DERIVATIVES

- An

Introduction

By Prof. A. G. Mendhi

4/3/2012

AGENDA FOR TODAY

What are derivatives? Types of derivatives: Forward Contracts & Types, Futures Contracts, Options & Types, Swaps, Basis & Spread Pricing of Derivatives (Futures only) Risk Management (through hedging) Profits through speculation
4/3/2012 2

What are Derivatives?

Definition: Depending on what the underlying asset is, the derivative could be named differently: Stock Derivative, Commodity Derivative, Currency Derivative, Index based Derivative, etc. Thus a Commodity Derivative is a contract to either sell or buy a commodity at a certain time in future at a price agreed upon at the time of entering into such a Contract.
4/3/2012 3

INTRODUCTION
DERIVATIVES ORIGIN
Uncertainties in fluctuations of asset prices Presence of risk-averse economic agents Started with commodities in Chicago Farmers and grain merchants were the initiators
4/3/2012 4

NEED FOR DERIVATIVES

Commodity markets like any other market for financial instruments, involve risks associated with frequent price volatility. Hedging is therefore required with the objective of transferring the risk related to the possession of physical assets due to any adverse movement of price.
4/3/2012 5

FUNCTIONS OF DERIVATIVES
Reflecting Market Perception Discovering Future as well as Current Price Transferring Risk from those who are averse to those who have an appetite Speculation in more controlled environment Involving more participants and increasing volumes
4/3/2012 6

Advantage - Derivatives
Derivatives are useful

when individuals or companies wish to buy asset or commodity in advance to insure against adverse market movements;
As effective tools for hedging risks designed to enable market participants to partially eliminate risk.

For business dealings in respect of a good that faces risk associated with price fluctuations.
Examples: A farmer can fix price for crop even before planting, partially eliminating price risk An exporter can fix a foreign exchange rate even before beginning to manufacture a product for exports, eliminating foreign exchange risk.

4/3/2012

Contracts / agreements
Contracts / agreements

Cash(Ready delivery contract)

Derivatives

Forward

Others (SWAPS) etc.

Futures(Standardised)

Merchandising,Customised

Options

NTSD
4/3/2012

TSD

CALL
8

PUT

FORWARD CONTRACT
A Forward Contract is one of the simplest forms of derivatives. It is an agreement to buy or sell an asset (in our case a commodity) at a certain time in future for a certain price mentioned in the contract. It is different from the spot contract Is usually traded in over the counter (OTC) mode. (Exception of selected overseas exchanges) Buyers and Sellers would usually know each other. No institutional set up like an exchange is necessary.
4/3/2012 9

FORWARD CONTRACT
Forward contract is specified by a legal document, the terms of which are binding on two parties involved in a specific transaction in the future.

on a priced asset, it is a financial instrument, since it has an intrinsic value determined by the market for underlying asset on a commodity, it is a contract to purchase or sell a specific amount of commodity at specific time in future at a specific price agreed upon today buyer (long ): is obliged to take delivery of asset & pay agreed-upon price at maturity seller (short): is obliged to deliver asset & accept agreed-upon price at maturity

Contract is between two parties, buyer and seller.

Forward price applies at delivery and is negotiated so that there is little or no initial payment.
4/3/2012 10

POSITIVE & NEGATIVE SIDES OF FORWARD CONTRACTS

Advantages:
Each party fixes the purchase or sale price in advance. Little or No money changes hands on date 0

Drawbacks:
Liquidity Credit Risk.
4/3/2012 11

In Nutshell:
A forward contract is an agreement today to buy or sell an asset on a fixed future date for a fixed price.
It is different from a spot contract which is an agreement to buy or sell immediately, The fixed future date is called the maturity date, The fixed price is called delivery / strike price (DP / SP) , The delivery price is to be paid at maturity.
4/3/2012 12

TERMINOLOGY
Please note that in a forward contract:
Agreement date is different from the delivery date. The spot price (SP) is different from the delivery price (DP) at least till maturity. The date of initiation is always taken as date 0 The date of maturity will always be represented by time to maturity (T).
4/3/2012 13

Commodity Futures
A Commodity Futures contract is an agreement between two parties to buy or sell a specified quantity of a commodity of defined quality at a certain time in future at a price agreed upon at the time of entering into the contract on a Commodity Exchange.
4/3/2012 14

TRADING IN FUTURES
MAJOR OBJECTIVES:
- PRICE DISCOVERY - PRICE RISK MANAGEMENT

4/3/2012

15

FUTURES PAY OFF

LONG FUTURES
PROFIT

STRIKE PRICE
0

LOSS
4/3/2012

PRICE
16

FUTURES PAY OFF

SHORT FUTURES
PROFIT STRIKE PRICE

LOSS
4/3/2012

PRICE
17

Advantages of Commodity Futures

Liquidity and price discovery to ensure base minimum volume in trading of a commodity through market information and demand supply factors that facilitate a regular and authentic price discovery mechanism. Liquidity in the contracts of the commodities traded also ensures that the equilibrium in demand and supply is maintained. Price stabilization is possible.
4/3/2012 18

Advantages (Contd.)
Hedging Maintaining just adequate buffer stocks - Resources can then be diversified for other investments. Flexibility, certainty and transparency facilitate bank financing.
4/3/2012 19

Special Features of a Futures Contract:

To ensure Liquidity: Futures contracts are Exchange traded and Have standardized contract terms To cover the Credit Risk: Futures contracts are guaranteed by the concerned clearing house and Are settled on daily basis by Marking to Market
4/3/2012 20

Futures contracts & Delivery

A very small percentage of Futures contracts would normally result into delivery of underlying commodities. In most cases traders would offset their futures positions before the contracts mature. The difference between the initial purchase or sale price and the price of offsetting the transaction would represent the realized profit / loss.
4/3/2012 21

Forward V/S Futures Contract

Forward Contract:
It is unique and hence non-standardized Not traded on exchanges. OTC is the preferred route. Usually buying & Selling parties would know each other

Futures Contract:
Have standardized contract terms (Quantity, Quality, Time) Are Exchange traded and Buyers & Sellers need not know each other

4/3/2012

22

OPTIONS

4/3/2012

23

Meaning and types of options:

An option is a formal futures contract which gives the holder the right, without the obligation, to buy or sell a certain quantity of an underlying asset at a stipulated price within a specific period of time.

Commodity Options are allowed in practically all commodity exchanges world-over except in some countries like India.
4/3/2012 24

Forward Contracts V/S Options

The holder of forward contract is obliged to trade at the maturity of the contract. Unless the position is closed before maturity, the holder must take possession of the commodity, currency or whatever is the subject of the contract, regardless of whether the asset price has risen or fallen. An option gives the holder the right to trade in the future at a previously agreed price but takes away the obligations. If stock / commodity price falls, you do not have to buy it after all.

An option is a privilege sold by one party to another that offers the buyer the right to buy or sell a security at an agreed-upon price during a certain period of time or on a specific date.
4/3/2012 25

Types of options
There are two types of options Call Option and Put Option.
A Call Option Gives holder the right, but not the obligation to buy the underlying asset. Upon exercise of that right, the option seller is obliged to sell the underlying product under the specified conditions to the option buyer. A Put Option gives the owner of the put option the right, but not the obligation to sell the underlying asset. Upon exercise of that right, the option seller has the obligation to sell the underlying product to the option buyer under the specified conditions. THESE OPTIONS ARE ALSO CALLED VANILLA OPTIONS AND ARE THE SIMPLEST FORM OF OPTIONS TRADED ON EXCHANGES.
4/3/2012 26

Call Option
The

right to buy a particular commodity for an agreed amount at a specified time in the future.

Call

option is exercised at expiry if the commodity price rises above the strike price and not if it is below.
has a bullish outlook
27

Buyer
4/3/2012

Put Option
The

right to sell a particular asset for an agreed amount at a specified time in the future. option is exercised if the commodity / stock price falls below the strike price and not if it rises above the strike price.
has a bearish outlook
28

Put

Buyer
4/3/2012

More about options:

The purchase of an option limits the maximum loss and at the same time allows the buyer to take advantage of favorable price movements. Options are called options since they are not obligatory! The process by which the option holder uses the right conveyed by the option is known as exercise and the time by which exercise has to have taken place is expiry.
4/3/2012 29

OPTION PAYOFF
FOR BUYER OF CALL OPTION
LOSS RESTRICTED TO PREMIUM, PROFIT UNLIMITED, IF PRICES RISE

Break-even = 205

Strike Price=185

Premium=20

4/3/2012

30

OPTION PAYOFF
FOR WRITER OF CALL OPTION
Break-even = 205,

INCOME RESTRICTED TO PREMIUM, LOSS UNLIMITED IF PRICES RISE

Premium=20

Strike Price=185

4/3/2012

31

OPTION PAYOFF
BUYER OF PUT OPTION
LOSS RESTRICTED TO PREMIUM PAID, PROFIT UNLIMITED, IF PRICES DECLINE

Strike Price=185

Break-even = 165

Premium=20

4/3/2012

32

OPTION PAYOFF
SELLER OF PUT OPTION
INCOME RESTRICTED TO PREMIUM, LOSS UNLIMITED IF PRICES DECLINE Break-even = 165 Premium=20 Strike Price=185

4/3/2012

33

PAY OFF SUMMARY FOR FUTURES & OPTIONS

Long Futures Traders rights and obligations Right and obligation to buy Short Futures Long Call Short Call Long Put Short Put

Right and obligation to sell

Right but not the obligation to buy

Obligation to deliver

Right but not the obligation to sell

Obligation to buy

Premium paid or received Margin requirement

Paid

Received

Paid

Received

Yes

Yes

None

Yes

None

Yes

Risk (loss)

Unlimited in case of a decline in prices

Unlimited, if prices rise

Unlimited in case prices rise.

Loss and risk limited to the premium paid upfront.

Unlimited in case prices rise

Unlimited in case prices rise

Loss and risk limited to the premium paid upfront

Unlimited, in case prices decline

Unlimited in case of a decline in prices

Return limited to the extent of the premium received upfront

Return (Profit)

Unlimited in case of a decline in prices

Return limited to the premium received upfront

4/3/2012

34

OPTIONS PREMIUM
An option premium is made up of two components its intrinsic value and time value. Intrinsic value is the difference between the exercise price and the current price. The intrinsic value is that part of the premium which could be realized as profit if the option were exercised. Such an option is referred to as "in-the-money". A call option has intrinsic value only if the underlying product price is above the option price. Conversely, a put option has intrinsic value only if the underlying product price is below the option price. Time value is the amount, if any, by which an options premium exceeds its current intrinsic value. Time value reflects the willingness of buyers to pay for the right offered by the option and the willingness of sellers to incur the obligations of the options.
4/3/2012 35

Types of Options (Exercise Mode)

American style options: The buyer of the option can choose to exercise his option at any given period of time between the purchase date and the expiry date European style options: The buyer of the option can choose to exercise his option only on the expiry date

WHY?
The premium paid to buy an American style option is normally equal to or greater than the European style option for the same underlying commodity futures contract.
4/3/2012 36

Some more options!!

Bermudan options Exercise on specific days or periods only
Asian Options Payoff depends on average price of underlying asset over a certain period of time Exotic Options More complex cash flow Structures. EXAMPLES :Barrier, look-back, Shout, Exchange, & so on
4/3/2012 37

PRICING OF FUTURES
Spot prices and Futures prices are different mainly because of the Cost of Carry Cost of carry in case of commodities would include following elements of cost : Cost of storage (Food Grains / perishable commodities, crude), Cost of insurance, Cost of financing, Cost of feeding (Live stock), and Other undefined on unquantifiable costs such as security risks (Gold).
4/3/2012 38

PRICING FUTURES
COST OF CARRY MODEL
F = FUTURES PRICE S = SPOT PRICE

F=S+C
OR

C = HOLDING COSTS/ COST OF CARRY

F=S(1+r

)T

r = FINANCING COST T = TIME PERIOD

PRICING FOR STOCKS AND COMMODITIES

4/3/2012 39

Pricing Futures Contract

F = S (1+r)n

Where, F=Futures price S=Spot price r= percentage cost of financing (annually compounded) n= Time till expiration of the contract If the value of 'r' is compounded m times in a year, the formula to calculate the fair value will be F = S (l+r/m)mn Where m = no. of times compounded in a year
4/3/2012 40

NUMERICAL ON PRICING
The cost of 100 grams of gold in the spot market is Rs. 220,000 & the cost of financing is 12% p.a., compounded monthly, the fair value of a 100 grams 4 month futures gold contract will be F = S * (l+r/m)mn F = 220,000 (1+0.12/ 12)12*4/12 F = 220,000(1.01)4 F = 220,000 * 1.0406 F = Rs. 228,932
ARBITRAGE OPPORTUNITY EXISTS IF VALUE OF F IS LESS OR MORE THAN RS. 228,932/4/3/2012 41

Daily / continuous compounding

The fair value of a futures price with continuous / daily compounding can be expressed as:

F=Sern Where:
r=percentage cost of financing n = Time till expiration of the contract e = 2.71828 The above formula is used to calculate the futures price of a commodity when no storage costs are involved. The futures price is equal to the sum of money 'S' invested at a rate of interest 'r' for a period of n years.

4/3/2012

42

NUMERICAL ON PRICING
If the cost of 100 grams of gold in the spot market is Rs. 220,000 & the cost of financing is 12% p.a., the fair value of a 100 grams 4 month futures gold contract on continuous compounding basis will be: F = 220,000 *e (0.12* 0.333) , F = 220,000 * 2.71828 (0.0399) F = 220,000 * 1.0407 F = Rs. 228,954/ARBITRAGE OPPORTUNITY EXISTS IF VALUE OF F IS LESS OR MORE THAN RS. 228,954/4/3/2012 43

SWAPS
After studying Forward Contracts and Futures and Options, we would also study another class of contract / financial instrument called Swap. A swap is an agreement / contract between two parties to exchange different streams of cash flows in the future according to a predetermined formula.
4/3/2012 44

SWAPS (CONTD.)
Usually swaps are used more often in case of cash flows related to interest rates and exchange rates. The first ever swap contract was negotiated and entered into between IBM and the World Bank in 1981. Ever since then the market for swaps (particularly in interest rates and exchange rates) has increased very rapidly. The swaps are however, still very rarely used in case of commodities.

4/3/2012

45

EXAMPLE OF SWAP
The company X : Pays 5.5% to its lender It pays at the LIBOR under the SWAP with Y It receives 5% under the SWAP with Y The company Y : It pays interest at (LIBOR + 0.30) to Lenders. It pays at 5% under the SWAP with X. It receives at LIBOR under the SWAP with X.

4/3/2012

46

AFTER THE SWAP IS IN PLACE!

Effective or net outflow for X will be LIBOR + 0.5
LIBOR

5.5%

Company X 5%

Company Y

LIBOR + 0.3%

Effective or net outflow for Y will be 5.3%

4/3/2012

47

Meaning of Basis and Spreads

Basis is the difference between the cash / spot price of a commodity and its futures price Basis = Spot or Cash Price Futures price If cash price is less than the futures price, basis is negative and the market is said to be in contango A strong basis is indicative of short supply. As soon as supply needs are met, basis levels (offerings) will weaken. Short supply in a given period for a commodity, will result in strong basis offerings until supply needs are met.
4/3/2012 48

Basis (Contd.)
If the spot price of an asset is more than the futures price of the underlying asset, the basis is positive and the market is said to be in backwardation. When the futures contract approaches expiry, the spot price and futures price converge with each other. (WHY?)

4/3/2012

49

PARTICIPANTS IN THE FUTURES MARKET

Hedgers: Producers or users of physical commodities who seek protection against adverse price changes by initiating a position in the futures market as a temporary substitute for the sale or purchase of the actual commodity. They use the futures or options markets to reduce if not totally eliminate the risk associated with adverse changes in price. Speculators: Private investors who attempt to profit from anticipated commodity price changes. They do not usually own or use the underlying product. Arbitragers: People who attempt to profit from temporary distortions, discrepancies or inconsistencies in prices usually in different markets by making purchases and sales in these (two or more) markets at the same time.
4/3/2012 50

SPREADS
Spread is the difference in prices of two futures contracts. If the price of the far month futures contract is higher than the price of the near month futures contract, the market is said to be normal. Otherwise, it is called an inverted market. In normal markets, if the spreads do exceed the cost of storage, it could be termed as a storage market and a storage hedge could be a profitable option. Inverted market offers an opportunity to sell a futures contract in near month and buy the same futures contract in far month.

4/3/2012

51

Intra & Inter commodity Spreads

An intra commodity spread is the difference in prices of two futures contracts of the same commodity having different expiry months. An inter commodity spread is the difference in prices of two futures contracts of two different commodities having the same expiry month.
4/3/2012 52

RISK MANAGEMENT
Many Corporate Companies are increasingly resorting to Risk Management Strategies if they are using commodities as their raw materials. This is immensely important because commodity prices can fluctuate wildly thus jeopardizing the profitability. For such companies hedging on commodity exchanges is one of the most important and effective tools of risk management.
4/3/2012 53

Hedging by merchants helps farmers!!

In December, a cotton merchant buys 1000 bales (170 Kg each) of cotton of a specific grade from a farmer at Rs. 5000/- per quintal. The merchant faces the risk of price fluctuations (fall in prices) and hence decides to hedge his risk by selling futures contracts of cotton on a commodity exchange. He sells 1000 bales of cotton (equivalent contracts) futures for April delivery at Rs. 5300/- per quintal. In April prices decline to Rs. 4800/- per quintal and the merchant sells his physical stock at this price in the market. Simultaneously, he would buy futures contract at Rs. 4800/- per quintal to square off his position in the futures market.

4/3/2012

54

Hedging: Example of Cotton Contract

Spot Market December 2006 Current market price is Rs. 5000/- per quintal -----------------------------April 2006: Sells at Rs. 4800/- per quintal Cotton Futures Sells April 2007 cotton contract at Rs. 5300/- per quintal ----------------------------------Buys cotton contract at Rs. 4800/- per quintal Profit made by X is Rs. 500/- per quintal

Net price locked: Rs. 5300/- per quintal

4/3/2012

55

Hedging: Example of Cotton Contract

Spot Market December 2006 Current market price is Rs. 5000/- per quintal -----------------------------April 2006: Sells at Rs. 5400/- per quintal Cotton Futures Sells April 2007 cotton contract at Rs. 5300/- per quintal ----------------------------------Buys cotton contract at Rs. 5400/- per quintal Loss incurred by X is Rs. 100/- per quintal

Net price locked: Is still Rs. 5300/- per quintal

4/3/2012

56

Speculators
Speculators accept the risk, which hedgers try to avoid. They provide the market with liquidity necessary to service the operations of hedgers. Speculators are not interested in taking delivery of commodities. They incur price risk with a view to reap potential rewards.
4/3/2012 57

Example of Speculation
Chartered Accountant A is anticipating rise in prices of gold in November 2007. He has surplus / idle cash of approximately Rs. 98,000/- by which he can buy only 100 gms of gold in open market at the ruling price of Rs. 9800/- per ten gm. Instead, he decides to trade in Gold futures contract. He buys two contracts (1Kg. Each) of November 2007 gold futures from the Commodity Exchange in April 2005 @ Rs. 9,900/- per ten gram. He has to pay say 5% margin i.e. Rs. 99,000/- as margin for two contracts. Gold price moves according to As expectation and rules at Rs. 10,000/- per ten gram in November 2007. Let us see how A is benefited by speculation.
4/3/2012 58

Profit through speculation

Buy in Spot Market April 2007 Buys 100 gms of gold at Rs. 98,000/--------------------------------------Sells 100 gms of gold in spot market in November 2007 for Rs. 100,000/-@ Rs. 10,000/per ten gm. --------------------------------------Makes a profit of Rs. 2000/Returns 2.04% Buy in Futures Market Buys two contracts (2Kg.) of November 2005 gold valued at Rs. 19,80,000/- @Rs. 9,900/per ten gm. Margin money paid = Rs. 99,000/-----------------------------Sells two contracts at Rs. 20,00,000/- @ Rs. 10,000/- per ten gms. -----------------------------Makes a profit of Rs.20,000/Returns 20.20%
59

4/3/2012

REVIEW QUESTIONS
Explain the difference between: Forward Contract and a Futures Contract Forward Contract and Option State whether the following statement is true. Explain with an example. A call option has intrinsic value only if the underlying commodity price is above the option price. Conversely, a put option has intrinsic value only if the underlying commodity price is below the option price. Explain briefly the concepts of the following and draw pay off diagrams: Long forward position in commodity futures and Short forward position in commodity futures. How would a speculator use them to make profit on a commodity exchange?

4/3/2012

60

REVIEW QUESTIONS
State whether the following statement is true. Explain with an example, when you would use which option.
Materially speaking, buying a call option may be the same as selling a put option; but financially they have different implications

Current price of gold in the spot market is Rs. 12,000/- per ten grams. What should be the fair value of four months one Kg. Gold Futures contract assuming that storage or other costs associated with gold are in-built into the cost of financing.
If the cost of financing is 12% per annum compounded on monthly basis? If the cost of financing is 12% per annum compounded on continuous basis?

4/3/2012

61

Thank You

4/3/2012

62