Derivative

Lecture # 1
Section 1
Risk:
Risk is a heart of financial management

To approach portfolio management /financial analyst mitigate the risk factor

Risk Management

Portfolio Insurance Hedging

Diversification

Portfolio Diversification
Risk free
Risk free
Investment in difference stick to minimize the risk factor

Risk seeker: a person who has a preference for risk for extra gain or loss
Risk-averse: Risk-averse people prefer certainty and they don’t like the extra outcomes

Insurance
To mitigate the risk factor through payment

Hedging:
A risk management straight use a limiting or offsetting probability of loss from fluctuation in the
price, hedging is the transfer of risk without buying insurance policy

Derivative
Is crested by the financial market or hedging /Risk management

Finical market is the place which buying and selling the financial securities such as
 Stock
 Bound
 Currencies

Definition
It is a financial instrument that drive its return and value based on some underlying assets

Underling assets.
Under the Derivative
Base on contract.
Derivative base on future

Underling assets
 Stocks
 Commodity
 Currency
Stock and future stock

Stock Future Stock

A(Buyer) B (Seller)
Long Position Short Position
RS Stock 119 RS Stock 125
Contract : Mr A Buy The Stock Rs 125 After 6 Month From Mr.B
After The Maturity (6 Month) The Stock Price Rs 123
Question Arise? Who Bear The Profit /Loss
Loss On A 125-123 Answer 2 (Loss Bear By The Mr.A At Maturity)
Profit On B 125-123 Answer Rs 2

Types of derivative

Types Of Derivative

Forward Contingent
Commitment Claims

Forward commitment
 Forward contracts
 Future contracts
 Swap
Contingent Claims
1. Option

Difference between these

Sr No Future Contract Forward contracts Swap

1 Exchange traded contracts Over the counter Swap is the series of

(proper channel use for the forward contact
contract ) contract
2 Regular contract DE regular contract Successful contract
3 Standardized contracts Customized contract
4 No default risk Default risk exist
5 Clearing House involve No Clearing House involve
6 Pricing will be decided start Pricing will be decided start
of the contract of the contract
7 Similarity Two parties Similarity Two parties
Involvement Involvement
General held until
expiration

Option

Option or Derivative in which payoff accrued if a specific event happen because its option not a
obligation
It is a financial instrument that is one party right but not obligation to buy or sell and underling
assets

Right to Buy Call Option

Right to Cell Put Option

Some Basic Points Regarding Option

Exercise price
The fixed price at which underling can be bought or sold is called exercise price.

Strict price
1. And is determine at the outset (start) of the transactions
2. The action of buying and selling of underling at the exercise price is called exercise the
option
3. Right to acquire this right the buyer of option must pay the price at the start to option
seller, this price is called option premium /option price
4. If option buyer has a right to buy, option seller may obligate to cell
5. If option buyer has right to sell the option seller may be obligated to buy.
6. The option seller received the amount of the option price from the option buyer for his
willingness bear this risk for option both type of contract like over the counter
(customized) and exchange traded contract (standardized)

Purpose of derivative
1. One of the basic and primary functions of derivative is price discovery
2. It improves the market efficiency
3. Risk management
4. Low transactional cost.
Lecture # 2
Hedge Specular Arbitrager Investment
Hedger is the trader Specular is one who Is one who want profit To analysis the
who used derivative as want to earn profit from the price financial
means to offset the from the fluctuation difference in two statement
risk of position in the of price different markets properly as per
assets decide purchase
Have existing Have not No existing risk & sale
risk existing risk
To reduce risk To earn the To earn profit
/to manage risk profit
Loss is Loss is not
possible possible
Chapter no 2
Forward market and contracts
Definition
Forward contract is an agreement b/w two parties in which one partly, the buyer agreed to buy the
form the other party. The seller underline assets at the future date at the price established at the
outset the contracts there fore it is a commitment but two parties to engaged in the transaction at
the later date with the price set in advance

Delivery

Delivery

A (Long) buyer B (short )seller

Cash settlement

Cash settlement

A (Long) buyer B (short )seller

Current price start of the contract 150
Agreement price 155
After 6 months A buy the product
And after 6-month current price Rs 154 & 157
Who will pay to whom?
A will pay Rs 1 to B
B will pay Rs 2 to B
Non deliverable forwards

Termination of forward contracts

1st Way of termination one party pay other cash
2nd Way of termination offsetting contract with same party
3rd way of termination offsetting contract with another party
Types of forward contract
Equity contract

Single stock forward contract

Portfolio forward contract

Sub portfolio
Select the stock from different companies

Bond forward
Similar

Interest rate /Forward rate agreement

Notation Contract Expire Price Underline rate

1*3 1 Month 60 days LIBOR
1*4 1 Month 90 days LIBOR
3*6 3 Month 90 days LIBOR
3*9 3 Month 180 days LIBOR

Lecture # 3
Future markets and contracts

Definition
A future contract is an agreement between the two parties in which one partly the buyer agree to
buyer from other party the seller the underline assets at the future date at a price agreed on today.

Some basic and important point

It is a public transaction the take place on an organized future exchange. In which buyer
benefit from price increase and seller benefit price decrease
In future contract prices are recorded and available from price reporting and services on
the internet
In future contract price in the only term established by the two parties and rest of the term
established through exchange
 EXCHANGE DECIDE
FOLLOWING TERM

Expiration QUANTITY PRICE

QUALITY
Month (SIZE) QUOTATION

Expiration Month
`for example exchange might established that a given future contract on in the month of
MARCH, JUNE, SEP, AND DEC, more over exchange decided which expiration month would
be actively traded and appropriated for trading

Price Quotation
104 20/32
Means 104.65625 is the current price

Par value 100

No of bonds 1000
Current price 1000*104.65625 = 104,656.25

Trading hours
Specific hours decide for different future contracts
 Physical
Location For
Trading

Electronic Or
Trade Floor ( Only
Avaliable in USA
Computer
Terminals
NUMERICAL AREA OF
THE FUTURE MARKET
AND CONTRACTS
Delivery and cash settlement

Delivery
Settlement price will be use one day before expiration date.

For example
Two dates

23 Sep the price of underline assets Rs 52 &

29 Sep the price of underline assets Rs 53

Call and put settlement one day before amount Rs 52 and after receiving sell into the market Rs 53 and
generate the profit Rs 1

Cash settlement
Cash settlement has advantage over delivery

23 Sep the price of underline assets Rs 52 &

29 Sep the price of underline assets Rs 53

Current date /Expire date cash settlement Rs 53

EFP (exchange for physical)

When two parties short and long (buyer and seller) report to exchange that they had settlement their
contract out side of the exchange “exchange normal delivery prosceger” which would be satisfactory to
exchange is called exchange for physical

Seat
 Future exchange
structure

Legel
Member
entity

Seat

broker (FCM) Futures

Local/Flor trader Commission Merchant
Floor trader
Local are market makers standing ready to buy and sell quoting a bid and ask price , they are primary
provider of liquidity to the market

BID
Highest price at which buyer willing to buy

ASK
Piece at which seller willing to sell
 Local/Floor
Trader

Scalper Day Trader podition

Scalper
Scalper offer to buy or sell future contract holding position for only brief period of time per have just a
second they attempt to profit by buying at bid price and selling at the highest ask price

They are not think what could be do at day end

Just buy and sell and generate the profit

Day Trader
A day trader hold the position open somewhat longer but closes all position at the end of the day

Position trader
A position trader hold position over nigh, day trader and position trader are different from scalper
because they attempt to profit from the anticipatory direction of the market

Broker
FCM excite transaction for other party by electronic party
Type of future contract
Commodities future
Agriculture product

Petroleum product

Mattel

Financial future
Stock

Stock bond

Currencies

Question No 1
Part A

Dave this time in long position (buyer) and he can close the position with contract to other parties like C
before the maturity date take the position of short

Lo

(A) Long Position (B) Short Position

Take the
Short position
Seller
(C) Long Position
For Example

Mr A take the short position and close the position of long with another contract with the 3rd
party Like C
Part B
Peggy smith in the short position and he can convert into the position with another contract with the
3rd party before the maturity date
For Example

Lo
(A) Long Position (B)Short Position
Take the
Long position
(C) Short Position Seller

Mr A take the Long position and close the position of Short with another contract with the 3rd
party Like C

Option market and contracts

Type of option regarding exercise style

Only

European option Style

European Option style mean that the option can be exercise on at expiration date

A B
Option cannot be excise before the maturity only option exercise on expiration day/date

American option
American option style option mean that option can be exercise on any day through the expiration

Option buyer

Call option
Price trend increases (Bullish)

Put Option
Price trend decrease (Bearish)
Some example of Option
Conceder some call and put option

Current date 13 June

Current stock price 16.25 per share

July option expire on 20 July

Oct option expire on 18 Oct

 July 15 Calls, July 17.50 call

 July 15 Puts, July 17.50 put
 Oct 15 Calls, Oct 17.50 call
 Oct 15 Puts, Oct 17.50 put

Exercise Price July Call Oct Call July Put Oct Put
15 2.35 3.30 0.90 1.85
17.50 1.00 2.15 2.15 3.20

Call option have low premium, the higher the exercise price
Put option have low premium, lower the exercise price
Both call and put option are cheaper shorter the time to expiration this statement is always true
for American option

Concept of moneyness of an option

In the market
In the money are those in which excessing the option would produce cash inflow that exceed the cash
out flow thus call are in the money when the value of underline exceeds the exercise price wise versa
put option

Call option
Underline assets as compare to exercise price

Put option
Underline assets as compare to exercise price

At the market
Underline assets = Exercise price

Out of the market

In the money are those in which exercising the option could not produce cash flow because underline
value is less than exercise price and wise versa
Pay Off value
The easiest time to determine an option values is at expiration and option value at expiration is call
payoff

Put Call parity

Protective put

Put + Risky investment

Fiduciary call

Call + Risk Free investment

Put call parity

Put call parity is the combination of European call & put option at same exercise price on same
underline assets for same maturity period

So + Po=Co+ Pv E
E zero coupon bond
The equation of put call parity is derive from with the help of two portfolio mention above