Futures, Options and Swaps

Derivatives: Basics
 A financial instrument whose value depends on or is derived
from the value of some other commodities or financial
instruments, called underlying asset, such as stocks, bonds,
wheat, snowfall, and stock market indices
 As opposed to spot markets, deals in derivative markets are
settled at a future date
Derivatives: Basics
 Investments in derivatives are different from outright
purchases of the underlying assets because the profit and
loss situations associated with a derivative instrument is
just the opposite of an underlying asset

 One party’s loss is another’s gain

 The purpose is to transfer or reduce risks

 Terminologies and Concepts
 Seller has the short position
 Buyer has the long position
 The specific date on which
exchange takes place is called the
settlement or delivery date
 The seller benefits from declines
in the price
 The buyer benefits from increases
in the price
 A clearing corporation or house
acts as the guarantor that both
parties will meet their obligations;
it is the counterparty to both sides
of the transaction
Categories
 Derivative Markets:
 Commodity Derivative Markets
 Financial Derivative Markets
 Types of Derivatives:
 Forwards and Futures
 Options
 Swaps
 Others, like credit and weather derivatives
 Forwards
 They are the simplest forms of derivatives
 A forward or forward contract is a customized or private
agreement between a buyer and a seller to exchange a
commodity or financial instrument for a specified amount
of cash on a pre-arranged future date. It is not traded in the
market
 An example: Forward contract for a basket of wheat
Spot Price: Rs 100
Contract period / term: 91 days
Forward price: Rs 103.74
where FP = SP × [1 + (i × t)] = 100 [1 + (0.15× 91/365)] = 103.74
If at maturity SP = Rs 120, buyer makes a profit of Rs 16.26
Example
 If the treasurer of a US corporation knows that the
corporation will pay £1 million in 6 months and wants
to hedge against exchange rate movements, the
treasurer can buy £1 million 6-month forward at an
exchange rate of 2.0489.

Spot and forward quotes for the USD/GBP exchange rate, July 20, 2007
Bid Offer
Spot 2.0558 2.0562
1-month forward 2.0547 2.0552
3-month forward 2.0526 2.0531
6-month forward 2.0483 2.0489
 Payoffs from Forwards
 Pay off from a long position in a forward contract on
one unit of an asset is ST – K
 Pay off from a short position is K – ST
ST is the spot price and K is the delivery price at the
maturity of the contract
Futures
 A futures contract is a forward contract that has been
standardized and sold through an organized exchange
 A wide variety of commodities and assets form the
underlying assets in futures contracts
 Financial assets include stock indices, currencies and
treasury bonds
Source: nseindia.com
 Operations of Clearing
Corporations
 Both parties to a futures contract place a deposit with the
corporation which is known as posting margin in a margin
account
 Clearing corporation also posts daily gains and losses on the
contract to the margin accounts known as marking to market
 To ensure that the initial margin account never becomes negative
a maintenance margin is set
 If the balance in the margin account falls below the maintenance
margin, the investor gets a margin call to top up the margin
account to the initial margin level the next day. The extra funds
deposited are known as variation margin
An example
 Assume that on June 5 an investor buys two December
gold futures contracts (each contract is of 100 ounces)
at a price of $600 per ounce. The initial margin is
$2000 per contract and the maintenance margin is
$3000 in total.
Day Futures Daily gain Cumulative Margin Margin call
price (loss) gain (loss) account
balance
600 4000
June 5 597 (600) (600) 3400
June 6 596.1 (180) (780) 3220
June 9 598.2 420 (360) 3640
June 10 597.1 (220) (580) 3420
June 11 596.7 (80) (660) 3340
June 12 595.4 (260) (920) 3080
June 13 593.3 (420) (1340) 2660 1340
June 16 593.6 60 (1280) 4060
June 17 591.8 (360) (1640) 3700
June 18 592.7 180 (1460) 3880
June 19 587 (1140) (2600) 2740 1260
June 20 587 0 (2600) 4000
June 23 588.1 220 (2380) 4220
June 24 588.7 120 (2260) 4340
June 25 591.0 460 (1800) 4800
June 26 592.3 260 (1540) 5060
Risk Transfer through Hedging & Speculation
 Seller gains from price fall and buyer gains from price
rise
 Hedging
Seller/Short Position Buyer/Long Position
Dealers of long term securities holding Pension Fund Managers planning to
an inventory of bonds purchase bonds in future
Goal: to hedge against possible decline Goal: to insure against possible price
in bond prices increases

 Speculation: They bet on price movements to make

profit
Seller/Short Position Buyer/Long Position
They bet that prices will fall They bet that prices will rise
 Comparison between Forwards
and Futures
Forwards Futures
Nature of Contract Non- Standardized in terms
standardized/customiz of contract size, trading
ed contract parameters, settlement
procedures

Trading Informal OTC market Traded on exchanges

or private contracts
between parties

Settlement Single, pre-specified in Daily settlement-

the contract marking to market and
final settlement

Risk Counter party risk No counter party risk

Arbitrage and the Determination of Futures
Price
 The practice of buying and selling financial
instruments in order to benefit from temporary price
differences is called arbitrage and the people who are
engaged in it are called arbitrageurs.
 Arbitrageurs drive down the prices of futures to the
level of the spot prices of the underlying assets
 On the date of settlement or delivery spot prices and
futures prices of the underlying assets are almost the
same
An example
 Suppose, that the stock price is $200 in NY while £100
in London while the exchange rate is 2.0300
dollars/pound. An arbitrageur can simultaneously buy
100 shares of the stock in NY and sell them in London
and make a risk-free profit of 100 × [($2.03×100) -
$200] = $300
 Interest Arbitrage
 Interest arbitrage refers to the international flow of short-term
liquid capital to earn higher returns abroad
 Uncovered interest arbitrage – possible losses from interest
arbitrage is not covered
 Carry trade – it refers to the strategy of borrowing low-yielding
currencies and investing in high-yielding currencies.
 Theoretically carry trade should not yield any predictable profit
as the low-interest-rate currency should appreciate with respect
to the high-interest-rate one
 In reality carry trade weakens the low-interest-rate currency and
appreciates the high-interest-rate one
 Covered interest arbitrage – it refers to the spot purchase of
the foreign currency to make the investment and the offsetting
simultaneous forward sale (swap) of the foreign currency to
cover the foreign exchange risk (transaction).
 Covered Interest Arbitrage Parity
(CIAP)
 Covered interest arbitrage continues till all the gains
are wiped out through
 Increase in the interest in the low-interest country
 Increase in spot rate and decrease in forward rate,
increasing forward discount

 When profit or net gain becomes zero, then Rupee is

said to be at covered interest arbitrage parity.
Covered Interest Arbitrage Parity
 Options
 Like futures, options are also agreement between two
parties, an option writer, and an option holder
 Option writers incur obligations while option holders obtain
rights
 There are two basic options: puts and calls
 There are four types of participants in option market
 Buyers of calls (holders)
 Sellers of calls (writers)
 Buyers of puts (holders)
 Sellers of puts (writers)
 Buyers of Contracts Sellers of Contracts

Buyers of Underlying
Call option holder Put option writer
Assets

Sellers of Underlying
Put option holder Call option writer
Assets
Example: Call Option
 A January 2008 call option on 100 shares of IBM stock
at a strike price of 90 gives the option holder the right
to buy 100 shares of IBM for Rs 90 a piece prior to the
third Friday of January 2008

 When the IBM stock exceeds the option strike price of

90, say Rs 95, the option holder can call away the 100
shares from the option writer for Rs 90 per share and
reap Rs 5 per share profit.
 Call Options
 A call option is the right to buy or call away a given quantity
of underlying asset at a predetermined price, called the strike
price or exercise price, on or before a specific date
 The writer of the call option must sell the shares if and when
the holder chooses to use the call option
 The holders of the call are not obligated to buy the shares;
rather they have the option to buy and will do so if it is
beneficial
 When spot price is above the strike price, exercising the call
option is profitable for the holder and the option is said to be
in the money
 If spot and strike prices are same, the option is at the money
 when the strike price exceeds the market price of the
underlying asset, the option is termed out of money
Pay-off for Call Option Holder
Pay-off
Pay-off function

0 K S1 S2 Spot price of
underlying asset (S)
C

K: Strike/Exercise Price
C: Option Price/Premium
π = Si – K – C, i = 1, 2
Pay-off for Call Option Writer
Pay-off K: Strike/Exercise Price
C: Option Price/Premium

0 K S1 S2 Spot price of
π underlying asset (S)

Pay-off function
Example: Put Option
 A put option gives the right to sell 100 IBM stocks with
strike price of Rs 90 per share becomes profitable
when the market price of IBM stocks fall below Rs 90.

 For instance, a stock price of Rs 80 would give a profit

of Rs 10 per share.
Put Option
 A put option gives the holder the right but not the obligation
to sell the underlying asset at a predetermined price on or
before a fixed date
 The holder can ‘put’ the asset in the hands of the option
writer
 The writer is obliged to buy the shares should the holder
choose to sell them
 The put option is in the money when the option’s strike price
is above the market price
 It is out of money when strike price is below the market price
 Only the option writer is required to post margin with a
clearing corporation
Pay-off for Put Option Holder
Pay-off K: Strike/Exercise Price
P: Option Price/Premium
π
π = K – Si – P, i = 1, 2

0 S1 K Spot price of
P underlying asset (S)
Pay-off function
Pay-off for Put Option Writer
Pay-off

Pay-off function
P

0
S1 K Spot price of
Underlying asset (S)

π = K – Si + P
K: Strike Price
P: Put price/premium
Types of Calls and Puts
 American options can be exercised on any date from
the time they are written till they expire
 American option holders during the holding period can
 continue to hold the option,
 sell the option to someone else or
 exercise the option
 European options can be exercised only on the day of
expiration
 European option holders during the holding period can
 continue to hold the option,
 sell the option to someone else
Options: How they work
 An investor instructs a broker to buy one April call option
contract (100 shares) on Intel with a strike price of $20.
 The broker will relay these instructions to a trader who will
then find another trader who wants to sell one April call
contract on Intel with a strike price of $20.
 Suppose the call price is $1.65 per share. Therefore, the
investor must arrange for $165 to be remitted to the
exchange through the broker and the exchange will arrange
for this amount to be passed on to the party on the other
side of the transaction.
 If the price of Intel shares does not rise above $20 per share
before the expiration date the option is not exercised and
the investor looses $165. But if the share price rises to say
$25, then the investor makes a gain of $500 - $165 = $335
 Options: How they work
 Alternatively, one can buy put option contract with a
strike price of $17.5

 Put price is $0.725; one buys 1 contract of 100 shares

 If spot price remains higher than strike, put is not

exercised

 Loss = $72.5

 If spot price = $15, then profit = ($2.5×100) – 72.5 = 177.5

 Functions of Options
 Options transfer risk from the buyer to the seller
 They can be used for both hedging and speculation
 Hedging:
 A hedger who wants to purchase an asset in future, a call option
ensures that the cost of buying the asset won’t rise above the strike
price
 A hedger who plans to sell an asset in future, a put option ensures
that the price at which the asset can be sold will not go below the
strike price
 Insurance contracts are call options sold by insurance companies
with strike price zero
 For a speculator a call option will be in the money when betting
on a fall in interest in future
 For a speculator a put option will be in the money when betting
on a rise in interest in future
 Example: Speculation through Options
 If you are expecting interest rate to fall, you can
 Buy bonds from the spot market and sell later,
Or
 Buy futures contract,
Or
 Buy call options
 If interest rate does not fall, losses are minimum with
options
 However, sometimes gains and losses could be more with
options
 Who writes Options?
 Speculators – for a fee they are willing to take the risk and
bet that prices will not move against them
 Market makers - are primarily dealers who engage in the
regular purchase and sale of underlying asset and are
insured against any losses that may arise
 Options can be bought and sold in many combinations
 Simultaneous purchase of an at the money call and sale of
an at the money put gives the same pay off pattern as the
purchase of a futures contract
 Buy a put and a call at the same strike price, and you have a
bet that pays off only if the underlying asset price moves up
or down significantly.
 Pricing of Options
 Option price = intrinsic value + time value of the option
 Intrinsic value: the value of the option if it is exercised
immediately
 The intrinsic value is the difference between the spot price of
the underlying asset and the strike price.
 If the option is not immediately exercised then intrinsic
value = 0
 For a call option intrinsic value is
 Stock price – Exercise price if Stock price > Exercise price
 Zero otherwise
 For a put option intrinsic value is
 Exercise price – Stock price if Exercise price > Stock price
 Zero otherwise
Pricing of Options
 Time value: relates to the time of the option’s expiration
 It is associated with the probability that the intrinsic
value of the option may increase till expiry date
 At expiration value of an option is its intrinsic value and
time value is zero.
 The longer the time to expiration, the bigger the likely
pay off.
 For example, if a stock has spot price of Rs 110 and its call
options have a strike price of Rs 100, then the intrinsic
value is Rs 10. If the option is priced as Rs 12, the time
value is Rs 2.
 An Example of Time Value of Option
 Consider an European at-the-money call option with strike
price of $100 that will expire in 3 months. The stock price
has equal probability of rising or falling by $10 each month.
The expected pay off from time value is

Possible outcomes
Months
1 2 3 4 5 6 7 8
1st +10 +10 +10 +10 -10 -10 -10 -10
2nd +10 -10 -10 +10 +10 -10 -10 +10
3rd +10 +10 -10 -10 +10 +10 -10 -10
Payoffs 30 10 -10 10 10 -10 -30 -10
Volatility in the Prices of
Underlying Asset
 The likelihood that an option will pay off depends on
the volatility or standard deviation of the price of the
underlying asset
 If there is no volatility of a stock price, i.e. the price is
fixed, then no one is going to pay for the option since it
will never pay off
 Whenever the price rises higher, the call option’s value
increases
IBM Puts and Calls on Feb 20, 2012
Stock Price at Close = 99.35
A. April Expiration
Strike Calls Puts
Price Intrinsic Time Value Call Price Intrinsic Time Put Price
Value (IV) (TV) (CP) Value Value
80 19.35 0.85 20.20 0 - -
90 9.35 1.05 10.40 0 0.20 0.20
95 4.35 1.45 5.80 0 0.75 0.75
100 0 2.55 2.55 0.65 1.70 2.35
105 0 0.75 0.75 5.65 0.15 5.80
110 0 0.15 0.15 10.65 - -
B. Strike Price of 95
Expiration month Calls Puts
IV TV CP IV TV PP
April 4.35 1.45 5.80 0 0.75 0.75
July 4.35 3.35 7.70 0 1.75 1.75
October 4.35 5.05 9.4 0 2.60 2.60
Swaps
 A swap is an agreement between two companies to
exchange cash flows in future
 The agreement defines the dates of cash flows and the
way in which they are to be calculated
 Usually, the calculation of cash flows involves the
future value of an interest rate, an exchange rate or
other market variable
 The most common type of swap is a ‘plain vanilla’
interest rate swap
 Plain Vanilla Interest Rate Swap
 A company agrees to pay cash flows at a predetermined
fixed interest rate on a notional principal for a number of
years.

 In return, it receives interest at a floating rate on the same

notional principal for the same period of time
 Example
 3-year swap between Microsoft and Intel on March 5, 2010
 Microsoft agrees to pay Intel at an interest rate of 5 percent
per annum on a notional principal of $100 million and in
return Intel agrees to pay Microsoft the 6-month LIBOR on
the same principal
Date of Fixed rate Floating rate Floating rate Net transfer
exchange payment payment from
Microsoft
Sept. 5, 2010 $2.5 million 4.2% on $2.1 million -$0.4 million
March 5, 2010
March 5, 2011 $2.5 million 4.8% on Sep $2.4 million -$0.1 million
5, 2010
Sept. 5, 2011 $2.5 million 5.1 % on $2.55 million +$0.05 million
March 2011
Swaps for Transforming Liability
 For Microsoft a floating rate loan could be transformed
into a fixed rate loan
 Suppose it borrows $100 million at a floating rate of
LIBOR plus 10 basis points and then gets into the swap
 The cash flows are:
 It pays LIBOR plus 0.1 to outside lender
 It receives LIBOR under the swap
 It pays 5% under the swap
 The net cash outflow is 5.1%
 Swaps for Transforming Liability
 Similarly, for Intel a fixed rate loan can be transformed
into a floating rate loan
 Suppose, Intel has a 3-year $100 million loan outstanding
on which it pays 5.2%
 The cash flows are
 It pays 5.2% to outside lender
 It receives 5% under the swap
 It pays LIBOR under the swap
 The net cash outflow is LIBOR plus 0.2 percent.
 Swaps for Transforming Assets
 Suppose Microsoft owns bonds worth $100 million which
provides interest at 4.7% per annum over the next three
years
 After the swap agreement, cash flows are
 It receives fixed interest payment at 4.7%
 It pays fixed interest payment at 5% under the swap
 It receives floating interest payment at LIBOR
 The net cash flows it receives is LIBOR minus 0.3 percent
 This transforms a fixed interest rate asset into a floating
interest rate asset.
 Swaps for Transforming Assets
 Similarly for Intel swap can transform an asset earning a
floating rate of interest into an asset earning a fixed rate of
interest
 Suppose, Intel has an investment of $100 million that yields
LIBOR minus 20 basis points
 The swap generates the following cash flows:
 It receives LIBOR minus 0.2 from outsider
 It pays LIBOR under the swap
 It receives 5% under the swap
 It receives a net cash inflow of 4.8 percent
Financial Intermediary
 Usually a financial intermediary acts as a counterparty
to the parties in a swap
 The financial intermediary earns a fee of 0.03-0.04% of
the notional principal on a pair of offsetting
transactions
 If one company defaults, the financial intermediary
has to honor the agreement with the other company
 Financial institutions act as market makers and opt for
warehousing swaps
Example: Quotes for Plain Vanilla US$
Swaps
Maturity Bid p.a. Offer p.a. Swap rate
(years) p.a.
2 6.03 6.06 6.045
3 6.21 6.24 6.225
4 6.35 6.39 6.370
5 6.47 6.51 6.490
7 6.65 6.68 6.665
10 6.83 6.87 6.850
The comparative Advantage Argument
 The argument explains the popularity of swaps
 A company would borrow from the market where it has a
comparative advantage
 Consider 2 companies AAA and BBB, where their name
suggests their credit ratings.
 The interest rate offered to them at fixed and floating rate
markets are
Fixed rate Floating rate
AAA 4.0% 6-month LIBOR – 0.1%
BBB 5.2% 6-month LIBOR + 0.6%
 AAA & BBB borrow from fixed rate and floating rate
markets, respectively
The Comparative Advantage Argument
 If they get into a swap where AAA pays LIBOR and receives
4.35% from BBB, then
 AAA’s cash flows
 It pays 4% to outsider
 It receives 4.35% from BBB under the swap
 It pays LIBOR under the swap
 AAA’s net cash outflow is LIBOR minus .35 which is lower
than the rate offered to him in the floating rate market
 BBB’s cash flows
 It pays LIBOR plus 0.6
 It receives LIBOR under the swap
 It pays 4.35% under the swap
 BBB’s net cash outflow is 4.95% which is lower than 5.2%
Credit Default Swap
 The most common type of credit derivatives
 Traded in OTC market
 The structure:

Protection Seller Premium Payment Protection Buyer

S B

Default Payment

Reference Entity
R Total Return –
Credit Loss
CDS: Features
 The maturity of the swap does not need to match the
maturity of the reference asset.
 It is common in the CDS market that the premium amount
is decided as a percentage of the value of the reference
asset.
 This percentage is usually called credit spread.
 Other Swaps
 Currency Swap
 Currency swap in its simplest form involves exchanging
principal and interest payments in one currency for interest
and principal payments in another currency.
 It could be fixed-for-fixed or fixed-for-floating currency swap
 Equity Swap
 Here the total returns (dividends plus capital gains) realized on
an equity index is exchanged for either a fixed or floating rate of
interest
 It is used by portfolio managers to convert return from a fixed
or floating investments to the returns from investing in an
equity index and vice versa
Problems
 What kind of an option should you purchase if you
anticipate selling $1 million of Treasury bonds in one
year and wish to hedge against the risk of interest rate
increase?
 You sell a bond futures contract and one day later the
clearinghouse inform you that it had credited funds to
your margin account. What happened to interest rates
over the day?
 Problem
 Consider an American call option with spot and strike
prices at 91 and 100, and it expires in 2 months. If spot
price is expected to increase or decrease every month
by Rs 5 with equal probability
 Calculate the price of the call option. Calculate the intrinsic
and time value separately.
 Calculate the option price if it is an American put option;
other information remains the same.
 How option price will vary if it is a European option?
Calculate the prices for both call and put options.
 Calculate option price for American call option if spot price
has equal chance of moving up or down by 10 percent and
the option expires in 1 month.
 Problems
 Of the following options, which one you would expect to
have the highest option price?
 An European 3-month put option on a stock whose market
price is $90 where the strike price is $100. The monthly
standard deviation of the stock price over the past five years
have been 15 percent.
 An European 3-month put option on a stock whose market
price is $115 where the strike price is $100. The monthly
standard deviation of the stock price over the past five years
have been 15 percent.
 An European 1-month at-the-money put option on a stock
whose market price is $100. The monthly standard deviation
of the stock price over the past five years have been 15
percent.
Problems
 Suppose you have $8000 to invest and you use the futures
market to leverage your exposure to the copper market.
The future price of copper is $3 a pound and the margin
requirement for a futures contract for 25000 pounds of
copper is $8000.
 If you expect the copper price to go up in future what would
be your strategy/position in the futures market?
 Calculate your return if copper price rise to $3.1 a pound
 How does it compare with the return you would have made
if you had simply purchased $8000 worth of copper and sold
later when the price goes up?
 Compare the risk involved in each of these strategies
Problems
 You are given the following information on 3 firms.
Firms A and B want to be exposed to floating interest
rate while firm C would prefer to pay a fixed interest
rate. Which pair(s) of firms (if any) should borrow in
the market they do not want and then enter into a
fixed-for-floating interest rate swap.
Fixed rate Floating rate

Firm A 7% LIBOR+50 bps

Firm B 12% LIBOR+150 bps

Firm C 10% LIBOR+150 bps

Problem
 Basis swaps are swaps where both payment streams are
based on floating interest rates. Why might anyone be
interested in entering a floating-for-floating interest
rate?