ii sem derivatives (1)

7/29/2019 II Sem Derivatives (1)

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Derivatives

Derivatives are financial products whosevalue is derived from the value of

underlying.

Underlying can be shares, commodities,bonds, currency, index, cost of living,weather, freight, electricity, LTC or any

other thing.1


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DERIVATIVES

Derivatives

Forwards Futures Options Swaps


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FORWARD CONTRACT

An agreement to buy or sell something on a specifieddate for a specific price decided at the time of

entering in to contract.

Features of a forward contract Bilateral Contract

Custom designed

Counter party risk

Settlement by delivery on expiry date

Low liquidity

Reversing trade is difficult


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PROBLEMS OF FORWARD CONTRACT

Lack of centralization of trading

Illiquidity

Counterparty risk risk of default


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PAY OFF FOR BUYER AND SELLER

Long position Shortposition


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FUTURES CONTRACT

A futures contract is a promise to buy or sell an asset/goodat a

certain time in the future for a certain price.

Features of futures contract Traded on the Exchange

Standardized contract

No counter party risk

High liquidity (any time it can be closed)


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FUTURES TERMINOLOGIES

Spot price Futures price

Contract cycle

Expiry date

Margin money

Marking to market

Open interest

Basis


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FORWARD VS FUTURES

1. Customized contract

2. Traded off the Exchange

3. No margin money

4. Counter party risk

5. Settlement on expiry

1. Standardized contract

2. On the Exchange

3. Margin money exists

4. No counter party risk

5. Daily settlement & Finalsettlement


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CASH MARKET VS FUTURES

MARKET

1.Actual assets are traded

2. One should have it tosell it

3. Settlement isimmediate

4. No Margin money

5. Full payment6. Actual delivery ofassets

1. Standardized contractsare traded

2. Not necessary

3. On expiry date or before

4. There is margin money

5. No Payment

6. Actual delivery is not

necessary


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Positions in the Futures Market

NowFirst Leg(1)

Before ExpirySecond Leg(2)

BUY (OPEN) SELL (CLOSE)

SELL (OPEN) BUY (CLOSE)


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EXAMPLEDays Settlement

price (RS.)

Transaction Profit/Loss

(Rs.)1 9500 Buy (Open)

2 9600

3 9550

4 9650 Sell (Close) + 150

5 9700

6 9600

7 9800 Sell (Open)

8 9700

9 9850

10 9700 Buy (Close) + 100


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PROCESS OF MARKING TO MARKET

Trade price Rs.6450

Day Daily

settlement

price

P/L to the

long

P/L to the

short

1 6500 +50 -50

2 6600 + 100 -100

3 6800 + 200 -200

4 6600 - 200 +200

5 6700 + 100 -100

Total + 250 - 250


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FUTURES PRICE

FP is determined in the same way as cash marketprices on the basis of demand and supply (after allthey are the same assets)

Futures price are generally more than the cash pricedue to cost of carry

Futures price converges with the spot price on expiry

There is interrelationship between cash price and

futures price Open-High-Low-Closing price-Volume-OI

Settlement price-Daily-Final

Change in price


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CONVERGENCE OF FUTURES PRICE

TO SPOT PRICE ON EXPIRY


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ARBITRAGE

Actual futures price must be equal totheoretical futures price

MIS-PRICING

Futures price > Theoretical Futures price

Futures price < Theoretical Futures price

Arbitrage results in:

Zero risk

Zero investment Positive profit


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EXAMPLE: COST OF CARRY

Cash Price Rs.100

Futures Price Rs.105 (6months to expiry)

Interest cost Rs. 100 X 0.10 X 6/12 = 5

Futures Price = Cash Price + Cost of Carry

105 = 100 + 5

STRATEGY WHEN FUTURE PRICE IS RICH


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Transactions

March 1,

Sell August Futures contract @ Rs. 110

Borrow Rs. 100 at 10% p.a. for 6 months

Buy the asset in the cash market

August 30,

Deliver the goods in the futures market and

Receive payment from the futures market

Repay loan with interest (100 + 5)

Arbitrageprofit

Cash Flow

(Rs.)-------

+ 100

- 100

---------00

---------

+ 110- 105

----------

5.00

----------


Buy in the spot market and sell in the futures market

Cash Price=Rs.100 and FP =Rs.110



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Transactions

March 1,Sell August Futures contract @ Rs. 110

Borrow Rs. 100 at 10% p.a. for 6 months

Buy the asset in the cash market

August 30,

Buy August Futures @Rs. 200

Payoff from futures

Sell the asset in the cash market @Rs.200

Repay the loan with interest

Arbitrage

profit

Cash Flow

(Rs.)-------

+ 100

- 100

---------00

---------

-90

+200-105

----------

+5

-------------


Buy in the spot market and sell in the futures market


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REVERSE ARBITRAGEWhen Futures price is poor compared to cash price

Market information

Cash price of the asset on march 1, Rs. 100 Per k.g.

August Futures price Rs. 102 Per k.g.

Interest rate 10 % p.a.

Theoretical futures price Rs. 100 + 5 = 105


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STRATEGY WHEN FUTURE PRICE IS POORBuy in the futures and sell in the cash market

TransactionsMarch 1,

Buy August Futures contract @ Rs. 102

per k.g.

Borrow pepper & sell it in the cash marketInvest the proceeds at 10 % p.a.

August 30,

Receive from the investment (100+5 )

Take delivery in futures market and pay

Repay pepper to the lender

Arbitrage profit

Cash Flow(Rs.)

-------

+ 100

- 100---------00

---------

+ 105

- 102

----------

3.00

----------


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STRATEGY WHEN FUTURE PRICE IS POORBuy in the futures and sell in the cash market

TransactionsMarch 1,

Buy August Futures contract @ Rs. 102 per

k.g.

Borrow pepper & sell it in the cash marketInvest the proceeds at 10 % p.a.

August 30,

Receive from the investment (100+5 )

Sell August Futures @150

Payoff from August Futures(150-102)

Purchase the asset in the cash market and

return

Cash Flow(Rs.)

-------

+ 100

- 100---------00

---------

+ 105

+48

-150

----------

3.00----------


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Types of traders/Uses of forward

contract

Hedgers- Hedging

Speculators- Speculation

Arbitrageurs -Arbitrage


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Hedging

Trading the forward/futures contract for the purpose ofreducing or controlling the price risk is called hedging.

Hedger must have position in both cash and derivativemarkets.

Hedging also reduces the potential gains

Hedging involves taking a position in the derivativescontract that is opposite in the cash market


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Speculation

Bull Buy the futures when you are expecting

an increase in price

Bear

Sell futures when you are expecting adecrease in price


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BULLISH VIEWLONG STOCK FUTURESMay 3, 2012Infosys cash market price Rs.2295

Infosys May Rs.2298

Infosys June Rs.2300

1 contract of 100 sharesBuy price Rs. 2300

Contract value Rs.230,000

Initial margin 20% - Rs. 46,000

Final settlement price Rs. 2400

Contract value Rs. 240,000

Profit or gain Rs. 10000

ROI 10000/46000 = 22% for 2 months or 130 % per annum !!!


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BEARISH VIEWSHORT STOCK FUTURESMay 3, 2012

Infosys cash market price Rs.2300

Infosys May Rs.2296

Infosys June Rs.2300

Market lot 100 shares

Sale price Rs. 2300

Contract value Rs.230,000

Initial margin 20% - Rs. 46,000

Final settlement price Rs. 2000Contract value Rs. 200,000

Profit or gain Rs. 30,000

ROI 30000/46000 = 65% for 2 months or 391 % per annum

!!!


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Settlement of Futures Contract

1. Physical delivery on expiry

2. Offsetting at any time beforeexpiry

3. Cash delivery at expiry


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Mechanics of Trading Futures

1. Signing an agreement and opening a derivativetrading account

2. Depositing the margin money

3. Placing the order & taking long or short position

4. Reversing the trade or giving or taking delivery

5. Settlement of the transaction

Trading shares and Trading futures


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Trading shares and Trading futures

1.Security Trading a/c the with CMbroker

2.Demat a/c is a must

3.Becomes SH of the Company

4.Receives div, notices to AGM etc

5.Must buy before selling

6.Minimum lot is one share

7.Maturity period is not there

1.Futures Trading a/c withderivative broker

2. Not Necessary

3. Does not become

4. Does not receive

5. Not necessary

6. Market lot is specified

7. There is maturity or expiry date.


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Futures Vs Options

1.Linear pay off

2.Both long and short are at risk

3.Price of the asset is determinedby the market forces

4.Buyer and seller need not paypremium

5.Both the parties must depositmargin money

6.Maximum loss to both buyer and

seller ins unlimited7.Futures do not have differentstrike prices

1.Non linear payoff

2. Only short is at risk

3.Price of the option is determinedby market forces

4. Buyer must pay the premium tothe seller

5.Only the seller must pay themargin money

6.Maximum loss to the buyer is

limited to the premium paid.7.Options are available at differentstrike prices.


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OPTIONS: MEANING

An option is a legal contractwhich gives the holder theright to buy or sell aspecific amount of underlying

asset at a fixed price within aspecified period of time.


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POINTS TO REMEMBER

1. Legal Contract2. Buyer and Seller of the option contract

3. Option Exchange OTC

4. Buyer has a right to buy / sell the asset

5. Seller has the obligation to buy / sell

6. Buyer must pay the premium to the seller

7. Contract should be completed within or onexpiry of the contract


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OPTIONS : TYPES

Options

Call Option Put Option

Buyer Seller Buyer Seller


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OPTIONS TERMINOLOGY

1. Call Option

2. Put Option

3. American Option

4. European Option5. Option Premium

6. Strike/Exercise Price

7. Expiry date8. Exercise date

9. Option holder

10. Option seller/writer

11. Option series

12. In the money option13. At the money option

14. Out of the money option

15. Deep ITM and OTM

16. Open interest

17. Assignment


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OPTION POSITIONS

Buy call Buy put

Write callWrite put


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PROFITABILITY OF OPTIONS

S=Stock price & x= exercise price

Price Call Option Put Option

S > X In the Money Out of the Money

S = XAt the Money At the Money

S < XOut of theMoney

In the Money


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Stock

Price (S)

Strike

Price (X)

Condition

s

Status for

call

Status for

put

270 360

300 360

360 360

400 360

450 360

500 360

EXERCISE FOR OTM, ITM & ATM


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Stock

Price (S)

Strike

Price (X)

Condition Status for

call

Status for

put

270 360 S < X OTM ITM

300 360 S < X OTM ITM

360 360 S = X ATM ATM

400 360 S > X ITM OTM

450 360 S > X ITM OTM

500 360 S > X ITM OTM

EXERCISE FOR OTM, ITM & ATM


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ATTITUDES OF BUYERS & SELLERS

1. Call Option Buyer

Bullish

2. Call Option Seller Bearish

3. Put Option Buyer Bearish

4. Put Option Seller Bullish


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OPTIONS TO OPTION HOLDERS

(BUYERS)

1. Do nothing till expiry day

2. Close out the position by reversing the trade

3. Exercise the option if it is American type


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Asset: Nifty-CE-4880-JulyAsset: Nifty-CE-4800-July

Option type: European

Strike price : 4800

Market lot : 50 times index

Option premium : Rs. 50 X 96= 4800

Nifty at expiry : 5200

Gross profit : 50 X400 = 20000

Less Premium : Rs. 4800

Brokerage (App.) Rs. 200

Net gain Rs. 15000

ROI : 15000 / 4800 =312.50% for 2 months or 1875% P.A


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Nifty-PE-4880-JulyAsset: Nifty-PE-4880-July

Option type: European

Strike price : 4880

Market lot : 50 times index

Option premium : Rs. 50 X 96 = 4800Nifty at expiry : 4480

Gross profit : 50 X 400 = 20,000

Less Premium : Rs. 4800

Brokerage (App.) Rs. 200Net gain Rs. 15,000

ROI : 15,000 /4800 = 312.50% for 2 months or 1875%

P.A

OPTIONS PAYOFF


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OPTIONS PAYOFFCall option buyer (Long Call)

Stock Price Strike Price Premium P/L to the

buyer

500 600 25

525 600 25

550 600 25575 600 25

600 600 25

625 600 25

650 600 25

675 600 25

700 600 25

OPTIONS PAYOFF


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OPTIONS PAYOFFCall option buyer (Long Call) (in Rs.)


buyer

500 600 25 -25

525 600 25 -25

550 600 25 -25575 600 25 -25

600 600 25 -25

625 600 25 00

650 600 25 25

675 600 25 50

700 600 25 75


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OPTIONS PAYOFFCall option Buyer (Long Call)

OPTIONS PAYOFF


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OPTIONS PAYOFFCall option Seller (Short Call)


seller

500 600 25

525 600 25

550 600 25575 600 25

600 600 25

625 600 25

650 600 25

675 600 25

700 600 25

OPTIONS PAYOFF


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OPTIONS PAYOFFCall option Seller (Short Call) (Rs.)


seller

500 600 25 25

525 600 25 25

550 600 25 25575 600 25 25

600 600 25 25

625 600 25 00

650 600 25 -25

675 600 25 -50

700 600 25 -75


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OPTIONS PAYOFFCall option Seller (Short Call)

Options Payoff


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Options PayoffPut option buyer (Long Put) (in Rs.)


buyer

500 600 25

525 600 25

550 600 25575 600 25

600 600 25

625 600 25

650 600 25

675 600 25

700 600 25

OPTIONS PAYOFF


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OPTIONS PAYOFFPut option buyer (Long Put)


buyer

500 600 25 75

525 600 25 50

550 600 25 25575 600 25 00

600 600 25 -25

625 600 25 -25

650 600 25 -25

675 600 25 -25

700 600 25 -25


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OPTIONS PAYOFFPut option buyer (Long Put)

OPTIONS PAYOFF


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OPTIONS PAYOFFPut option writer (Short Put)


buyer

500 600 25

525 600 25

550 600 25575 600 25

600 600 25

625 600 25

650 600 25

675 600 25

700 600 25

OPTIONS PAYOFF


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buyer

500 600 25 -75

525 600 25 -50

550 600 25 -25575 600 25 00

600 600 25 25

625 600 25 25

650 600 25 25

675 600 25 25

700 600 25 25


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INDEX OPTIONS


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INDEX OPTIONSNifty

Contract specificationsContract size : 50 Nifty

Style : European

Price band : Not Applicable

Trading cycle : 3 months, 3 contracts

Near, Next and Far month

New contract: Next day of the expiry date

Expiry date: Last Thursday of the 3rd monthSettlement : Cash Settlement on T+1 basis


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Stock options

Asset: Suzlon-CE-June-30Option type: European

Strike price : 20

Market lot : 8000 shares

Option premium : Rs. 2 X 8000 = 16000Suzlon at expiry : 30

Gross profit : 10 X8000 = 80,000

Less Premium : Rs. 16,000

Brokerage (App.) Rs. 200

Net gain Rs. 64,000

ROI : 64000 / 16000 =400%p.m


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Stock option

Asset: P E- Suzlon- JuneOption type: European

Strike price : 20

Market lot : 8000 shares

Option premium : Rs. 2 X 8000 = 16000

Suzlon at expiry : 15

Gross profit : 5 X8000 = 40,000

Less Premium : Rs. 16,000Brokerage (App.) Rs. 200

Net gain Rs. 24,000

ROI : 24000 / 16000 =150%p.m


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Introduction to swaps Swaps are private agreements between 2 parties to exchange cash

flows in the future according to prearranged formula.

Started from early 1980s

In 1984 ONGC entered in to swap with consortium of foreign banks tohedge interest rate risk (foreign jurisdiction).

RBI permitted swaps in 1995on a case by case basis.

RBI permitted banks to enter in to swap and report such deals from1999

In 2005 finance minister allowed the swap contract by amending SCRAin parliament.

58


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Types of Swaps

Commodity swap

Equity swap

Interest rate swap

Currency swap

Credit default swap

COMMODITY SWAP


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COMMODITY SWAP

FARMER USER

Market Price

Rs. 120

FARMER USER FARMER USER

-150

+120

+ 150

-120

-60

+120

+60

-120- 30 + 30 + 60 - 60

If the price is Rs.150 If the price is Rs. 60

EQUITY SWAP


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A (Equity) B( Debt)

Variable return

Fixed return (10%)

When the variable return is

40% and -10%

A B A B

Receives in cash market

Pays under swap

Receives under swap

+40%

-40%

+10%

+10%

-10%

+40%

-10%

+10%

+10%

+10%

-10%

-10%

Net cash flow +10% +40% +10% -10%

Position of variable return payer and fixed return payer

EquityInvt.

DebtInvt.

I t d ti t I t t R t S


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Introduction to Interest Rate Swap Definition: A contract which involves two counter parties to exchange

over an agreed period, two streams of interest payments, each based ona different kind of interest rate, for a particular notional amount.

Contract between two parties

Notional principal amount

One party pays fixed rate and receives floating rate

The other party pays floating rate and receives fixed rate

Fixed rate remains the same and floating rate changes

Interest amount is exchanged for several future dates


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Fixed or Floating Rate?

Borrow atFixed Rate

Borrow atFloating Rate

Risk of fall ininterest rate

Benefit ifinterest raterises

Risk of riseininterest rate

Benefit fromfall inInterest rate

Low risk if theinterest rates are near thebottom of a cycle

Low risk if theInterest rates are

At the top of a cycle

I t t R t S


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Interest Rate Swap

A borrowed at fixed rate and B at floating rate

A BMIBOR

7 %

A B

- 7% Fixed

+ 7% Fixed

- MIBOR

- MIBOR

+ MIBOR

- 7 % Fixed

- MIBOR - 7 %

-7 % -MIBOR

Transformation of assets and


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Transformation of assets andliabilities

IRS can be used to transform

1. Fixed rate loan in to floating rate loan

2. Floating rate loan in to fixed rate loan

3. Fixed rate investments in to floating rate investments

4. Floating rate investments in to fixed rate investments

T f i Fl ti R t L i t Fi d R t L


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Transforming Floating Rate Loan in to Fixed Rate Loan

The company must enter in to swap as a floating rate payer

After the swap cash flows are as below

1. Pays floating rate under loan contract

2. Receives floating rate under swap contract

3. Pays fixed rate under swap contract

The above 3 cash flows net out as a floating rate loan

Company X Company Y

Floating rate loan Pays fixed rate under swap

Receives floating rate under swap

T f i fi d t l i t fl ti t l


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Transforming fixed rate loan in to floating rate loan

The company must enter in to swap as a floating rate payer


1. Pays fixed rate under loan contract

2. Receives fixed rate under swap contract

3. Pays floating rate under swap contract

The above 3 cash flows net out as a floating rate loan

Company X Company Y

10% under loan

Pays floating under swap

Receives fixed 10% under swap

T f i fl i i i fi d


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Transforming floating rate investment in to fixedrate investment

The company must enter in to swap as a floating ratepayer


1. Receives floating rate for its investments

2. Receives fixed rate under swap contract

3. Pays floating rate under swap contract

The above 3 cash flows net out as fixed rateinvestments

Comparative advantage argument


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Comparative advantage argument

AAA wants to borrow floating & BBB wants to borrow fixed rate funds

AAA has comparative advantage in fixed rate market because it need to pay2.5% less than BBB

BBB has comparative advantage in floating rate market because it need to pay0.5% more than AAA

AAA wants floating but borrows fixed and transforms fixed loan in to floatingthrough swap

BBB wants fixed but borrows floating and converts floating in to fixedthrough swap

Rates quoted to them by their banks are:

Fixed Floating

AAA 10% MIBOR+0.50%

BBB 12.50% MIBOR+1.00%

E l C ti Ad t


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Example Comparative Advantage

AAA BBB

Fixed 10%

Libor

10.50%

Libor+1.00%


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Cash Flows to Parties

Cash flows AAA BBB

Payment under loan -10% -LIBOR+1.00%

Receipt under swap

Payment under swap

+10.50%

-LIBOR

+LIBOR

-10.50%

Net payment after swap

Net cost before swap

-LIBOR-0.50%

-LIBOR+0.50%

-11.50%

-12.50%


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Currency Swap

A currency swap is an agreement betweentwo parties to exchange payments or receiptsin one currency for payments or receipts inanother currency.

In an IRS the principal is not exchanged

In a currency swap the principal is exchangedat the beginning and the end of the life of theswap


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Mechanics of currency swap

A (Borrows USD) B (Borrows GBP)

Pays $ principal Receives $ principal

Receives GBP principal Pays GBP principal

Pays GBP interest Receives GBP interest

Receives $ interest Pays $ interest

Receives $ principal Pays $ principal

Pays GBP principal Receives GBP principal

Transforms $ loan in toGBP loan

Transforms GBP loan into $ loan

What happens in a currency swaps


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TIME

$ principalSterlingprincipal

GBP Interest $ Interest




GBP Principal $ Principal

Near valuedate

Periodic intervals

Far valuedate

Exchange of principal at on agreed rate of exchange

Exchange of interest payment at previously agreed rateof interest

Re-exchange of principal at same rate of exchange as for

the original exchange at the near value date

Currency swap( with no exchange of principal at the near value date)


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Exchange of principal at an agreed rate of exchange

TIME

Euro Interest $ Interest





Euro Principal $ Principal

SWAP termbegins

Maturity Exchange of interest payment on specifiedamount of principal

Party A Party B

Euro principal $ principal

Credit default swaps


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Credit default swaps1. Bilateral contract CPB and CPS

2. CPB pays fixed periodic payment to CPS

3. Protection against adverse credit event.

4. Buyer has aright to sell the bond for face value when the credit

event occurs.

5. Payment is expressed as annualized basis point on notional

principal.6. Third party and specific obligation Ref entity and ref

obligation.

7. Credit event triggers the obligation (Bankruptcy, Rating downgrade,

Obligation default etc.)

8. CDS can be settled in cash or physical based on formulaagreed.

9. CDS spread is the % p.a. of notional principal paid for the

protection

10. In credit market, banks quote two way price on CDS (250-260

bps)

C dit d f lt


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Credit default swaps

CPB CPS

Ref entity/obligation

Premium (periodic) X bps per annum.

No credit event

Credit event

Zero

Cr Event payment(CEP)

CEP = Par value recovery value

CASH SETTLEMENT BASIS

ii sem derivatives (1)

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