LECTURE

Derivatives: An Overview

Topics Forwards and Futures Contracts Options Contracts

Swaps

Forwards and Futures

Forward/Futures Contract
The buyer(long) in a forward/futures contract: acquires a legal obligation to buy an asset (the underlying)
at

some specific future date (maturity/expiry date)

in

an amount (contract size).

and

at a price (the forward/futures price) which is fixed today.

Uses of Forward/Futures Contract

Hedging (removing risk) In Jan. MacDonalds purchases a forward contract for delivery of live cattle in December at price fixed today ~ holds to maturity

Speculation Buy a 3m futures contract today at F0 =$100 and sell after 1m at F=$110 ~ close out contract (no delivery) and profit of $10.
Arbitrage Keeps movement of F in line with S (underlying)

Futures Contracts
1. Contract Exchange Contract Size Grains and Oilseed Corn CBOT 5,000 bu Wheat MCE 1,000 bu Food Cocoa CSCE 10 metric tons Orange NYCTN 15,000 lbs Metals and Petroleum Gold MCE 33.2 troy oz Silver CBOT 5,000 troy oz Livestock and Meat Hogs CME 50,000 lbs Pork Bellies CME 40,000 lbs

2.

3.

4.

Futures Contracts
5. Contract Exchange Foreign Currency British Pound IMM Swiss Franc CME Euro CME Japanese Yen Yen12.5m
6. Index Stock Indices S&P500

Contract Size 62,500 SFr125,000 Euro 125,000

CME

IOM

$500 x

Value Line
Index FTSE100 index Eurotop100 LIFFE

KCBT
LIFFE

$500 x
10 x Euro 20 x index

Futures Contracts
Contract
7.

Exchange

Contract Size

Interest Rates Eurodollar - 90 day Euromark US T-Bills IMM IMM

IMM

$ 1,000,000 DM 1,000,000 $ 1,000,000

US T-Bonds CBOT $ 100,000 UK 3m-Sterling Int rate LIFFE 500,000 UK 3m EuroLIBOR LIFFE Euro 1m UK Long Gilt Future LIFFE 100,000

Comparison of Forwards and Futures

FORWARDS Private contract Delivery at expiry FUTURES Traded on an exchange Usually closed out before maturity

Usually one delivery date

No cash paid until expiry

Range of delivery dates

Cash payments Daily( margin)

Negotiable choice of delivery dates, size of contract

Standardised Contract

Options Contracts

Options
Holder has the right to buy or sell an asset (underlying) at some time in the future at a fixed price but she does not have to exercise this right can walk away from the contract if holder wishes

~ latter is key distinction between options and futures/futures contracts.

E.g. In Jan, purchase an option to buy 100 Microsoft shares in September, at a fixed price of $102 What happens in Sept if actual stock price is $90 or $110?

Uses of Options
Insurance (form of hedging) e.g. can insure a minimum selling price for a stock, at maturity of the option contract (e.g. in 6m time), but can also benefit from higher prices should these occur Speculation Can buy an option at a low price and may be able to sell it (before maturity) at a high price ~ close out the position (hence no delivery at maturity)

Arbitrage Keeps option price and price of underlying (e.g. stock) moving (broadly) together (but not one-for-one)

Options
Contract Exchange Contract Size

1.Individual Stocks BOE, NYSE, AMEX, PHSE, LIFFE, SIMEX 2. Index Options S&P500 Index CBOE FTSE100 Index LIFFE NYSE Index NYSE Foreign Currency Options Sterling PHSE Deutsche Mark PHSE Japanese Yen PHSE Canadian Dollar PHSE Swiss Franc PHSE

Usually 100 stocks $500 x index 10 per index point $500 x index GBP 31,250 DEM62,500 JPY6.25m CND50,000 CHF62,500

Options
Contract Exchange Contract Size

3.Options on Futures Contracts Options on interest rate futures: Eurodollars IMM $1m US T-Bills IMM $1m US T-Bond CBOT $100,000 3-month EuroLIBOR LIFFE as for futures UK Long Gilt LIFFE as for futures Options on index futures: S&P500 Index IOM $500 x premium Nikkei 225 IOM $5 x premium Most commodities (agriculture and metals) on which there are futures contracts (see above). CBOT,CME,KCBT, COMEX,CTN The same as in the futures contract

Call Option
A European call option gives the holder (the long) the right (but not an obligation)
to

purchase the underlying asset at a specified future date (known as the expiration, expiry or maturity date)
for

a certain price (the exercise or strike price)

and

in an amount (contract size) which is fixed in advance.

this privilege you pay today, the call premium/price.

For

Figure 1.1 : Buy one European Call Option

Strike price K = $80 Profit

$5
0
Call premium

K = $80 $83 $88 ST

-$3

Figure 1.8 : Leverage from option (on 100 shares)

OPTIONS MARKET (JULY)

Call premium, C = $3 Premium paid = $300 Strike price, K = $80

CASH MARKET (JULY)

Spot price, S = $78 Cash paid = $7800

OPTIONS MARKET (OCT.)

Profit = $8 = ($88 - $80) Net profit = $800 - $300 Return = $500/$300 = 167%

CASH MARKET (OCT.)

Profit = $10 = ($88 - $78) Total profit = $1000 Return = $1000/$7800 = 12.8%

Figure 1.2 : Sell (write) a European Call Option

Strike price K = $80 Profit

$3
Call premium

0 -$5

$83 K = $80 $88 ST

Put Option
A European put option gives the holder (the long) the right (but not an obligation)
to

sell the underlying asset at a specified future date (known as the expiration, expiry or maturity date)
for

a certain price (the exercise or strike price)

and

in an amount (contract size) which is fixed in advance.

this privilege you pay today, the call premium/price.

For

Figure 1.3 : Buy (long) a European Put Option

Strike price K = $70

Profit

$3 0 -$2 $68 $65 K = $70 ST

Put premium

Figure 1.4 : Sell (write) a European Put Option

Strike price K = $70

Profit $2 0 -$3 $65 $68 K = $70

Put premium

ST

Swaps

Figure 1.5 : Liabilities : Using Swaps

Swap A negotiated (OTC) agreement between two parties to exchange cash flows at a set of pre-specified future dates Plain Vanilla Interest Rate Swap M/s A. agrees to pay interest at a floating rate and receive fixed rate payments from the other side of the swap transaction (eg. M/s B) e.g. 5 year swap, with floating rate at 6m LIBOR, with resets every 6 months. Fixed rate is say 5% p.a. Usually the interest payments are in the same currency

Figure 1.5 : Liabilities : Using Swaps

Floating to Fixed: Liability

LIBOR + 0.5% LIBOR

Issue Floating Rate Bond

Firms Swap
6% fixed

Net Payment = 0.5% + 6% = 6.5% (fixed)

Fixed to Floating :Liability

6.2% fixed 6% fixed

Issue Fixed Rate Bond

Firms Swap

LIBOR

Net Payment = 0.2% + LIBOR (floating)

Figure 1.6 : Assets : Using Swaps

Floating to Fixed: Asset

LIBOR - 0.5% LIBOR

Hold Floating Rate Bond

Firms Swap
6% fixed

Net Receipts = 6% - 0.5% = 5.5% (fixed)

Fixed to Floating: Asset

5.7% fixed 6% fixed

Hold Fixed Rate Bond

Firms Swap

LIBOR

Net Receipts = LIBOR - 0.3% (floating)

Figure 1.7 : Swap : financial intermediary

12% fixed

Hold Floating Rate Bond

LIBOR - 1%

Without swap if LIBOR > 13% firms swap makes a loss.

11% fixed

Firms Swap

LIBOR

After swap : Net Receipts = (12% - 11%) + LIBOR - (LIBOR - 1%) = 2% (fixed)

Collateralized

debt

obligation

A type of structured asset backed security(ABS) whose value and payments are derived from a portfolio of fixed income underlying assets. CDOs securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.

Credit Credit

default

swap

default swap (CDS) is a swap contract and agreement in which the protection buyer of the CDS makes a series of payments (often referred to as the CDS "fee" or "spread") to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event. It is a form of reverse trading.

If the reference bond performs without default, the protection buyer pays quarterly payments to the seller until maturity

If the reference bond defaults, the protection seller pays par value of the bond to the buyer, and the buyer physically delivers the bond to the seller

Exchange traded Vs OTC Derivatives Markets Derivatives that trade on an exchange are called exchange traded derivatives.

Privately negotiated derivative contracts are called OTC contracts.

The OTC derivatives markets have the following features compared to exchange traded derivatives:
* The management of counter-party(credit) risk is decentralized and located within individual institutions, * There are no formal centralized limits on individual positions, leverage, or margining, * There are no formal rules for risk and burden sharing * There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and * The OTC contracts are generally not regulated by a regulatory authority and the exchanges self regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance

Regulatory

framework

The trading of derivatives is governed by the provisions contained in the SC(R )A, the SEBI Act, the rules and regulations framed there under and the rules and bye-laws of stock exchanges.

Securities Contracts( Regulation) Act,1956

Securities and Exchange board of India act,1992

Securities Contracts( Regulation) Act,1956 *This is the principal act which governs the trading of securities in India. * Aims at preventing undesirable transactions in securities by regulating the business of dealing therein and by providing for certain other matters connected therein.

Securities and Exchange board of India act,1992 * SEBI act,1992 provides for the establishment of Securities and Exchange Board of India(SEBI) with statutory powers for a) protesting the interests of investors in securities b) promoting the development of the securities market c) regulating the securities market

Regulation for Derivatives trading

SEBI set up a 24 member committee under the chairmanship of Dr. L.C. Gupta to develop the appropriate regulatory framework for derivatives trading in India.
On May 11,1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures

1) Any exchange fulfilling the eligibility criteria as prescribed in the L.C. Gupta committee report can apply to SEBI for grant of recognition under section 4 of the SC(R )A, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading /clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange would have to regulate the sales practices of its members and would have to obtain prior approval of SEBI before start of trading in any derivative contract.

2) The exchange should have minimum 50 members. 3) The members of an existing segment of the exchange would not automatically become the members of derivative segment. The members of the derivative segment would need to fulfill the eligibility conditions as laid down by the L.C. Gupta committee. 4) The clearing and settlement of derivatives trades would be through a SEBI approved clearing corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval.

5) Derivatives brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the derivatives clearing corporation/house shall be Rs300 lakh. The net worth of the member shall be computed as follows: * Capital + Free reserves *Less non allowable assets viz., a) Fixed assets b) Pledged securities c) Members card d) Non-allowable securities(unlisted securities) e) Bad deliveries f) Doubtful debts and advances g) Prepaid expenses h) Intangible assets i) 30%

6) The minimum contract value should not be less than 2 lakh. Exchanges have to submit details of the futures contract they propose to introduce. 7) The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange from time to time.

8) The L.C. Gupta committee report requires strict enforcement of Know your customer rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client.

9) The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI

FORWARD CONTRACTS

An agreement to buy or sell an asset at a certain future time for a certain price.

A forward contract is traded in the over the counter market- usually between two financial institutions or between a financial institution and one of its clients. Long position : agrees to buy Short position: agrees to sell

Spot and forward quotes for the USD/GBP exchange rate, July20,2007 Bid Offer Spot 2.0558 2.0562 1 m forward 2.0547 2.0552 3 m forward 2.0526 2.0531 6 m forward 2.0483 2.0489

Investment Assets Vs Consumption Assets

Short Selling

Forward Price for an Investment Asset

Securities Lending & Borrowing Mechanism

Securities lending occurs when a holder lends eligible securities to borrowers in return for a fee. This creates income opportunities for the security holders and also gives rise to increased liquidity that facilitates trading strategies of the borrowers. Security lending began as a means to cover short sales( selling shares without possessing them) but has since evolved as a means of facilitating sophisticated trading strategies.

The legal title of a security is temporarily transferred from a lender to a borrower, however, the lender retains all the benefits of ownership, other than voting rights. The borrower is entitled to make use of the securities as required but is liable to the lender for all benefits( e.g. dividends, interest, or rights). To guarantee the transaction and avoid default on return of the securities, the borrower has to deposit collateral securities( eg cash, bank guarantees, govt securities) with an approved intermediary.

NSCCL & SHCIL, Deutsche Bank, and Reliance Capital are approved intermediaries in India

Participants in SLB mechanism are the clearing and trading members of stock exchanges, corporations, financial institutions and foreign institutional investors, and mutual funds. Banks & individuals can participate as well.

F0 =(S0 - I) erT

Where, I is present value of income provided by the asset

Question
Consider a 10- month forward contract on a stock when the stock price is $50. The risk-free rate of interest(continuously compounded) is 8% per annum for all maturities. Dividends of $0.75 per

share are expected after 3 months, 6 months, and

9 months . Find the forward price.

Solution
The present value of the dividends, I = 0.75e-0.08x3/12 + 0.75e-0.08x6/12 +0.75e-0.08x9/12 =2.162 T=10 months

F0 =(50-2.162)e0.08x10/12 = $51.14

F0 =S0 e(r-q)T
where , q is the average yeild per annum on an asset during the life of a forward contract with continuous compounding

Question
Consider a 6- month forward contract on an asset that is expected to provide income equal to 2% of the asset price once during a 6-month period. The risk free rate of interest(with continuous

compounding) is 10% pa. The asset price is $25.

What is the yield per annum with semiannual compounding? What will be the forward price?

Valuing Forward Contract

f = (F0 - K)e-rT (long fwd contracts) = ( K- F0 )e-rT (Short fwd contracts) where, f : Value of forward Contract today K: the delivery price for a contract that was negotiated some time ago T: The delivery date is T years from today r: The T year risk free interest rate F0 : the forward price that would be applicable if we negotiated the contract today

Question
A long forward Contract on a non-dividend paying stock was entered into some time ago. It currently has 6 months to maturity. The risk free rate of interest(with continuous compounding) is 10% pa,

the stock price is $25, and the delivery price is

$24. Find the value of the Forward Contract.

Solution

So=25
r=0.10 T=0.5 K=24 F0 = 250.1x0.5 = $26.28
The value of the forward contract is f= (26.28-24)-0.1x0.5 = $2.17

Specifications of a futures Contract

Contract Exchange Contract Size 1. Grains and Oilseed Corn CBOT 5,000 bu Wheat MCE 1,000 bu 2. Food Cocoa CSCE 10 metric tons Orange NYCTN 15,000 lbs Metals and Petroleum Gold MCE 33.2 troy oz Silver CBOT 5,000 troy oz Livestock and Meat Hogs CME Pork Bellies CME

3.

4.

50,000 lbs 40,000 lbs

Contract Exchange Contract Size 5. Foreign Currency British Pound IMM 62,500 Swiss Franc CME SFr125,000 Euro CME Euro 125,000 Japanese Yen CME Yen12.5m
6. Stock Indices S&P500 Value Line x Index FTSE100 Eurotop100 index
IOM $500 x Index KCBT $500 10 x index Euro 20 x

LIFFE LIFFE

Convergence of Futures Price to Spot Price

Introduction to futures

Futures Vs Forwards

Basic risk and Hedging practices Using Futures

Daily settlement and Margins

Quotes and Delivery

Cost of Carry models

Stock Index futures

Commodity Futures

Currency futures A binding obligation to buy or sell a particular currency against another at a designated rate of exchange on a specified future date.

Examples of contact size specifications for the few currencies traded in CME:

1)British Pounds- 62,500 as minimum trading quantity. 2) Canadian Dollars- 100,000 as minimum trading quantity 3) Japanese Yen- 12,500,000 as minimum trading quantity 4) Swiss francs- 125000 as minimum trading quantity 5) Australian Dollars- 1,00,000 as minimum trading quantity

Examples of some important future exchanges and currencies traded on these exchanges CME: Chicago Mercantile Exchange

SIMEX: Singapore International Financial Futures Exchange PBT: Philadelphia Board of trade SFE: Sydney Futures Exchange TIFFE: Tokyo International Financial futures Exchange NZFOE: New Zealand Futures and Option Exchange

Hedging With Currency Futures Assume that a US exporter is exporting goods to his German client. On Sep 14,2001, the exporter got the confirmation from the German Client that the payment of Euro 625,000 will be made on Nov 1,2001. Here the US exporter is exposed to the risk due to currency fluctuations. If the Euro depreciates there will be loss on his dollar receivables. To cover the risk the exporter can sell Euro futures contract on the CME.

Working: Sep,14,2001 : Spot rate $/ is 0.4407 December Euro futures contract is available Contract size -> 125,000 rate-> 0.4442 Nov,1,2001: Spot rate $/ is 0.43908

Sell five Dec Euro futures contracts Loss in the Spot Market =$ 275437.5 - $ 274,425= $ 1,012.5

Profit on futures contract= $277,625-$276,612.5 = $1012.5

Normal Backwardation and Contango

When the futures price is below the expected future spot price, the situation is known as NORMAL BACKWARDATION.

When the futures price is above the expected future spot price, the situation is known as CONTANGO.
*Note : Sometimes these terms are used to refer to whether the
futures price is below or above the current spot price, rather than the expected future spot price

DETERMINATION OF FORWARD AND FUTURES PRICES

Investment assets: Three different situations 1. The asset provides no income 2. The asset provides a known income 3. The asset provides a known yield

Summary
Asset Forward/futures price Value of long forward contract with delivery price K S0 - Ke-rT

Provides no income Provides known income present value I :

S0erT (S0 I ) erT

S0 I - Ke-rT

Provides known yield q :

S0e (r-q)T

S0e-qT - Ke-rT

For a Consumption asset, the futures price is F0= S0e(c-y)T

where y is the convenience yield Convenience yield The benefits from holding the physical asset are sometimes referred to as convenience yield provided by. the commodity

Futures prices on Stock Indices

Consider a 3-month futures contract on the Nifty. Suppose that the stocks underlying the index provide a dividend yield of 1% per annum, that the current value of the index is 2,700, and that the

continuously compounded risk free interest rate

is 5% pa. Find the futures price.

Solution

r=0.05 S0=2700 T=0.25 q=0.01

Hence,

F0= 2700e(0.05-0.01)X 0.25=Rs. 2727.16

Calculation of Initial margin for the Naked Options 1) If the investor writes a naked call or put option which is out of the money, the margin is calculated in two ways and higher of these two is deposited as the margin First method (i) Calculate the option premium for 100 shares( each option contract is on 100 shares). (ii) Then compute 0.20(Market value per share)(100) (iii) Then compute the amount by which the contract is out of the money.

Second method Margin = 100XOption premium per share + 0.10(Stocks market price)(100).

Question

An option trader writes a single naked call option. The option premium is Rs 2. The stock price and the exercise price are Rs 52 and Rs 55

respectively. Calculate the margin required.

Solution The option is Rs 3 out of the money. We calculate the margin by both methods. M1 : Option premium for 100 shares is Rs 200. 100 X Option premium per share + 0.20(Stock markets price)(100)- The amount by which the contract is out of the money. We have, (2)(100) + 0.20(52)(100) 100 (55 - 52) = 940 M2: 100X Option premium + 0.10 (Stocks market price) (100) = 200 + 0.10(52)(100) = 720 The initial margin hence is Rs 940.

Question A trader writes a single naked put option at a premium of Rs 3.50. The options exercise price and market price are Rs 32 and Rs 35 respectively. Calculate the margin

Properties of stock options

There are six factors affecting the value of a stock option 1) The current stock price 2) The strike price 3) The expiration date 4) The stock price volatility 5) The risk free interest rate 6) The dividends expectd during the life of the option

** The value of a call option increases as the current stock price, the time to expiration, the volatility, and the risk-free interest rate increase.
** The value of a call decreases as the strike price and expected dividends increase.

** The value of a put increases as the strike price, the time to expiration, the volatility, and the expected dividends increase.
** The value of a put decreases as the current stock price and risk free interest rate increase.

A European call option on a non dividend paying stock must be worth more than max( S0 Ke-rT , 0)
Where , S0 is the stock price K is the strike price r is the risk free interest rate T is time to expiration

When dividends with present value D will be paid

max( S0 D Ke-rT , 0)

A European put option on a non dividend paying stock must be worth more than max (Ke-rT - S0 , 0) When dividends with present value D will be paid max (Ke-rT + D - S0 , 0)

End of Slides