1 - Introduction To Derivatives

Introduction to Derivatives
B. B. Chakrabarti
Professor of Finance (Retd.)
Indian Institute of Management, Calcutta
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.61 per USD.
This contract is an example of derivative contract
where the underlying is the foreign currency
(USD)
B. B. Chakrabarti: bbc@iimcal.ac.in
Derivatives Markets
Two types:
Exchange traded and Over-the-counter (OTC)
Exchange traded
Exchanges mostly use electronic trading.
Contracts are standard, virtually no credit risk
Example: Futures, Options
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, FRAs, Exotic options
Types of Derivatives
Forward Contracts - OTC

Futures Contracts Exchange traded
Swaps - OTC
Options Exchange traded / OTC
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.
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.
Example of Forward Contract

Suppose on April 01,2016 the treasurer of
an export company in India knows that it
will receive USD 1 million in 6
months (i.e. on October 01,2016) 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.
Spot and Future Quotes for

INR/USD (Not Actual Values)
Spot
6 month
Forward
Bid Price
61.85
62.80
Offer Price
62.10
63.15
INR/USD means Rs. per USD

Bid price at which one market maker is prepared to buy
Ask price at which one market maker is prepared to sell
These quotes are for inter-bank transactions, for retail investors spread
(difference between bid and ask) is more
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 )
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 )
10
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
11
Swaps
A swap is an agreement to exchange cash flows
at specified future times according to certain
specified rules.
Examples: Interest rate swap, currency swap etc.
12
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.
13
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.
14
Payoff Diagram Long Call

Payoff from
Long Call
-C
ST
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 )
15
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 )
16
Payoff Diagram Long Put

Payoff from
Long Put
K
-P
ST
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 )
17
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 )
18
Types of Traders
Hedgers
Speculators
Arbitrageurs
19
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.
20
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, speculators
loss is limited to the amount paid for the option.
21
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.
22
Problem No. 1
An investor enters into a short forward
contract to sell 100,000 British pounds for
US dollars at an exchange rate of 1.9000
US dollars per pound. How much does the
investor gain or loose if the exchange rate
at the end of the contract is (a) 1.8900 and
(b) 1.9200?
23
Problem No. 1 (Ans.)

a. Gain = $1,000
b. Loss = $2,000
24
Problem No. 1 (Explanation)

Part a:
The trader sells 100,000 British pounds for
1.9000 US dollar per pound when the exchange
rate is 1.8900 US dollar per pound.
The gain is 100,000*(1.9000 1.8900) = $1,000
Part b:
The trader sells 100,000 British pounds for
1.9000 US dollar per pound when the exchange
rate is 1.9200 US dollar per pound.
The loss is 100,000*(1.9200 1.9000) = $2,000
25
Problem No. 2
You would like to speculate on a rise in the
price of a certain stock. The current stock
price is $29, and a three-month call with a
strike of $30 costs $2.90. You have $5,800
to invest. Identify two alternative
strategies, one involving an investment in
the stock and the other involving
investment in the option. What are the
potential gains and losses from each?
26

Strategy 1: Buy 200 shares
Strategy 2: Buy 2000 options
If share price does well strategy 2 will give
better gain
If share price does badly strategy 2 will
give greater loss
27
Problem No. 3
Suppose that sterling-USD spot and forward
exchange rates are as follows:
Spot
90-day forward
180-day forward
2.0080
2.0056
2.0018
What opportunities are open to an arbitrageur in

the following situations?
a. A 180-day European call option to buy 1 for $1.97
costs 2 cents.
b. A 90-day European put option to sell 1 for $2.04
costs 2 cents.
28
Problem No. 3 (Ans. Part A)
The trader buys a 180-day call option and takes a short position in a 180day forward contract
If ST is the terminal spot price,
The profit from the call option is
= max (ST 1.97,0) 0.02
The profit from the short forward contract
= 2.0018 ST
The profit from the strategy is therefore
= max (ST 1.97,0) 0.02 +2.0018 ST
= max (ST 1.97,0) +1.9818 ST
This is
1.9818 ST
0.0118
when
when
ST < 1.97
ST > 1.97
Hence profit is always positive
The time value for money has been ignored in these calculations.
29
Problem No. 3 (Ans. Part B)
The trader buys a 90-day put option and takes a long position in a 90-day
forward contract
If ST is the terminal spot price,
The profit from the put option is
= max (2.04 ST,0) 0.02
The profit from the long forward contract
= ST 2.0056
The profit from the strategy is therefore
= max (2.04 ST,0) 0.02 + ST 2.0056
= max (2.04 ST,0) + ST 2.0256
This is
ST 2.0256
0.0144
when
when
ST > 2.04
ST < 2.04
Hence profit is always positive
The time value for money has been ignored in these calculations.
30
Problem No. 4
The price of gold is currently $600 per
ounce. The forward price for delivery in
one year is $800. An arbitrageur can
borrow money at 10% per annum. What
should the arbitrageur do? Assume that
the cost of storing gold is zero and that
gold provides no income.
31

The arbitrageur could
Borrow money to buy 100 ounces of gold today and
Short futures contracts on 100 ounces of gold for delivery in one
year
This means gold

Purchased for $600 per ounce
Sold for $800 per ounce
The return = 33.3% per annum >> 10% cost of borrowing

fund
The arbitrageur should do this as much he can.
Unfortunately this type of opportunity rarely arise in
practice.
Even if this arises this does not sustain.
32
Problem No. 5
A bond issued by Standard Oil worked as follows. The
holder received no interest. At the bonds maturity the
company promised to pay $1,000 plus an additional
amount based on the price of oil at that time. The
additional amount was equal to the product of 170 and
the excess (if any) of the price of a barrel of oil at
maturity over $25. the maximum additional amount paid
was $2,550 (which corresponds to a price $40 a barrel).
Show that the bond is a combination of regular bond, a
long position in call options on oil with a strike price of
$25 , and a short position in call options on oil with a
strike price of $40.
33

Suppose ST is the price of oil at the bonds maturity
In addition to $1,000 the standard oil bond pays:
ST < $25 :
0
$40 > ST > $25 :
170(ST 25)
ST > $40 :
2,550
This is the payoff from 170 call options on oil with a strike
price of 25 less the payoff from 170 call options on oil with
a strike price of 40
The bond is a combination of regular bond, a long
position in 170 call options on oil with a strike price of
$25 , and a short position in 170 call options on oil with a
strike price of $40
34

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1 - Introduction To Derivatives

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Introduction to Derivatives

What is a Derivative Security?

Forward Contracts - OTC

Example of Forward Contract

Spot and Future Quotes for

INR/USD means Rs. per USD

Payoffs From Long Forward

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

Payoffs From Short Forward

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

Agreement (obligation) to buy or sell

an asset for a certain price at a certain

A call option is an option to buy a certain

The price of the contract is known as

time during its life.

The terms American or European do not refer to the

Payoff Diagram Long Call

The payoff from a long position in a call option

Payoff Diagram Short Call

The payoff from a short position in a call option

Payoff Diagram Long Put

The payoff from a long position in a put option

Payoff Diagram Short Put

The payoff from a short position in a put option

Problem No. 1 (Ans.)

Problem No. 1 (Explanation)

Problem No. 2 (Ans.)

What opportunities are open to an arbitrageur in

Problem No. 3 (Ans. Part A)

Hence profit is always positive

Problem No. 3 (Ans. Part B)

Hence profit is always positive

Problem No. 4 (Ans.)

This means gold

The return = 33.3% per annum >> 10% cost of borrowing

Problem No. 5 (Ans.)

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