Financial Management

Session -28

Derivatives

What is a Derivative?

A derivative is an instrument whose value depends on, or is derived from, the value of another asset.

Examples: futures, forwards, swaps, options

Derivatives play a key role in transferring risks in the economy

The underlying assets include stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, the weather, etc.

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How Derivatives Are Traded

On exchanges such as the Chicago Board Options Exchange, NSE, MCX, IEX etc.

Through over-the-counter (OTC) markets

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Forward Contracts

A relatively simple derivative is forward contract. It is an agreement to buy or sell an asset at a certain future time for a certain price.

While on Spot contract, which is an agreement to buy or sell an asset today.

The party that has agreed to buy has what is termed a long position

The party that has agreed to sell has what is termed a short position

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Forward Contracts: Example

On May 24, 2010 the treasurer of a corporation enters into a long forward contract to buy 1 million after six months at an exchange rate of 1.4422

This obligates the corporation to pay $1,442,200 for 1 million on November 24, 2010

What are the possible outcomes? A forward contract settlement can occur on a cash or

delivery basis.

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Futures Contracts

Agreement to buy or sell an asset for a certain price at a certain time

Similar to forward contract Whereas a forward contract is traded OTC, a futures

contract is traded on an exchange

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Futures Contracts

Available on a wide range of assets

Exchange traded

Specifications need to be defined: What can be delivered, Where it can be delivered, & When it can be delivered

Settled daily

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Convergence of Futures to Spot

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Time Time

(a) (b)

FuturesPrice

FuturesPrice

Spot Price

Spot Price

Margins

A margin is cash or marketable securities deposited by an investor with his or her broker

The balance in the margin account is adjusted to reflect daily settlement

Margins minimize the possibility of a loss through a default on a contract

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Example of a Futures Trade

An investor takes a long position in 2 December futures contracts on June 5

contract size is 100. futures price is US$1200 initial margin requirement is US$6000/contract maintenance margin is US$4500/contract Suppose you take long position in two contracts

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A Possible Outcome

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Day TradePrice($)

SettlePrice ($)

DailyGain($)

Cumul.Gain ($)

MarginBalance ($)

MarginCall($)

1 1,250.00 12,000

1 1,241.00 1,800 1,800 10,200

2 1,238.30 540 2,340 9,660

.. .. .. ..

6 1,236.20 780 2,760 9,240

7 1,229.90 1,260 4,020 7,980 4,020

8 1,230.80 180 3,840 12,180

.. .. .. ..

16 1,226.90 780 4,620 15,180

Margin Cash Flows When Futures Price Increases

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LongTrader

Broker

ClearingHouseMember

ClearingHouse

ClearingHouseMember

Broker

ShortTrader

Terminology

Open interest: the total number of contracts outstanding equal to number of long positions or number of

short positions Settlement price: the price just before the final

bell each day used for the daily settlement process

Volume of trading: the number of trades in one day

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Terminology

Open interest: the total number of contracts outstanding equal to number of long positions or number of

short positions

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Key Points About Futures They are settled daily

Closing out a futures position involves entering into an offsetting trade

Most contracts are closed out before maturity

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Crude Oil Trading on May 26, 2010

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Open High Low Settle Change Volume OpenInt

Jul2010 70.06 71.70 69.21 71.51 2.76 6,315 388,902

Aug2010 71.25 72.77 70.42 72.54 2.44 3,746 115,305

Dec2010 74.00 75.34 73.17 75.23 2.19 5,055 196,033

Dec2011 77.01 78.59 76.51 78.53 2.00 4,175 100,674

Dec2012 78.50 80.21 78.50 80.18 1.86 1,258 70,126

Delivery

If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract.

the party with the short position chooses about what is delivered, where it is delivered, and when it is delivered from the available alternatives.

A few contracts (for example, those on stock indices and Eurodollars) are settled in cash

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Forward Contracts vs Futures Contracts

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Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cashsettlement usually occurs prior to maturity

FORWARDS FUTURES

Some credit risk Virtually no credit risk

Types of Traders

Hedgers They are generally the commercial producers and

consumers of the traded commodities. They participate in the market to manage their spot market price risk.

Speculators They are traders who speculate on the direction of the

futures prices with the intention of making money. Thus, for the speculators, trading in commodity futures is an investment option.

Arbitrageurs They are traders who buy and sell to make money on price

differentials across different markets.

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Hedging Examples An investor owns 1,000 Microsoft shares currently worth $28

per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

Value of the Microsoft Share with/without hedging

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20,000

25,000

30,000

35,000

40,000

20 25 30 35 40

Value of Holding ($)

Stock Price ($)

No Hedging

Hedging

Speculation Example

An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of 22.50 is $1

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Arbitrage Example

A stock price is quoted as 100 in London and $140 in New York

The current exchange rate is 1.4300 What is the arbitrage opportunity?

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Long & Short Hedges Companies should focus on the main business they

are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables

A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price

A short futures hedge is appropriate when you know you will sell an asset in the future and want to lock in the price

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Long Hedge Suppose that it is now Jan 15. A copper fabricator knows

it will require 100,000 pounds of copper on May 15 to meet a certain contract.

The spot price of copper is 340 cents per pound and the futures price for May delivery is 320 cents per pound.

The fabricator can hedge its position by taking a long position in four futures contracts and closing its position on May 15. Each contract is for delivery of 25,000 pounds of copper.

This strategy has the effect of locking in the price of the required copper at close to 320 cents

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Long HedgeContd

Suppose that the spot price of copper on May 15 proves to be 325 cents per pound

Because the delivery month is May for the futures contract, spot price should be very close to the futures price. Therefore fabricator gains approx.

1000*(3.25-3.20)= $5000

Therefore the net cost = 325000-5000 = $320,000

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Long HedgeContd

Suppose that the spot price of copper on May 15 proves to be 305 cents per pound

Because the delivery month is May for the futures contract, spot price should be very close to the futures price. Therefore fabricator loses approx.

1000*(3.20-3.05)= $15000 On futures contracts it pays 100,000* 3.05

Therefore the net cost = 305000+15000 = $320,000

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Short Hedge Suppose it is May 15 today and that an oil producer

has just negotiated a contract to sell 1m barrels of crude oil. It has been agreed that the price that will apply in the contract is the market price on Aug 15.

Suppose on May 15 the spot price is $60 per barrel and the crude oil futures price for Aug delivery is $59 per barrel, The company can hedge its exposure by shorting 1000 futures contract (each of 1000 barrels).

The effect of this strategy should be to lock in a price close to $59 per barrel.

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Short HedgeContd Suppose that the spot price on Aug 15 proves to be $ 55

per barrel.

The company will realizes $55m for the oil from the sales contract.

Because Aug is the delivery month the futures price would be very close to the spot prices i.e. $55, Therefore company gains from futures

$59-$55=$4 per barrel or 4m

The total amount realized from both the futures and sales contract would be 55m+4m=59m

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Short HedgeContd Suppose that the spot price on Aug 15 proves to be $ 65

per barrel.

The company will realizes $65m for the oil from the sales contract.

Because Aug is the delivery month the futures price would be very close to the spot prices i.e. $65, Therefore company loses from futures

$65-$59=$6 per barrel or 4m

The total amount realized from both the futures and sales contract would be 65m-6m=59m

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Basis Risk

Basis is usually defined as the spot price minus the futures price

Basis risk arises because of the uncertainty about the basis when the hedge is closed out

Ideally the spot price and futures price should be close at the time of maturity but what if they are not?

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Options: Basics

A call is an option to buy A put is an option to sell

A European option can be exercised only at the end of its life

An American option can be exercised at any time

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Option Positions

Long call Long put Short call Short put

For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold

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Long Call

Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months

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30

20

10

05

70 80 90 100

110 120 130

Profit($)

Terminalstockprice($)

Short Call

Profit from writing one European call option: option price = $5, strike price = $100

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30

20

10

05

70 80 90 100

110 120 130

Profit($)

Terminalstockprice($)

Long Put

Profit from buying a European put option: option price = $7, strike price = $70

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30

20

10

0

770605040 80 90 100

Profit($)

Terminalstockprice($)

Short Put

Profit from writing a European put option: option price = $7, strike price = $70

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30

20

10

70

70

605040

80 90 100

Profit($)Terminal

stockprice($)

Thank You!

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