MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit V: Managing Foreign Operations
Lesson 5.1

(Financial Derivative, Foreign Currency futures and Options)

2
FINANCIAL DERIVATIVES
Fluctuations in the prices of financial assets
expose the dealers in such assets to risk. The
dealers would like to hedge the risk involved in
their financial transactions. Financial derivatives
have evolved as instruments for hedging the risk
involved in buying, holding and selling various
kinds of financial assets.
Basically, they are financial instruments for the
management of risk arising from the uncertainty
prevailing in financial markets regarding asset
prices.

3
FINANCIAL DERIVATIVES
Financial Derivatives are those assets whose
value is derived from the value of underlying
assets
Underlying assets may be equity, commodity,
or currency
Derivatives have no independent value
Derivatives are promise to convey ownership
Derivatives may be exchange traded or
privately negotiated over the counter

4
Types of Derivatives
Forwards
Futures
Options
5
FORWARD CONTRACTS
A forward contract is customised contract
between two entities where settlement
takes place on a specific date in the future
at todays pre agreed price
Two parties irrevocably agree to settle a
trade at a future date, for a stated price and
quantity
No money changes hands
6
LIMITATATIONS OF FORWARD CONTRACTS
Private Bilateral agreement, Involves Counter
Party Risk
Cannot take Reverse Position, Lack of Liquidity
Lack of Standardization
These limitations can be overcome by use of
Future Contracts
7
Futures Contracts
FUTURES
A future contract is an agreement between two
parties to buy or sell an asset at a certain time in
the future at a certain price. These are special
types of forward contracts in the sense that the
former are standardised exchange- traded
contracts.
Traded over an Exchange
Standardized Forward Contract
Contract to buy or sell a specified asset at a
specified price on a specific date

Currency Futures - Example
Mr. X purchases $1000 at Rs 62/$ (on 1
st
April,
2014) in 3- months futures market and the due
date of contract is 30 June, 2014. Now, as per the
terms of the contract, irrespective of actual
relationship between Rupee and dollar on 30
th

June,2014, Mr. X would get $ 1000 at Rs 62/$. If
the actual price of a dollar on 30
th
June,2014 is Rs
65, Mr. X would make gain of Rs 3000. However, if
the actual price of a dollar happens to be Rs 60/$ ,
Mr. X would be having loss of Rs 2000.
Illustration
A software company in India expects to get
$10000 three months from now. The
prevailing price of dollar in terms of rupees in
the currency market is Rs 61/$. It is being
anticipated that rupee will get strengthen
against dollar and the relationship between is
expected to be Rs 59/$. Explain the impact on
the earning of the company and advise
suitable strategy to protect fall in earning of
the company.
Illustration
In case the actual price of dollar happens to be Rs 59 at
the time of receipt of dollar, the company would suffer
forex loss of Rs (61 59) x 10000 = Rs 20,000.

In order to protect itself from this loss, the company shall
sell $ 10,000 in the 3 months futures market at a
current price of Rs 61. The company would be required
to make delivery of dollars after three months which
will be made through the receipt of payment due to
the company.
11
COMPARISON OF FORWARDS AND FUTURES
BASIS FORWARDS FUTURES
Standardization Non standardized
products
Standardized
Liquidity No liquidity Highly liquid
Risk Risk of non
performance
No such risk
Margin Money Nil Paid to clearing
corporation
P & L Settlement At the time of
maturity
Daily cash
settlement



12
OPTIONS CONTRACTS
Options may be defined as a contract, between two
parties whereby one party obtains the right, but not
the obligation, to buy or sell a particular asset, at a
specified price, on or before a specified date
Give the buyer the right but not the obligation to
buy/sell a specified underlying asset
At a set price
On or before a specified period
One who receives the right is the Option buyer/holder
One who is obliged to perform the contract is the
Option seller/writer
13
COMPARISON OF FUTURES AND OPTIONS
BASIS FUTURES OPTIONS
Obligatory Obligatory on both
the parties
Not obligatory for
the buyer/holder
Premium No premium paid Buyer pays
premium to seller
Risk Return
Exposure
Buyer exposed to
entire downside
risk and potential
for upside returns
Downside risk
limited for buyer
but infinite
potentials for
upside returns
Performance of
the contract
Obligatory to
perform on the
expiry date
Can be on or before
the maturity date
depending upon
whether option is
american or
european
14
Call Option
Put Option

Types of Options
15
Call Option
A Call Option gives 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.
16
PUT OPTION
Put Option gives 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.

17
Comparison of Call & Put Option
Buyer / Holder
(privileged
person)
Seller/ Writer
(Bearing risk)
Call Option Right to buy an
asset
Obligation to
Sell
Put Option Right to Sell Obligation to
Buy
18
Styles of Options
European Style : They can be exercised on
specified future date only. ( Last Thursday of
expiry month in India )
American Style : They can be exercised on or
before a specified future date.( They are
difficult to administer but more beneficial to
the buyer.
19
Terminology to be used for Options Pricing
Spot Price : The current price of the stock
Exercise Price/Striking Price: The fixed price at
which the option holder can by and / or sell
the underlying asset.
Exercise Date : When option is exercised
Expiry Date : Last Date when option can be
exercised
Option Premium :It is the price the buyer
pays the writer for an option contract.
20
Advantages Of Options
Leverage
Unlimited Profit Potential
Fixed Risk

21
Example- Call Option
A dollar is traded at prevailing market price of
Rs.60 (S
0
). A call option contract having exercise
price (E) of 61 and 3 months maturity is available
at an option premium of Re 1(c).
Interpretation
Out of pocket cost right now is Re.1
If market price 3 months hence S
1
= 64
Exercise the call option
Net pay off = (64 - 61 1 )
= 2 (gain)

22
If price of dollar after three months price is Rs
62
Do not exercise the call option
No benefit / No loss
Net payoff = Re1 (loss)
Net loss will remain max Re1 irrespective of S
1

If S
1
= 66
Net pay off = (66 - 61 1 )
= Rs 4 (gain)
There is potential for unlimited gain
23
Diagrammatic Representation

Break even
point
Loss
Gain Area
Price of one
dollar in terms of
rupee
62
61
24
If S
1
> E
Exercise Call Option
If S
1
< E
Do not exercise call option
A call option will be exercised if S
1
> E or S
1
= E
Net payoff = S
1
- E -c





25
Option Pricing

FACTORS AFFECTING OPTION PRICE

Stock price (on expiration date): The value of call option, other things
being constant, increases with the stock price.

Strike/ Exercise price: Other things being constant, the higher the exercise
price, lower would be the value of a call option.

Time to Expiration: Other things being constant, longer the time to
expiration date the more valuable the call option. The holder gets more
time for exercising the option

Variability of the stock price: Other things being constant, the higher the
variability of the stock price, the greater the likelihood that the stock price
will exceed the exercise price.

Risk Free Rate of Interest: The higher the interest rate , the greater the
benefit will be from delayed payment and vice-versa. So, the value of a call
option is positively related to the interest rate.

Dividends: The call option price is lower at the ex-dividend date compared
to the pre-dividend date.
26
BLACK AND SCHOLES OPTION PRICING MODEL

Assumptions
No dividends are paid out
The option can be exercised at the expiry
Efficient markets
Commissions are non existent
Interest rate are known and constant
Stock returns follow a log normal distribution
27
Black and Scholes Model

C0 = S0 N (d1) - E N (d2)
e
rt

Where
C0 = value of a call option now

S0 = current price of the stock

E = exercise price

e = base of natural logarithm

r = continuously compounded risk-free annual

interest rate

t = length of time in years to the expiration date
N(d) = value of the cumulative normal density function




28
d
1
= ln (S
0
/ E) + (r +
2
) t
t
d
2
= d
1
- t



where ln = natural logarithm
= standard deviation of the continuously
compounded annual rate of return on the stock

29
ASSIGNMENT 1
1. Calculate the value of a call option given the
following information, using the Black-
Scholes formula:
Stock price = Rs. 60
Exercise price = Rs. 50
Risk free rate = 8%
Time to expiration = 3 months
Standard deviation = 0.4
30
ASSIGNMENT 1
2. Following is the information available for
Abhishek Industries:
Stock price (S
0
)= Rs. 70
Exercise price (E) = Rs. 72
Risk free rate (r)= 12%
Time to expiration (t)= 6 months
Standard deviation = 0.3

31
ASSIGNMENT 1
3. The following data is available for Thermal
Plastics Limited, a company that is not
expected to pay dividend for a year::
S
0
= Rs. 120
E = Rs. 110
r = 0.14
t = 1.0
= 0.4