Derivative MarketFuturesForwardsOptions

What is in today’s lecture?

Introduction to Derivative

Forward and Futures

Various aspects of forwards

Pricing of forward contracts

Financial Derivatives

OptionsOptions

DerivativesIn the last 20 years derivatives have

become increasingly important in the world of finance

In Pakistan derivative market was developed in 2001

Few banks like SCB, UBL and RBS are allowed by the SBP to deal in derivative transactions

SBP regulates the OTC market for ◦Foreign currency options◦Forward rate agreements ◦ Interest rate swaps

DerivativesA derivative can be defined as a

financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables or asset.

Types of DerivativesAmong many variations of

derivative contracts, following are the major types:◦Forward contracts◦Future Contract◦Options

Forward Contract• Definition: 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

• A party assuming to buy the underlying asset is said to have assumed a long-position

• The other party assumes a short-position and agrees to sell the asset

A Real life example

As you know next football world cup will be played in Brazil. Like South Africa did, Brazil will need to construct football stadiums, seating arrangements, parking areas etc which need heavy consumption of cement. Brazil does not have the required amount of cement, it will call many producers of cement to send their quotations to Brazil. If from Pakistan, Lucky cement company is short-listed and approved for export of cement to Brazil at $10 a bag, 500,000 bags by December 2011, it will be an example of forward contract

In the above contract, lucky cement has a short-position

(sold cement now deliverable in future) and Brazil government has a long position

Example continuedThe contract exposes lucky

cement to few risks. ◦If the cost of raw material increases,

it cannot be passed on to the Brazil government

◦If the value of rupee against dollar increases, Lucky cement will receive fewer rupees per dollar

To control these risks, lucky cement should use forward/future contracts (HOW?)

SolutionLucky cement should buy raw

material (coal, oil, chemicals) in advance through future contracts (i.e going long)

Lucky cement should sell dollars derivable in December 2009 (when it will receive them from Brazilian government)

Table

Example-2Suppose on July 20,2007 a US

corporation knows that it will have to pay £1 million in 6 months

Risk: exchange rate fluctuations6 months long forward contract at

an exchange rate of $2.0489/£ (according to the previous table)

The bank has a short forward contract for selling £ at the rate of $2.0489/£ after 6 months

Payoffs from the forward contractsHowever if at the end of 6 months the

spot rate becomes $1.9000/££1 million will be worth$1,900,000 in

the open market whereas under the contract the company will be obligated to buy for $2,048,900

Here the worth of the forward contract will be ($148,900)

The company will be paying $148,900 more for £1 million pounds as compared to the open market

Payoffs from the forward contractsHowever if at the end of 6 months the

spot rate becomes $1.9000/££1 million will be worth$1,900,000 in the

open market whereas under the contract the company will be obligated to buy for $2,048,900

Here the worth of the forward contract will be ($148,900)

The company will be paying $148,900 more for £1 million pounds as compared to the open market

Payoffs from the forward contractsIn general the payoff from the

long forward contract on one unit of an asset is,

 here ST is the spot price and K is the delivery price locked in the forward contract

 this shows that since we need to honor the contract so we buy the asset worth ST at the price K. 

Payoffs from the forward contractsSimilarly the payoff from the short forward

contract on one unit of an asset is,

These payoffs can be negative as well as positive

In the example we considered, K = 2.0489 and the corporation has a long position. When ST = 2.1000, the payoff is $0.0511 per £1, and when ST = $1.900, it is -0.1489 per £1.

Graph for payoffs

Exchange traded markets • A derivatives exchange• A market where individuals trade standardized

contracts that have been defined by the exchange• Exchange standardizes contracts with regard to:• Number of units in one contract (quantity)• Maturity (usually at the end of a month)• Quality/ grade• Delivery place

• Standardization increases liquidity but reduce flexibility• Contracts on exchange are marked-to-market on daily

basis • Margin requirements (usually 5%)• Margin call if margin falls due to losses• Chicago Mercantile Exchange, NYMEX, NCEL in Pakistan

Over the counter marketContracts outside an organized exchange

are traded in over the counter marketIn over the counter market, there is no

standardization, the parties themselves agree on different aspects of the contract

Contracts in OTC are flexible, but not liquidChances of default are comparatively

higher in OTC as contracts are not marked-to-the-market

The aggrieved party can go to court against the defaulting party

In OTC market financial institutions act as market makers

OTC market is larger than the exchanges

Pros and cons of forward contractsPROS

◦ Flexibility

CONS◦ Lack of

marketability ◦ Lack of liquidity ◦ High default risk

Forward prices and spot prices

Consider a non dividend paying stock having a spot price of $60 and the 1 year interest rate prevailing in market is 5%. What should be the forward price for this stock?

Simple this spot price of $60 grosses up by 5% making the forward price equal to $63. this would be the theoretical forward price. Now if the forward market price $67, this indicates that the stock is not fairly priced and the arbitrage can be done. How?

If forward market is $67If the forward market is $58

Future Contracts• The exchange provides a mechanism

that gives the two parties a guarantee that the contract will be honored.

• Futures contracts are traded on organized exchanges that are standardize– the size of the contract,– the grade of the deliverable asset, – the delivery month, –and the delivery location.

• Traders negotiate only over the contract price.

Characteristics of future contractsStandardized Highly liquid Continuously Tradable – tradable even after

bought or sold future contracts are marked to market every

day. Margin requirementsMargin Mechanism (Book Example)Future prices established on the basis of

demand and supply forces If more traders enter as long in the future

contracts than as short than the prices go up and vice versa.

OptionsOption is a right to buy or sell a stated

number of shares(or other assets) within a specified period at a specified price

There are two types of option contracts:◦Put option◦Call option

Put optionA put option gives the holder the right

to sell the underlying asset by a certain date for a certain price.

Options (Contd.)Call Option:A call option gives the holder the

right to buy the underlying asset by a certain date for a certain price.

The price in the contract is known as the exercise price or strike price;

The date in the contract is known as the expiration date or maturity

American and European options

Table: Prices of options

Inferences from the tableThe price of the call option decreases as

the strike price increasesThe price of a put option increases as the

strike price increases Options become valuable as the maturity

increases so the price also increasesNumerical example to buy one April call

option contract on Intel with a strike price of $20.00?

Numerical example to buy one April put option contract on Intel with a strike price of $17.50? (size of 1 contract = 100 shares)

Graphical Representation of profits from option contracts

Participants in Options markets

Buyers of calls……….long call option contract

Sellers of calls……….short call option contracts or call option writer

Buyers of put………..long put option contracts

Sellers of put………..short put option contract

Intention of call option writer………..the prices of underlying assets will decrease

Intention of call option buyer……….the prices of underlying assets will increases

Participants in Options markets (Contd.)Intention of put option

writer………..the prices of underlying assets will increase

Intention of put option buyer……….the prices of underlying assets will decrease

Some more jargons related to optionsIf price of the common stock S

exceeds the exercise price of a call, E, the call is said to be in the money

If the price of common stocks is less than the exercise price, it is said to be out of money

if the price of common stock is equal to the exercise price, it is said to be at the money