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Introduction to Derivatives
Pulkit Singhal & Kush Shah

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What are derivatives?

Derivatives are financial instruments whose prices depend on, or are h i d d derived from, the prices of other assets. assets

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What are the assets on which their prices depend?

Underlying is financial in nature
Stock prices Credit rating Interest rates te est ates Exchange rates

Also..
Electricity y The weather Insurance Cattle prices

In sum, if you can price the underlying asset, there can always be a derivative on it.

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Why are derivatives useful?

Hedging Speculation S l i Arbitrage profit-making Balance sheet changes B l h t h
To change the nature of a liability To change the nature of an investment/assets

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The various kinds of derivatives

There are three principal classes of derivative securities: Options Futures and Forwards Swaps In addition, it is possible to have options on futures, futures on options, swaptions.. swaptions Infinite complexity. complexity
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Forward Contracts
An A agreement to buy or sell an asset b ll at a certain time in the future for a certain price p No daily settlement. When the contract expires, one party buys the asset for the agreed price from the other party. The contract is an over-the-counter (OTC) agreement between 2 institutions.

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Profit from Forward Positions

Profit
Price of Underlying at Maturity Profit Price of Underlying at Maturity

Long position

Short position

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Working of a forward contract

Exchange Rate (INR/USD) Spot Bid Ask

39.94

40.11

1-month

39.78

40.02

3-month 3 th

39.55 39 55

39.94 39 94

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Working of a forward contract

Suppose Reliance has to make a payment of $25 M to Total 3 months from now and wish to lock in an exchange rate. y They would enter a 3-month forward contract to buy $ at the 3-month forward exchange rate. What happens if the exchange rate 3months from now is different from 39.94? 39 94?
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Futures Contracts
An agreement to buy or sell an asset at a certain time in the future for f a certain price. t i i They are exchange-traded, and hence, are standardized contracts. h t d di d t t Important futures exchanges: CBOT, CME, NYMEX etc. In India: BSE, NSE, MCX, NCDEX.
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Examples of Futures Contracts

Agreement to: Buy 1000 shares of Reliance at Rs. 2500 in May (BSE) y( ) Sell $1 million at 1.5000 US$/ in april (CME)

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Futures Arbitrage
Suppose that: The spot price of Reliance is p p Rs. 1500 The quoted 1-year futures price is Rs. 2000 Rs 1-year interest rate is 10% Is there an arbitrage opportunity?
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Futures Arbitrage
Solution: Borrow Rs. 1500 at 10% Go long spot g p Short futures End of year profit = 2000 1500*(1+10%)

What if the futures price is Rs. 1600? Rs

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Non-arbitrage futures price

If the spot price is S and futures price is F for a contract deliverable in T years, then F = S (1+r )T If F > S (1+r )T, go short on futures and long on spot and vice versa. What is the value of the futures contract?
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Daily settlement and margins

Margin i cash or marketable M i is h k t bl securities deposited by an investor with the broker Marking to market: Balance in the margin account is adjusted to reflect daily settlement Margins guard against default How are margins set?
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Forward Contracts vs Futures Contracts

FORWARDS Private P i t contract between 2 parties t tb t ti Non-standard contract Usually 1 specified delivery date Settled at maturity Delivery or final cash settlement usually occurs FUTURES Exchange t d d E h traded Standard contract Range of delivery dates Settled daily Contract usually closed out prior to maturity

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Options
An option is a security that gives the holder the right but not the obligation to buy or sell a security for a specified price at a specified date. Basic classification of options:
Call options/Put options American options/European options

How are options different from futures/forwards? f t /f d ?

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Intrinsic and Time Value

Option premium = Intrinsic Value + Time Value Intrinsic value: payoff if option is exercised immediately, immediately always greater than or equal to zero zero. Usually the price of an option in the marketplace will be greater than its intrinsic value The value. difference between the market value of an option and its intrinsic value is called the time value of an option. option What are in-the-money, out-of-the-money and at-the-money at the money options?
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Long Call
Profit from buying European call option: option price = $5, strike price = $100, option life = 2 months

$ 30 Profit ($) 20 10 0 -5
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90

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Terminal stock price ($) t k i 110 120 130

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Short Call
Profit from writing a European call option: option price = $5, strike price = $100

Profit ($) 5 0 -10 -20 -30 30

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110 120 130 70 80 90 100 Terminal stock price ($)

Long Put g
Profit from buying an European put option: option price = $7, strike price = $70

30 Profit ($) 20 10 0 -7
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Terminal stock price ($) 40 50 60 70 80 90 100

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Short Put
Profit from writing an European put option: option price = $7, strike price = $70

Profit ($) 7 0 -10 -20 -30

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60 70 80

Terminal stock price ($) 90 100

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Effect of Variables on Option p Pricing

Variable S0 X T r D c

+ ? + +
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What is the relation between price of an American

option and a European option?

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Put Call Put-Call Parity; No Dividends

Consider the following 2 portfolios: Portfolio A: European call on a stock + PV of the strike price in cash

Portfolio C: European put on the stock + the stock Both are worth Max (ST , X) at the maturity of the options They must therefore be worth the same today y y This means that

c + Xe -rT = p + S0
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Valuation using Black Scholes equation

c = S0 N (d1 ) X e rT N (d 2 ) p = X e rT N ( d 2 ) S0 N ( d1 ) ln( S0 / X ) + (r + 2 / 2)T where d1 = T ln( S0 / X ) + (r 2 / 2)T d2 = = d1 T T

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What is Risk-Neutral Valuation?

1. Assume that the expected return from an asset is the risk-free rate 2. 2 Calculate the expected payoff from the derivative 3. 3 Discount at the risk-free rate
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Naked and Covered Positions

Naked position Take no action Covered position Buy 100,000 shares today Both strategies leave the bank exposed to significant risk. How? H ?
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Stop Loss Stop-Loss Strategy

This involves: Buying 100,000 shares as soon as price reaches $50 i h Selling 100,000 shares as soon as price falls below $50 What i th Wh t is the problem with bl ith this strategy?
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The Greeks: Delta

Delta () is the rate of change of the option price with respect to the underlying

Option price Slope = A

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Delta
Delta = sensitivity of an option's theoretical y p value to a change in the price of the underlying contract. delta = change in the option price change in the stock price

What is the range of deltas for calls and g puts? Why is delta also called the hedge ratio?
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Theta
Theta () of a derivative (or portfolio of h ( ) f d ( f l f derivatives) is the rate of change of the value with respect to the passage of time

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Gamma
Gamma () is the rate of change of delta () with respect to the price of the underlying asset
The Gamma of a portfolio of derivatives on an underlying asset is the rate of change of the portfolio s delta with portfolio's respect to the price of the underlying asset. If gamma is large, delta is highly sensitive to the price of the underlying iti t th i f th d l i asset.

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Vega
Vega () is the rate of change of the value of a derivatives portfolio with respect to volatility

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Managing Delta, Gamma, & Vega

Delta, , D lt can be changed b b h d by taking a position in the underlying asset d l j gamma, , and vega, , , , g , , To adjust g it is necessary to take a position in an option or other derivative

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Rho
Rho is the t Rh i th rate of change of f h f the value of a derivative with respect to the interest rate

For currency options there are 2 rhos

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Hedging in Practice
Traders usually ensure that their portfolios are delta-neutral at least delta neutral once a day Whenever the opportunity arises arises, they improve gamma and vega As portfolio becomes larger hedging becomes less expensive
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Exotic Options
Bermudan option - non-standard American option in which early exercise is limited to certain dates during the life of the option. Also referred to as "hybrid-style" exercise. Forward start option is an option that is paid for now, but does not begin until some later date. Compound option is an option on an option. Compound options have two strike prices and two expiration dates. For example, a call on a call is purchased. At some specified p , p p date in the future, a person will have the right but not the obligation of purchasing a call option.

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Exotic Options
Chooser option also called an "as you like it" option allows option, as it option, the holder to choose after a specified period of time whether the option is a call or a put. Barrier option is an option in which the payoff depends on whether the underlying asset's price reaches a certain level during the life of the option.
Up and out Up-and-out option becomes worthless once the underlying asset price reaches a specified boundary price. Up-and-in option requires the underlying asset price to reach the boundary price before the option can be activated.

Rainbow option is an option involving two or more risky assets.

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Exotic Options
Lookback option - payoffs depend on the maximum or minimum the stock price reaches over the life of the option. Asian option (average price option) - payoff depends on the average price of the asset (not the stock price itself) over a specified amount of time during the life of the option. Spread option - strike price is the spread between two underlying assets. For example, crack spreads on the spread between the price of crude and its by-products. Basket option - payoff depends upon a portfolio of assets.

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Terms to watch out for

Volatility trading, correlation t di V l tilit t di l ti trading Delta hedging, Gamma Hedging Long, short, spread Basis risk Libor, yield curve

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Butterfly Spread Using Calls

Butterfly Spread: buying a call option with a relative low strike price, K1, buying a call option with a relative high strike price. K3, and selling two call options with a strike price halfway in between, between K2.
Stock price Range Payoff from First Long C ll L Call Option ST - K1 ST - K1 ST - K1 0 Payoff from Payoff from Total Payoff Second Short Calls Long C ll L Call Option ST - K3 0 0 0 -2(ST - K2) -2(ST - K2) 0 0 0 K3 - ST ST - K1 0

ST K3 K2 < ST < K3 K2 < ST < K3 ST K1

Butterfly Spread Using Calls

Example: Call option prices on a $61 stock are: $10 for a $55 strike, $7 for a $60 strike, and $5 for a $65 strike. The investor could create a butterfly spread by buying one call with $55 strike price, buying a call with a $65 strike price, and selling two calls with a $60 strike price price.

Stock price Range

Payoff from First Long Call Option ST - $55 ST - $55 ST - $55 0

Payoff from Payoff from Total Payoff Second Short Calls Long Call Option ST - $65 0 0 0 -2(ST - $60) 2(S -2(ST - $60) 0 0 0 $65 - ST ST -$55 0

ST $65 $60 < ST <$65 $55 < ST <$60 ST $55

Butterfly Spread Using Calls y p g

Profit K1 K2 K3 ST

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Butterfly Spread Using Puts y p g

Profit K1 K2 K3 ST

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