INTRODUCTION TO

Derivatives
17th August, 2010
 Background to Derivatives
• In recent decades, financial markets have been marked by
excessive volatility. As foreign exchange rates, interest rates and
commodity prices continue to experience sharp and unexpected
movements ,it has become increasingly important that corporations
exposed to these risks be equipped to manage them effectively.
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. Risk
management process is used to control such price volatility. It is
here that derivative instruments are of utmost utility.
 Derivatives

What is a derivative?
A Derivative is a financial instrument which derives its
value from its underlying asset (it does not have any
value of its own). The underlying asset can be Futures,
Equities, Index and Currency.
 General characteristics of Derivatives

• It has one or more underlying assets.

• Require negligible initial investment compared to other
types of financial contracts.
• Should provide for net settlement i.e., offsetting of initial
contract position.
• The value of derivatives depends on their underlying
asset price movement.
• The parties involved may be obliged to exercise their
contracts or offset them ( Forwards, Futures) ; or may
have rights ( like option buyers).
 Common Derivatives..

Forward contracts.

Futures contracts.

Options.
 Forward Contract

• A Forward Contract is a contract made today for delivery

of an asset at a prespecified time in the future at a price
agreed upon today. The buyer of a forward contract
agrees to take delivery of an underlying asset at a future
time at a price agreed upon today. The seller agrees to
deliver the underlying asset at a future time at a price
agreed upon today. Again, no money changes hands
until time. A forward contract, therefore, simply amounts
to setting a price today for a trade that will occur in the
future. Forward Contracts are not standardized products.
They are OTC derivatives that are tailored to meet
specific user needs.
 Advantages of Forward Contracts

• Forward contracts can be used to hedge or lock-in the

price of purchase or sale of commodity or financial asset
on the future commitment date.
• On forward contracts, generally, margins are not paid
and there is also no upfront premium. So, it does not
involve initial cost.
• Since forward are tailor- made, price risk exposure can
be hedged up to 100%, which may not be possible in
futures or options.
 Disadvantages of Forward Contracts

• Counterparty risk is very much present in a forward

contract since there is no performance guarantee. On
due date, the possibility of counterparty’s failure to
perform his obligation creates another risk exposure.
• `Forward contracts do not allow the investor to derive
any gain from favourable price movement or unwind the
transactions once the contract is made. At the most, the
contract can be cancelled on the terms agreed upon by
the counterparty.
• Since forward are not exchange- traded, they have no
ready liquidity. Further, it is difficult to get counterparty
on one’s terms.
 Futures vs. Forwards

• Standardised • Not Standardised

• Standard Lot size • Odd lot size
• Exchange Traded • Over the Counter
(OTC)
 Some of the Exchanges :

Chicago Mercantile Exchange (CME)

Chicago Board of Trade (CBOT)
New York Board of Trade (NYBOT)
New York Mercantile Exchange (NYMEX)
National Stock Exchange (NSE)
 What is a future ?
• Definition: A future contract is a
standardised contract traded on an
exchange, to buy or sell a certain
underlying instrument at a certain date
in the future, at a pre-set price.
 Types of Futures :

• Equity
• Commodity
• Index
• Foreign Currency
 Characteristics:
• Standardisation
• Pricing
• Margin
• Always traded on an Exchange
• Settlement
 Standardisation
• The contract usually specifies the
following:
i. The underlying instrument
ii. Whether the settlement would be in cash or physical

iii. The amount and number of units of the underlying

assets.
iv. Currency in which the future contract is quoted.
v. Date of delivery & month.
vi. Last date of delivery – This varies from exchange to
exchange.
 Mark to Market
Example: Spot price of Gold is $ 400.
Futures Price of Gold is $ 415 at the beginning of the day.

The movements over 3 days as shown below explains the

concept of Mark to Market:

Time period Gold Future Buyer's Cash Flow

1 $420.00 $5.00
2 $430.00 $10.00
3 $425.00 - $5.00

Net Cash Flow $10.00

 Margin Componenets
• Initial margin – VAR technique
• Maintenance margin – minimum requirement
• Margin Call -Variation margin
• Additional margin –market trends /
volatility

 Any credit balance in a margin account

can be withdrawn.
 Simple Illustration
Reliance Future having lot size of 600 @ Rs.
1000/- = Rs. 600,000/-
Margin fixed by Exchange = 15% = Initial
Margin
Amount deposited with Broker = Rs.
600,000/- * 15% = Rs. 90,000/-

Maintenance margin = 50% of initial margin

= 90,000/- * 50% = 45,000/-
2nd day :

Next day, the rate of Reliance future is Rs. 950/-

Mark to market: 600 lots @ Rs. 950/- = Rs. 570,000/-

Current Margin 90,000.00 15%

Less : Notional loss 30,000.00 (600,000 – 570,000)
60,000.00 > 45,000
3rd day:

Next day, the rate of Reliance future is Rs. 900/-

Mark to market: 600 lots @ Rs. 900/- = Rs. 540,000/-

Calculation :
Current Margin 60,000.00
Less : Notional loss 30,000.00 (570,000 – 540,000)
30,000.00 < 45,000
Required margin 90,000.00
Variation Margin required (60,000.00) margin call
 Who trades futures?
• Hedgers : those who are interested in the underlying
and want to hedge out their risk of price changes. For
eg. farmers who sell future contracts for the crops that
guarantee a certain price. Also, hedging against an
existing equity position with a view to earn on short term
fluctuation while keeping the original position as intact.
• Speculators : those who seek to make profit by
predicting market movements and have no interest in the
underlying equity / commodity.
• Strategist / Traders: With the help of cash and
derivative products, large number of strategies are being
formulated and traded.
 What is an option ?
• An option contract is a standardised
contract traded on an exchange,
offering the right, but not the
obligation, to buy or sell a certain
underlying instrument at a pre-set
price called the strike price
An option is the right, but not the
obligation, to buy or sell underlying
asset (futures, commodity, currency,
index) and other financial instrument
at an agreed price, on or before a
given expiry date.
 Kinds of options
European Options: These are exercised
only on the maturity date. On the expiry
date, the option buyer's right to exercise
the option (and the seller's obligation to
perform) ends.

American Options: These can be

exercised at any time prior to or up to the
maturity date
 Option terminology
 Strike price/ Exercise price - Price at which the
option can be exercised.
 Expiration date - Date on which the option expires.
 Exercise date - Date on which the option gets
exercised by the option holder/buyer.
 Option premium/price - The price paid by the
option buyer to the option seller for granting the
option.
 Types of Option
There are two types of option - Call and Put

A Call option gives the “buyer” the right, but not

the obligation, to purchase the underlying asset
at a strike price, before or on the date of expiry.

A Put option gives the buyer the right, but not the
obligation, to sell the underlying asset at the
strike price, before or on the date of expiry.
 Option features
Buyer (Holder) Seller (Writer)

• Right but not an obligation • Obligation but not a right to

to buy / sell the underlying buy / sell the underlying
security at the strike price security at the strike price
• Pay the premium • Receive the premium
• Margin requirements – No • Margin requirements – Yes
• Extent of risk – limited to • Extent of risk – unlimited.
the extent of premium
paid
 Characteristics:
• Standardisation
• Premium
• Call / Put option
• Always traded on an Exchange
• Settlement
 Standardisation
• The contract usually specifies the
following:
i. The underlying instrument
ii. Whether the settlement would be in cash or
physical
iii. The amount and number of units of the underlying
assets.
iv. Currency in which the option contract is quoted.
v. Date of delivery & month.
vi. Last date of delivery – This varies from exchange to
exchange.
 Call option –Right to Buy
Example: Strike price of Gold is $ 400.
The premium paid at the time of entering the option is $5.
1) Option Spot Price of Gold is $ 420 at the expiry of the contract.
Payoff = Spot price – Strike Price = $420 – $400 = $20
The buyer will exercise his option.
P& L = Payoff – Premium = $20 - $5 = $15
 Potential profit can be unlimited.
2) Option Spot Price of Gold is $ 380 at the expiry of the contract.
Since Payoff = Spot price – Strike Price = $380 – $400 = - $20
The buyer does not exercise his option
Loss = Premium = $5
 Risk / loss will be limited to the premium paid.
 Put option –Right to Sell
Example: Strike price of Gold is $ 400.
The premium paid at the time of entering the option is $5.
1) Option Spot Price of Gold is $ 380 at the expiry of the contract.
Payoff = Strike Price - Spot price = $400 – $380 = $20
The seller will exercise his option.
P& L = Payoff – Premium = $20 - $5 = $15
 Potential profit will be limited since the price of the asset will not fall below 0
at any point of time.
2) Option Spot Price of Gold is $ 420 at the expiry of the contract.
Since Payoff = Strike Price - Spot price = $400 – $420 = - $20
The seller does not exercise his option.
Loss = Premium = $5
Risk / loss will be limited to the premium paid.
 Example – Call option buyer
 Mr.X holds a bullish view on Microsoft.
 Microsoft is trading on NASDAQ in the cash market at
$100.
 Call option on Microsoft with three-months maturity is
available at various strikes. Let us take strike of $100.
 Mr.X buys one call option contract, with 3-months
maturity (say one contract has 100 underlying shares).
 He pays a premium, say, @ $5 per share i.e. $500.
 What happens next?
Example – Call option buyer
 He waits for 3 months.
 During this time Microsoft may go up, it may
go down or it may remain stable.
 If Microsoft remains same or goes down i.e.
below $100, Mr.X will not exercise his
option and would lose the premium
amount, i.e. $500. In other words, Mr. X’s
loss is capped at this value.
 Example – Call option buyer
If Microsoft rises above $105 (strike price
of $100 + premium of $5), the Option
would generate money for Mr. X.
The higher the Microsoft rises, the higher
the profit to Mr.X.
Hence, the maximum profit potential of
Mr.X is unlimited, while the maximum loss
is limited to the premium paid ($500).
 Example – Call option seller
 Consider the Option on Microsoft, which Mr.X had bought say
from Mr.Y.
 The position of the Call option seller, i.e. Mr.Y is exactly the
opposite of the Option buyer - Mr. X.
 Mr.Y collects the premium amount of $500 from Mr.X.
 If Microsoft falls below $100 - Mr. Y pockets the premium
amount, which is the maximum profit he can make.
 However, if the stock moves up, Mr.Y’s loss is unlimited – which
is proportional to Mr.X’s gain.
 Payoff profile of Call options

Strike 100 Premium 5

20
15
10
Profit/Loss

5
Buyer
0
Writer
-5 90 95 100 105 110 115 120
-10
-15
-20
Price
 Position of Put option buyer
 Buyer’s rights- Sell underlying, at strike price
 Buyer’s obligations- Pay Premium
 Margin requirements - No
 Risk profile - Limited, to the extent of the premium
paid
 Profit potential – To the extent of the Strike Price
 Breakeven price = Strike price - Premium
Payoff profile of Put options
Strike 100 Premium 5
15

10
P rofit/L oss

0 Buyer
85 90 95 100 105 110 115 Writer
-5

-10

-15
Price
Value of option- Premium

Option premium valuation

Intrinsic Time value

value
 Intrinsic value

• Intrinsic value is the difference between

the exercise price of the option and the
market price (spot price) of the underlying
shares at any given time.
 In, At- and Out-of-the-Money
• The type of option and the relationship between the
spot price of the underlying asset and the strike price of the
option determine whether an option is in-the-money, at-the-
money or out-of-the-money.
• Call Option Put Option
• In-the-Money Spot > Strike Spot < Strike
• At-the-Money Spot = Strike Spot = Strike
• Out-of-the-MoneySpot < Strike Spot > Strike

• Exercising an in-the-money call or in-the-money put will

result in a payoff. Neither a call nor put that is at-the-money
or out-of-the-money will produce a payoff.
 Example – Trading options
at-the-money calls and puts

in-the-money Puts out-of-the-money Puts

35 40 45 $50 55 60 65

35 40 45 $50 55 60 65

out-of-the-money Calls in-the-money Calls

 Time Value of Option.
• The amount you are willing to pay for the possibility
that you could make a profit from the option
transaction. It is influenced by the following factors:

• Time to expiry
• Market volatility
• Market expectations
 Example – Time value
 Again taking the same example of IBM, we may choose
Call option from among the different maturities
(assuming same strike price for simplicity sake) say 1-
month, 3-month, 6-month and 9-month.
 If the stock is trading at $50, which is also the strike
price, the uncertainties associated with the stock to gain
intrinsic value is the maximum on a longer time frame,
than on a shorter time-frame.
 Hence, the time value premium for a longer term
maturity is higher than that of the near term maturity.
 Time decay

As the expiry of the option draws closer and the opportunities for
the option to become profitable declines, the time value
declines.
This erosion of option values is called as time decay.
 Benefits of Option Trading
• Leverage.
• Limited risk.
• No margin, only premium.
 Risk Neutral valuation
• In economics , risk neutral behavior is in between risk aversion and
risk seeking . If offered either €50 or a 50% chance of €100, a risk
averse person will take the €50, a risk seeking person will take the
50% chance of €100, and a risk neutral person would have no
preference between the two options.
• In finance , when pricing an asset, a common technique is to figure
out the probability of a future cash flow, then to discount that cash
flow at the risk free rate. For example, if the probability of receiving
$1 one instant from now is 50%, the value is $0.50. This is called
'expected value', using real world probabilities. Risk neutral
demonstrates that when pricing some assets, the real world
probabilities assigned to future cash flows are irrelevant.
• The fundamental assumption behind risk-neutral valuation is to use
a replicating portfolio of assets with known prices to remove any risk
 Risk Neutral valuation
• The risk neutral formula does not refer to the volatility of the
underlying – p as solved, relates to the risk-neutral measure as
opposed to the actual probability distribution of prices. Nevertheless,
both arbitrage free pricing and risk neutral valuation deliver identical
results.
• Futures
• n a futures contract, for no arbitrage to be possible, the price paid on
delivery (the forward price) must be the same as the cost (including
interest) of buying and storing the asset. In other words, the rational
forward price represents the expected future value of the underlying
discounted at the risk free rate (the "asset with a known future-price").
Thus, for a simple, non-dividend paying asset, the value of the
future/forward,F(t) will be found by accumulating the present value S
(t) at time t to maturity T by the rate of risk-free return r
• F (t) = S(t) X (1+r ) (T-t).
• This relationship may be modified for storage costs, dividends, dividend
yields, and convenience yields; see futures contract pricing.
• Any deviation from this equality allows for arbitrage as follows.
 Risk Neutral valuation
• In the case where the forward price is higher:
• The arbitrageur sells the futures contract and buys the underlying today (on
the spot market) with borrowed money.
• On the delivery date, the arbitrageur hands over the underlying, and
receives the agreed forward price.
• He then repays the lender the borrowed amount plus interest.
• The difference between the two amounts is the arbitrage profit.
• In the case where the forward price is lower:
• The arbitrageur buys the futures contract and sells the underlying today (on
the spot market); he invests the proceeds.
• On the delivery date, he cashes in the matured investment, which has
appreciated at the risk free rate.
• He then receives the underlying and pays the agreed forward price using
the matured investment. [If he was short the underlying, he returns it now.]
• The difference between the two amounts is the arbitrage profit.