium
Rs. 55.
– Lot size is 150
– The contract is cash settled

• This contract gives an obligation on him to sell 150 shares of

Reliance at Rs.1590 per share at any time between the current date
and the option expiry date of May.

• If the price goes above Rs. 1590 long position holder will exercise the option.

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 Example of American Option – Short Call –
contd.
• Suppose the price goes to 1650 and long position holder exercises the
option.
– For short position holder this is equivalent to selling the option @ 1590 after
buying it @ 1650.
– He will make loss Rs. (1650 – 1590) = 60 per share or RS. 60* 150 = Rs. 9,000 for one
contract
– However, he receives a fee of Rs.8250 (Rs.55 a share for 150 shares) from long position
holder.

• However, if the price remains below 1590 over the life of the option
– Long position will not exercise the option.
– The entire fee of Rs.8250 (Rs.55 a share for 150 shares) is the profit of short position
holder.

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 Payoff Diagram – Long Call
Payoff from
Long Call

K ST
-C

The payoff from a long position in a call option

= Max (ST – K, 0) (K = Strike price, ST = Price of the
underlying security at maturity, C = Call option premium )

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 Payoff Diagram – Short Call
Payoff from
Short Call

C
K ST

The payoff from a short position in a call option

= – Max (ST – K, 0) = Min (K - ST, 0) (K = Strike price, ST =
Price of the underlying security at maturity, C = Call option
premium )

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 Payoff Diagram – Long Put
Payoff from
Long Put

K
ST
-P

The payoff from a long position in a put option

= Max (K – ST, 0) (K = Strike price, ST = Price of the
underlying security at maturity, P = Put option premium )

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 Payoff Diagram – Short Put
Payoff from
Short Put

P
K ST

The payoff from a short position in a put option

= – Max (K – ST, 0) = Min (ST – K, 0) (K = Strike price, ST =
Price of the underlying security at maturity, P = Put option
premium )

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 Payoff diagram – Combined
Payoff from Payoff from
Long Call Long Put

K ST K ST

Payoff from Payoff from

Short Call Short Put
K K

ST ST

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 Types of Traders
• Hedgers
• Speculators
• Arbitrageurs

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 Hedging
• Hedgers are essentially spot market players.

• Hedgers are interested in reducing price risk (that they already

face in the spot market) with derivative contracts and options.

• Forward contracts are designed to neutralize risk by fixing the price

that hedger will pay or receive for the underlying asset.

• Future contracts can be used to undertake minimum variation

hedging.

• Option strategy enables the hedger to insure itself against adverse

exchange rate movements while still benefiting from favorable
movements.

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 Hedging Using Forward Contracts
• Suppose that it is June 16, 2007, and ImportCo, a
company based in the United States, knows that it will
pay £ 10 million on September 16,2007, for goods it has
purchased from a British supplier.

• The USD-GBP exchange rate quotes made by a financial

institution are known.

• ImportCo can hedge its foreign exchange risk by buying

pounds (GBP) from the financial institution in the three-
month forward market at 1.4407.
– This would have the effect of fixing the price to be paid to the
British exporter at $14,407,000.

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 Hedging Using Forward Contracts – contd.
• Consider next another U.S. company, which we will refer to as
ExportCo, that is exporting goods to the United Kingdom and on
July 16, 2007, knows that it will receive £30 million three months
later.

• ExportCo can hedge its foreign exchange risk by selling £30

million in the three month forward market at an exchange rate of
1.4402.
– This would have the effect of locking in the U.S. dollars to be realized from
the sterling receipts at $43,206,000.

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Hedging Using Forward Contracts – Some Issues
• There is no assurance that the outcome with hedging will be better than the
outcome without hedging.
• For ImportCo.:
– If the exchange rate is 1.4000 on September 16 and the company has not hedged, the £10
million that it has to pay will cost $14,000,000, which is less than $14,407,000.
– If the exchange rate is 1.5000, the £10 million will cost $15,000,000.
• For ExportCo. the outcomes are reverse:
– If the exchange rate on October 16 proves to be less than 1.4402, hedging would give
better result.
– If the rate is greater than 1.4402, it will be pleased that it had not hedged.

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 Hedging Using Options
• Consider an investor who in May 2007 owns 1,500 Reliance
shares
– The current share price is Rs.1750 per share
• The investor is concerned that the share price may decline sharply
in the next two months and wants protection.

• The investor could buy 10 July put option contracts with a strike
price of Rs.1750 on NSE.
– This would give the investor the right to sell 1,500 shares for Rs.1750 per
share.

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 Hedging Using Options – contd.
• If the quoted option price is Rs.25, each option contract would
cost 150 x Rs. 25 = Rs. 3750, and the total cost of the hedging
strategy would be 10 x RS. 3750 = Rs. 37,500

• The strategy costs Rs. 37,500 but guarantees that the shares
can be sold for at least Rs. 1750 per share during the life
of the option.

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 Hedging Using Options – contd.
• If the market price of Reliance falls below Rs. 1750, the options
can be exercised so that Rs. 26,25,000 is realized for the entire
holding.
– When the cost of the options is taken into account, the amount realized is
Rs.25,87,500

• If the market price stays above Rs. 1750, the options are not
exercised and expire worthless.
• However, in this case the value of the holding is always above
26,25,000 (or above 25,87,500 if the cost of the options is taken
into account).
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 Speculation
• Speculators wish to take a position in the
market either by betting that the price will go
up or down.

• Futures and options can be used for speculation

• When a speculator uses futures then the

potential gain or loss is high.

• When a speculator uses options, speculator’s

loss is limited to the amount paid for the option.

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 Speculation Using Future Contracts
• Consider that a trader fancies his chances in predicting the market
trend. So instead of buying different stocks, he buys NIFTY
Futures.

• On May 1, 2007, he buys 50 NIFTY May futures @ 4000 on

expectations that the index will rise in future. On May 22, 2007,
the NIFTY rises to 4200 and at that time he sells an equal number
of contracts to close out his position.

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 Speculation Using Future Contracts – contd.
• Selling Price : 4200*50 = Rs 210,000
• Less: Purchase Cost: 4000*50 = Rs 200,000
• Net gain Rs 10,000

• The trader has made a profit of Rs 10,000 by taking a long

position on NIFTY May Futures. However, if the NIFTY had fallen
he would have made a loss.
• Similarly, if he would have been bearish he could have sold
NIFTY futures and made a profit from a falling market.

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 Speculation Using Options
• Suppose that it is October and a speculator considers that Cisco is
likely to increase in value over the next two months.
– The stock price is currently $20, and a two-month call option with a $25 strike price is
currently selling for $1.
• The speculator is willing to invest $4,000.
• It has two alternatives
– The first alternative involves the purchase of 200 shares
– The second involves the purchase of 4,000 call options (i.e., 20 call option contracts)
• Suppose that the speculator's hunch is correct and the price of Cisco's
shares rises to $35 by December.

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 Speculation Using Options – contd.
• The first alternative of buying the stock yields a profit of
200 x ($35 - $20) = $3,000
• However, the second alternative is far more profitable.
• A call option on Cisco with a strike price of $25 gives a payoff of $10, because
it enables something worth $35 to be bought for $25.
– The total payoff from the 4,000 options that are purchased under the second alternative
is:
4,000 x $10 = $40,000
– Subtracting the original cost of the options yields a net profit of $40,000 - $4,000 =
$36,000
• The options strategy is, therefore, 12 times as profitable as the strategy of
buying the stock.

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 Speculation Using Option – contd.
• Options also give rise to a greater potential loss.
• Suppose the stock price falls to $15 by December
– The first alternative of buying stock yields a loss of 200 x ($20-
$15) = $1,000.
– Because the call options expire without being exercised, the
options strategy would lead to a loss of $4,000—the original
amount paid for the options.

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 Arbitrageurs
• Arbitrage involves locking in a riskless profit by
simultaneously entering into transactions in two
markets.

• Example:
– Consider a stock that is traded in both New York and London.
Suppose that the stock price is $172 in New York and £100
in London at a time when the exchange rate is $1.7500
per pound.
– An arbitrageur could simultaneously buy 100 shares of the stock
in New York and sell them in London
– He will obtain a risk-free profit of:
100*($1.75*100 – $172) or $300 in the absence of transactions
costs.

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