1 financial derivatives recap

20-Jul-15

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Financial Derivatives : A Recap

Financial Derivatives - An Overview 2

Spot Transactions

• In any market transaction, there are three components:

� Price Negotiation

� Settlement (Calculating the amount due from each party),and

� Clearing (Payment of price in exchange of goods)

• If the three steps takes place with ‘no or minimal delay’ i.e. ‘on the spot’, we call it a Spot transaction carried out in Spot or Cash Market.

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Financial Derivatives

• Financial derivative is a financial instrument whose

value is dependent on (derived from) the value of

some other underlying asset or some other financial

price (Interest rate or Index).

• Common Underlying Assets are:

» Stocks » Commodities

» Stock Indices » Foreign Exchange

» Interest rates

• Financial Derivatives may broadly be classified as:

▪ Forward Contracts ▪ Options

▪ Futures Contracts ▪ Swaps


Forward Contracts

• In a Forward Contract, two parties irrevocably agree to buy or sell at a future date at a pre-determined price.

• No exchange of goods or money takes place at the time of entering into a Forward Contract.

• Buyer is obligated to pay for the goods and take delivery on the expiry date and Seller is obligated to deliver goods and receive the payment, irrespective of

the price of the goods on the expiry date.

• Buyer of goods is said to have a “Long” position while the seller has a “Short” position .

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Forward Contracts

• Each Forward Contract is a Unique Contract,

customised to the requirements of the contracting

parties.

• Such contract are Over-the-Counter (OTC) products &

not traded freely.

• Forward Contracts are mostly settled on maturity with

the seller delivering the underlying assets and the

buyer paying the specified price.

• Problems with Forward Contracts:

• Poor Liquidity

• Counter-party Risk


Futures Contract

• Futures contract is an agreement to buy or sell an

asset for a certain price at a certain future date.

• A Futures contract IS a forward contract, except that it

is standardized and hence traded on an Exchange.

• It is characterized by the following:

� Standardization of the Contract

� Traded on Exchange means:� Centralization of Trading on Price-time priority

� Enhanced Liquidity

� Novation by Clearinghouse

� Mark-to-Market (MTM) margining system

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7

Pay-off from a Forward / Futures Contract

Long Position

Market price

Pro

fit/

loss

-6

-4

-2

0

2

4

6

100 101 102 103 104 105 106 107 108 109 110

Short Position

-6

-4

-2

0

2

4

6

100 101 102 103 104 105 106 107 108 109 110

Market priceP

rofi

t/lo

ss


Options Contracts

• Options contract is an agreement between the buyer (holder)& the seller (writer) of the contract, which gives the buyer the right to buy (or sell) without the obligation to buy (or sell) the underlying asset from (to) the seller of the option for a specified price at a specified future date.

• The seller is obligated, under the contract, to perform.

• An option contract, thus, defines the rights of the buyerand the obligations of the seller.

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Calls and Puts

Financial Derivatives - An Overview

Buyer Seller

Call

Option

Has the right to buy the

Asset

Has the Potential

obligation to sell the

Asset, if exercised against

Put

Option

Has the right to sell the

Asset

Has the Potential

obligation to buy the

Asset, if exercised against

• Call Option-, which gives the holder thereof the right to buy an asset for a certain price at a certain future date.

• Put Option-, which gives the holder thereof the right

to sell an asset for a certain price at a certain future

date.


Types of Options

• American Options can be exercised at any time up to

the Expiration date.

• European Options can be exercised only on the

Expiration date.

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Pay-off & Profit(loss) on Long position on Call Option

Terminal

Price

Buy Call @ Rs. 75 for Rs 6.70

Initial Cash Flow (CF0) Exercise/Not Exercise Terminal Cash Flow (CFt) CF0+CFt

67 -6.70 No 0.00 -6.70

68 -6.70 No 0.00 -6.70

69 -6.70 No 0.00 -6.70

70 -6.70 No 0.00 -6.70

71 -6.70 No 0.00 -6.70

72 -6.70 No 0.00 -6.70

73 -6.70 No 0.00 -6.70

74 -6.70 No 0.00 -6.70

75 -6.70 Indifferent 0.00 -6.70

76 -6.70 Yes 1.00 -5.70

77 -6.70 Yes 2.00 -4.70

78 -6.70 Yes 3.00 -3.70

79 -6.70 Yes 4.00 -2.70

80 -6.70 Yes 5.00 -1.70

81 -6.70 Yes 6.00 -0.70

82 -6.70 Yes 7.00 0.30

83 -6.70 Yes 8.00 1.30

84 -6.70 Yes 9.00 2.30

85 -6.70 Yes 10.00 3.30

86 -6.70 Yes 11.00 4.30

87 -6.70 Yes 12.00 5.30

88 -6.70 Yes 13.00 6.30

89 -6.70 Yes 14.00 7.30

90 -6.70 Yes 15.00 8.30


Pay-off & Profit(loss) on Call Option

Buyer of a Call option hopes that the price

of the underlying asset will INCREASE in

the future.

-10

0

10

20

68 70 72 74 76 78 80 82 84 86 88 90

Pro

fit/

(Lo

ss)

Terminal Stock Prices

Buy a Call Option @ 75 for Rs 6.70

-10

-5

0

5

10

68 70 72 74 76 78 80 82 84 86 88 90

Pro

fit/

(Lo

ss)

Stock Prices

Sell a Call option @ Rs. 75 for Rs. 6.70

Limited Profit & unlimited

losses for the Call writer

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Pay-off & Profit/(Loss) on Long position on a Put Option

Terminal

Price

Buy Put @ Rs. 75 for Rs 5.20

Initial Cash Flow (CF0) Exercise/Not Exercise Terminal Cash Flow (CFt) CF0+CFt

68 -5.20 Yes 7.00 1.80

69 -5.20 Yes 6.00 0.80

70 -5.20 Yes 5.00 -0.20

71 -5.20 Yes 4.00 -1.20

72 -5.20 Yes 3.00 -2.20

73 -5.20 Yes 2.00 -3.20

74 -5.20 Yes 1.00 -4.20

75 -5.20 Indifferent 0.00 -5.20

76 -5.20 No 0.00 -5.20

77 -5.20 No 0.00 -5.20

78 -5.20 No 0.00 -5.20

79 -5.20 No 0.00 -5.20

80 -5.20 No 0.00 -5.20

86 -5.20 No 0.00 -5.20

87 -5.20 No 0.00 -5.20

88 -5.20 No 0.00 -5.20

89 -5.20 No 0.00 -5.20

90 -5.20 No 0.00 -5.20

14

Pay-off & Profit/(Loss) on Put Option

Purchaser of a Put option hopes that the

price of the underlying asset will

DECREASE in the future.


-10

-5

0

5

10

15

66 68 70 72 74 76 78 80 82 84 86 88 90Pro

fit/

(Lo

ss)

Stock Prices

Buy a Put Option @ 75 for Rs 5.20

Pay-off

Profit & Loss

-10

-5

0

5

10

66 68 70 72 74 76 78 80 82 84 86 88 90

Pro

fit/

(Lo

ss)

Sell Put @ Rs. 75 for Rs 5.20

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Moneyness of options

• In the money : positive cash flow, if exercised

immediately

• At the money : zero cash flow, if exercised

immediately

• Out of the money : negative cash flow, if exercised

immediately.


Pay-off & Moneyness of Call option purchased

• Suppose you have bought a call option on stock of ABCLimited with an exercise price of Rs. 75/-

• If Spot Price on expiration is: then Call Option is :

�Rs. 80/- In the Money

�Rs. 75/- At Money

�Rs. 70/- Out of Money

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Pay-off & Moneyness of Call option purchased

0

1

2

3

4

5

6

7

8

67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82

Pa

y-o

ff

Stock Prices

In the Money

At the Money

Out of Money

Buy a Call Option at Rs. 75/-


Moneyness of Call option purchased

• A Call option is

• In-the-Money: if the Spot price on expirationis greater than the Exercise price. (ST > X)

• At-the-Money: if the Spot price on expirationis equal to the Exercise price. (ST = X)

• Out-of-Money: if the Spot price on expirationis less than the Exercise price. (ST < X)

• Deep-In-the Money: if ST >> X

• Deep-Out-of-the-Money :if ST << X

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Pay-off and Moneyness of Put option purchased

• Suppose now you buy a Put option on stock of ABCLimited with an exercise price of Rs. 75/-

• If Spot Price on expiration Put Option is :

• Rs. 80/- Out of Money

• Rs. 75/- At Money

• Rs. 70/- In the Money


Pay-off and Moneyness of Put option purchased

0

2

4

6

8

10

12

66 68 70 72 74 76 78 80 82 84 86 88 90

Pa

y-o

ff

Stock Prices

Buy a Put Option @ 75/-

At the Money

In the Money Out of Money

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Moneyness of Put option purchased

• A Put option is

• In-the-Money: if the Spot price/cash price isless than the Exercise price. (ST< X)

• At-the-Money: if the Spot price/cash price isequal to the Exercise price. (ST = X)

• Out-of-Money :if the Spot price/cash is greaterthan the Exercise price. (ST >X)

• Deep-In-the Money: if ST<<X

• Deep-Out-of-the-Money :if ST>>X

22

Long on Call Option vs Long on Futures


Call Option at Rs 75/--20.00

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

20.00

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90Pro

fit/

(Lo

ss)

Stock Prices

Futures at Rs 75/-

If stock price increases, futures contract is more profitable as it

does not entail paying any premium. But if stock price falls

sufficiently, Call option is more profitable, as the call option

holder’s losses are restricted to the premium paid.

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23Financial Derivatives - An Overview

What about:

• Short on Call Option vs. Short on Futures

• Long on Put Option vs. Short on Futures

• Short on Put Option vs. Long on Futures

Evaluate !!!

Hedging Strategies using Futures24

Spot & Derivatives Market in Stocks/Indicies

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Derivatives Products in India

Equities (NSE, BSE, MCX-SX)

• Index Futures & Options

• Individual Stock Futures & Options

Commodities (MCX, ICX, NMCE, NCDEX)

• Futures in 113 commodities

Currencies

• Futures on 4 pairs of currencies :USD; EUR; GBP; JPY.

• Currency options are currently available on USD.

• Swaps & Forwards (OTC)

Interest Rate

• Interest Rate Forwards (OTC)

• Interest Rate Futures – 91 days t-bills & 10 year bonds

� Stock Futures & Options on 144 securities;

� Index Options -European

� Stock Options (initially American, but now European)


1 financial derivatives recap

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