Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

DERIVATIVE SECURITIES
Rise of Derivatives The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provide them a valuable set of tools for managing this risk. Meaning and definition

In finance, a derivative is a financial instrument derived from some other asset; rather than trade or exchange the asset itself, market participants enter into an agreement to exchange cash, assets or some other value at some future date based on the underlying asset. The term derivatives indicates that it has no independent value ie., its value is entirely derived from value of underlying asset. The underlying asset can be securities, commodities, bullion, currency, interest rates, indices, live stock etc. Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. There are many types of financial instruments that are grouped under the term derivatives, but options/futures and swaps are among the most common.

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

BASIC FEATURES OF DERIVATIVES 1. As derivatives are not physical assets, transactions are settled by offsetting/squaring transactions. The difference in value of derivative is cash settled. 2. There is no limit on the number of units transacted in the derivative market because there is no physical asset to be transacted. 3. Derivative markets are usually computerized. 4. Derivatives are secondary market securities and cannot help in raising funds for a firm. 5. Derivative market is quite liquid and transactions can be effected easily. 6. Derivative provides hedging against different risks.

The participants in a derivatives market Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock-in a profit.

Types of derivatives
OTC and exchange-traded
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

other intermediary. Products such as swaps, forward rate agreements, and exotic
options are almost always traded in this way. The OTC derivatives market is huge.

According to the Bank for International Settlements (BIS), the total outstanding notional amount is USD 298 trillion (as of 2005)[1].

Exchange-traded derivatives are those derivatives products that are traded via
Derivatives exchanges. A derivatives exchange acts as an intermediary to all

transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest[2] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options),
Eurex (which lists a wide range of European products such as interest rate & index

products), Chicago Mercantile Exchange and the Chicago Board of Trade. According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Types of Derivatives

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former is standardized exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years. They tend to trade thinly. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.

Swaps: Is an agreement between two parties, called counterparties, to exchange cash flows in the future. No formal exchange to guarantee performance, so the arrangement involves a dealer or OTC market and there is credit risk. Have evolved into a bank instrument, with banks or swap dealers serving as intermediaries. The two commonly used swaps are : Interest rate swaps: An exchange of interest payments on a principal amount in which borrowers switch loan rates. Often this involves one counterparty trading fixed loan payments for variable rate loan payments. Currency swaps: These entail swapping both principal and interest between the parties, with participants having cash flows of different currency. - Currency swaps require exchange of all cash flows. - Currency swaps permit the firms to adjust their foreign exchange exposure.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaption market has receiver swaption and payer swaption. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receives floating.

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

Examples
Some common examples of these derivatives are: CONTRACT TYPE

UNDERLYING

Exchange traded futures DJIA Index

Exchange traded options Option on DJIA Index future Option on NASDAQ Index future Option on

OTC swap

OTC forward

OTC option

Equity Index

future NASDAQ Index future

n/a

Back-to-back

n/a

Eurodollar Money market future

Eurodollar future

Interest rate Interest rate swap Forward rate agreement cap and floor Swaption Basis swap Repurchase agreement

Euribor future Option on Euribor future Bonds Bond future Option on Bond future

n/a

Bond option Stock option

Single Stocks

Single-stock future

Single-share option

Equity swap

Repurchase agreement

Warrant Turbo warrant

Foreign exchange

FX future

Option on FX future

Currency swap Credit

FX forward

FX option Credit

Credit

n/a

n/a

default swap

n/a

default option

Fin 480 (Fall 2009) Other examples of underlying are:

Faculty: Saif Rahman (SfR)

Economic derivatives that pay off according to economic reports ([1]) as measured

and reported by national statistical agencies

Energy derivatives that pay off according to a wide variety of indexed energy

prices. Usually classified as either physical or financial, where physical means the contract includes actual delivery of the underlying energy commodity (oil, gas, power, etc)

Commodities Freight derivatives Inflation derivatives Insurance derivatives Weather derivatives Credit derivatives

FORWARDS
Forward contract is an agreement entered today between two parties namely buyer and seller wherein buyer agrees to buy a particular asset at a particular price on a particular date. In a forward contract, two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands at the time the trade is agreed upon.

Suppose a buyer L and a seller S agree to do a trade in 100 grams of gold on 31 Dec 2008 at Rs.5,000/tola. Here, Rs.5,000/tola is the forward price of 31 Dec 2008 Gold. The buyer L is said to be long and the seller S is said to be short. Once the contract has been entered into, L is obligated to pay S Rs. 500,000 on 31 Dec 2008, and take delivery of 100 tolas of gold. Similarly, S is obligated to be ready to accept Rs.500,000 on 31 Dec 2008, and give 100 tolas of gold in exchange.

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

Features

Its a unique contract between two parties buyer and seller Forward is unique in terms of size, time and types of asset. Price fixation may not be transparent and is publicly not disclosed. Forwards are traded off the exchanges and exposed to default risk. Unlike Options where you are not obligated to make or receive delivery (rather you have a right/choice), in forward contracts you are obligated to satisfy the terms of the deal.

Forward markets tend to be afflicted by poor liquidity and from unreliability deriving from counterparty risk (also called credit risk).

FUTURES
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts

Features Futures are organized or standardized contract in terms of quantity, quality, delivery time and place of settlement Three parties are involved buyer, seller and clearing house. Contract expires on a pre-specified date which is called the expiry date of the contract. On expiry futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the futures/option contract in cash. Futures are traded in organized exchanges only. Exchange provides counter party guarantee through its clearing house.

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

Participating parties have to deposit an initial cash margin as well as the difference in traded price and actual price on daily basis. This daily settling is called Marking-to-Market.

Determinants of future prices

Supply and demand on the secondary market determines the futures price. Price of future refers to the rate at which the futures contract will be entered into. The basic determinants of future prices are spot rate and other carrying costs which in turn are based on rate of interest and time involved. Economic arguments give us a clear idea about what the price of a futures should be. If the secondary market prices deviate from these values, it would imply the presence of Arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market which forces the theoretical prices to come about.

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

FORWARD V/S FUTURES MARKET

OPTIONS
The right but not the obligation to buy (sell) some underlying cash instrument at a predetermined rate on a pre-determined expiration date in a pre-set notional amount. An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. A call option gives one the right to buy; a put option gives one the right to sell.

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

The buyer /holder of the option purchases the right from seller / writer for a consideration which is called a premium. The seller / writer of an option is obligated to settle the option as per the terms of contract when the buyer /holder exercises his right. The underlying asset could be an index, security etc.

Features Options are organized or standardized contract Three parties are involved buyer, seller and clearing house. Contract expires on a pre-specified date which is called the expiry date of the contract. Options are traded both OTC or via exchange

Call option (an option to buy)

A call option is a financial contract giving the owner the right but not the obligation to buy a pre-set amount of the underlying financial instrument at a pre-set price with a preset maturity date. Put Option (an option to sell) A put option is a financial contract giving the owner the right but not the obligation to sell a pre-set amount of the underlying financial instrument at a pre-set price with a preset maturity date.

European Style Option

European options are options that can be exercised only at maturity. An option that can be exercised only at expiry as opposed to an American Style option that can be exercised at any time from inception of the contract. European Style option contracts can be closed out early, mimicking the early exercise property of American style options in most cases.

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

American Style Option

American options can be exercised throughout their life up to and including the expiration date. An option that can be exercised at any time from inception as opposed to a European Style option which can only be exercised at expiry. Early exercise of American options may be warranted by arbitrage. These two types of options are not confined by geography. European options are traded in North America. Premium charged in case of American option is more compared to that of European option as the former can be exercised at any time before expiry date.

Writing Covered Call Options Selling call options while owning the underlying asset. - The writer receives the option premium at the time of writing the call. - The strike price can be set above the current market priceso some increase in the underlying asset will not automatically cause the holder of the call to exercise the option (this means writing an out-of-the-money call) - If the underlying asset price stays the same or falls during the life of the option, the call wont be exercised, and the writer wont be forced to sell the underlying. On the other hand, if the option is not covered by physical asset, it is known as Naked option.

Differences between forward, future and option

Features Standardization Liquidity Margin Guarantor Obligation to perform Default risk Parties Contract closure Forward No NO No No B&S Yes 2 By delivery Future Yes Yes Yes CH B&S No 3 By paying price differentials Option Yes Yes Yes CH Seller No 3 By paying price differentials

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

Strike Price
The price at which the holder of a derivative contract exercises his right if it is economic to do so at the appropriate point in time as delineated in the financial product's contract.

Valuation of options
Valuation depends upon number of factors such as, 1. Current price of the underlying asset 2. Expected volatility in the value of the underlying asset. 3. Strike price of the option. 4. Expiration time of options.(longer the time of expiry higher would be the value of options) 5. Rate of interest 6. Income from the underlying asset ( int/div income is generated value of asset reduces and value of options changes)

In money, out of money and at money options

An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM).

An option will be profitable, excluding the cost of the premium, if exercised immediately is said to be in-the-money (ITM).

An option that would not be profitable, again excluding the cost of the premium, if exercised immediately is referred to as out-of-the money (OTM)

For call option -

Mp > Sp In-the-money Mp < Sp Out-of-the-money Mp = Sp At-the-money

[Mp = Market Price Sp = Strike Price]

For put option -

Mp < Sp

In-the-money

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

Mp > Sp Out-of-the-money Mp = Sp STRADDLE An option strategy with which the investor holds a position in both a call and put with the same strike price and expiration date. Straddles are a good strategy to pursue if an investor believes that a stock's price will move significantly, but is unsure as to which direction. The stock price must move significantly if the investor is to make a profit. However, if there is only a small movement in price occurs in either direction, the investor will experience a loss. As a result, a straddle is extremely risky to perform. Additionally, on stocks that are expected to jump, the market tends to price options at a higher premium, which ultimately reduces the expected payoff should the stock move significantly At-the-money

WARRANTS
A warrant, like an option, gives the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time. However, unlike an option, an instrument of the stock exchange, a warrant is issued by a company. The security represented in the warrant (usually share equity) is delivered by the issuing company instead of an investor holding the shares.

Companies will often include warrants as part of a new-issue offering to entice investors into buying the new security. A warrant can also increase a shareholder's confidence in a stock, if the underlying value of the security actually does increase overtime.

There are two different types of warrants: a call warrant and a put warrant. A call warrant represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date. A put warrant represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date. Characteristics of a Warrant Warrant certificates have stated particulars regarding the investment tool they represent.

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

All warrants have a specified expiry date, the last day the rights of a warrant can be executed. Warrants are classified by their exercise style: an American warrant, for instance, can be exercised anytime before or on the stated expiry date, and a European warrant, on the other hand, can be carried out only on the day of expiration.

The underlying instrument the warrant represents is also stated on warrant certificates. A warrant typically corresponds to a specific number of shares, but it can also represent a commodity, index or a currency.

The exercise or strike price is the amount that must be paid in order to either buy the call warrant or sell the put warrant. The payment of the strike price results in a transfer of the specified amount of the underlying instrument.

The conversion ratio is the number of warrants needed in order to buy (or sell) one investment tool. Therefore, if the conversion ratio to buy stock XYZ is 3:1, this means that the holder needs three warrants in order to purchase one share. Usually, if the conversion ratio is high, the price of the share will be low, and vice versa. (In the case of an index warrant, an index multiplier would be stated instead. This figure would be used to determine the amount payable to the holder upon the exercise date.)

Investing In Warrants Warrants are transferable, quoted certificates, and they tend to be more attractive for medium-term to long-term investment schemes. Tending to be high risk, high return investment tools that remain largely unexploited in investment strategies, warrants are also an attractive option for speculators and hedgers. Transparency is high and warrants offer a viable option for private investors as well. This is because the cost of a warrant is commonly low, and the initial investment needed to command a large amount of equity is actually quite small.

Advantages Let us look at an example that illustrates one of the potential benefits of warrants. Say

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

that XYZ shares are currently priced on the market for $1.50 per share. In order to purchase 1,000 shares, an investor would need $1,500. However, if the investor opted to buy a warrant (representing one share) that was going for $0.50 per warrant, with the same $1,500, he or she would be in possession of 3,000 shares instead!

Because the prices of warrants are low, the leverage and gearing they offer is high. This means that there is a potential for larger capital gains and losses. While it is common for both a share price and a warrant price to move in parallel (in absolute terms) the percentage gain (or loss), will be significantly varied because of the initial difference in price. Warrants generally exaggerate share price movements in terms of percentage change.

Let us look at another example to illustrate these points. Say that share XYZ gains $0.30 per share from $1.50, to close at $1.80. The percentage gain would be 20%. However, with a $0.30 gain in the warrant, from $0.50 to $0.80, the percentage gain would be 60%.

In this example, the gearing factor is calculated by dividing the original share price by the original warrant price: $1.50 / $0.50 = 3. The '3' is the gearing factor, and the higher the number, the larger the potential for capital gains (or losses).

Warrants can offer significant gains to an investor during a bull market. They can also offer some protection to an investor during a bear market. This is because as the price of an underlying share begins to drop, the warrant may not realize as much loss because the price, in relation to the actual share, is already low. Disadvantages Like any other type of investment, warrants also have their drawbacks and risks. As mentioned above, the leverage and gearing warrants offer can be high. But these can also work to the disadvantage of the investor. If we reverse the outcome of the example from above and realize a drop in absolute price by $0.30, the percentage loss for the share price would be 20%, while the loss on the warrant would be 60%!

Fin 480 (Fall 2009)

Faculty: Saif Rahman (SfR)

Another disadvantage and risk to the warrant investor is that the value of the certificate can drop to zero. If that were to happen before it is exercised, the warrant would lose any redemption value. Finally, a holder of a warrant does not have any voting, shareholding or dividend rights. The investor can therefore have no say in the functioning of the company, even though he or she is affected by any decisions made.

CONVERTIBLE SECURITIES
A convertible security is a bond or debenture or preferred stock that can be converted into equity of a company. Usually an original security is a debt instrument, which can be converted into ownership instrument, after a time. The period of time necessary for conversion, the ratio of conversion and other terms including the price are laid down in the beginning only. Convertible bonds are a combination of bonds and equity. Convertible bonds are bonds with a maturity date and coupon, with a call option where the holder has the right to convert into equity. A convertible bond has several desirable qualities for the investor or trader. Some of them include the following:

They provide asset protection. The value of the convertible bond will only fall to the value of the bond floor.

Convertible bonds can provide the possibility of high equity returns. Convertible bonds are usually of a less volatile nature than regular shares.

In short, Convertible bonds offer the following main advantages for the trader or investor:

Asset protection of the bond, combined with the possibility of equity returns.

Convertible bonds offer the following main advantage for the issuer of the CB:

Debt at a relatively low cost.