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Financial Derivatives Recap
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20-Jul-15
1
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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2
Financial Derivatives - An Overview 3
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
Financial Derivatives - An Overview 4
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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Financial Derivatives - An Overview 5
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
Financial Derivatives - An Overview 6
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
Financial Derivatives - An Overview 8
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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9
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.
Financial Derivatives - An Overview 10
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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Financial Derivatives - An Overview 11
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
Financial Derivatives - An Overview 12
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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Financial Derivatives - An Overview 13
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.
Financial Derivatives - An Overview
-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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Financial Derivatives - An Overview 15
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.
Financial Derivatives - An Overview 16
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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Financial Derivatives - An Overview 17
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/-
Financial Derivatives - An Overview 18
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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Financial Derivatives - An Overview 19
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
Financial Derivatives - An Overview 20
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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Financial Derivatives - An Overview 21
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
Financial Derivatives - An Overview
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.
20-Jul-15
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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
20-Jul-15
13
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)
Financial Derivatives - An Overview 25