Session 2

Introduction to
Derivatives
Basics
 Finance is the study of risk.
 How to measure it

 How to reduce it

 How to allocate it
 All finance problems ultimately boil
down to three main questions:
 What are the cash flows, and when

do they occur?
 Who gets the cash flows?

 What is the appropriate discount

rate for those cash flows?

 The difficulty, of course, is that
normally none of those questions
have an easy answer.
 The market “pays” you for bearing
non-diversifiable risk only.
 In general the more non-

diversifiable risk that you bear, the

greater the expected return
Basics
 In this sense, we can view the field of
finance as being about two issues:
 The elimination of diversifiable risk in

portfolios;
 The allocation of systematic (non-

diversifiable) risk to those members of

society that are most willing to bear it.
What is a Derivative Security?
 Derivative securities, more appropriately
termed as derivative contracts, are assets
which confer the investors who take
positions in them with certain rights or
obligations.
Why Do We Call Them
Derivatives?
 They owe their existence to the presence of a
market for an underlying asset or portfolio of
assets, which may be considered as primary
securities.
 Consequently such contracts are derived from
these underlying assets, and hence the name.
 Thus if there were to be no market for the
underlying assets, there would be no derivatives.
Why derivatives and derivatives
markets?
 Because they somehow allow investors to better
control the level of risk that they bear.
 They can help eliminate idiosyncratic risk.
 They can decrease or increase the level of
systematic risk.
Example
 This example illustrates an interesting
notion – that insurance contracts (for
property insurance) are really derivatives!
 They allow the owner of the asset to “sell”
the insured asset to the insurer in the event
of a disaster.
Basics
 Positions
 Buy Position - “LONG”
 Sell Position – “ SHORT”
Basics
 Commissions – Virtually all transactions in
the financial markets requires some form of
commission payment.
Basics
 Bid-Ask spread
 If you wish to sell, you will get a “BID” quote
 If you wish to buy you will get an “ASK”
quote.
Basics
 Bid-ask spread can be a huge factor in
determining the profitability of a trade.
 Many “trading strategies” lose their
effectiveness when the bid-ask spread is
considered.
Basics
 Market Efficiency
 Discovery and analysis of new information.
 The limiting factor in this is the transaction costs
associated with the market.
 For this reason, it is better to say that financial markets
are efficient to within transactions costs. Some financial
economists say that financial markets are efficient to
within the bid-ask spread.
Basics
 Credit risk – the risk that your trading partner
might not honor their obligations.
 Liquidity risk – the risk that when you need to
buy or sell an instrument you may not be able to
find a counterparty.
Basics
 So now we are going to begin examining
the basic instruments of derivatives. In
particular we will look at (tonight):
 Forwards
 Futures
 Options
Forward Contracts
The specified price for the sale is known as
the delivery price, we will denote this as K.
 Note that K is set such that at initiation of the
contract the value of the forward contract is 0.
Thus, by design, no cash changes hands at time
0.
Forward Contracts
As time progresses the delivery price doesn’t
change, but the current spot (market) rate
does. Thus, the contract gains (or loses)
value over time.
 Consider the situation at the maturity date of the
contract. If the spot price is higher than the
delivery price, the long party can buy at K and
immediately sell at the spot price ST, making a
profit of (ST-K), whereas the short position could
have sold the asset for ST, but is obligated to sell
for K, earning a profit (negative) of (K-ST).
Forward Contracts
Consider the situation at the maturity date of
the contract.
If the spot price is higher than the delivery
price, the long party can buy at K and
immediately sell at the spot price ST, making
a profit of (ST-K),
Forward Contracts
Short position could have sold the asset for ST,
but is obligated to sell for K, earning a profit
(negative) of (K-ST).
Forward Contracts
 If, however, the market price is less than 40, you
are not pleased because you are paying more
than the market price for the wheat.
 Indeed, we can determine your net payoff to the
trade by applying the formula: payoff = ST – K,
since you gain an asset worth ST, but you have to
pay K for it.
 We can graph the payoff function:
Forward Contracts
Payoff to Futures Position Delivery Price (K) is 40

2
Payoff to Forwards

0
0 1 2 3 4 5 6 7 8
-1

-2

-3

-4
Spot Price, December 14
Forward Contracts
 What about the short party?
 They have agreed to sell wheat to you for Rs.40
on December 14.
 Their payoff is positive if the market price is less
than Rs.40 – they force you to pay more for the
wheat than they could sell it for on the open
market.
 Indeed, you could assume that what they do is buy
it on the open market and then immediately deliver
it to you in the forward contract.
Forward Contracts
 Their payoff is negative, however, if the market
price is greater than Rs.40.
 They could have sold for more than Rs.40 had
they not agreed to sell it to you.
 So their payoff function is the mirror image of
your payoff function:
Forward Contracts
Payoff to Short Futures Position
Delivery Price (K) is 40

2
Payoff to Forwards

0
0 1 2 3 4 5 6 7 8
-1

-2

-3

-4
Market (Spot) Price, December 14
Forward Contracts
 Clearly the short position is just the mirror
image of the long position, and, taken
together the two positions cancel each
other out:
Forward Contracts
Long and Short Positions in a Forward Contract
at Rs.40

3
Short Position
2

1 Long Position
Payoff

0
0 1 2 3 4 5 6 7 8
-1
Net
-2
Position
-3

-4
Price
 Futures Contracts
 A futures contract is similar to a forward
contract in that it is an agreement between
two parties to buy or sell an asset at a certain
time for a certain price. Futures, however, are
usually exchange traded and, to facilitate
trading, are usually standardized contracts.
This results in more institutional detail than is
the case with forwards.
 Futures Contracts
 Exchange guarantees performance of the
contract regardless of whether the other party
fails.
 Futures Contracts
 The exchange will usually place restrictions
and conditions on futures. These include:
 Daily price (change) limits.
 For commodities, grade requirements.
 Delivery method and place.
 How the contract is quoted.

 Note however, that the basic payoffs are the

same as for a forward contract.
Options Contracts
 A Call option is the right, but not the obligation, to
buy the underlying asset by a certain date for a
certain price.
 A Put option is the right, but not the obligation, to
sell the underlying asset by a certain date for a
certain price.
Options Contracts
 The date when the option expires is known
as the exercise date, the expiration date, or
the maturity date.
 The price at which the asset can be
purchased or sold is known as the strike
price.
Options Contracts
 European - Holder can exercise only on the
maturity date.
 American - Holder can exercise on any date
up to and including the exercise date.
 An options contract is always costly to enter
as the long party. The short party always is
always paid to enter into the contract
 Looking at the payoff diagrams you can see why…
Comparison of Futures/Forwards
versus Options
Instrument Nature of Nature of
Long’s Short’s
Commitment Commitment
Forward/Futures Obligation to buy Obligation to
Contract sell
Call Options Right to buy Obligation to sell

Put Options Right to sell Obligation to buy

Options Contracts
 Let’s say that you entered into a call option
on a stock:
 Today the stock is selling for roughly
Rs.78.80/share, so let’s say you entered into a
call option that would let you buy the stock in
December at a price of Rs.80/share.
Options Contracts
 If in December the market price were greater
than 80, you would exercise your option, and
purchase the share for 80.
Options Contracts
 If, in December the stock were selling for less
than 80, you could buy the stock for less by
buying it in the open market, so you would not
exercise your option.
 Thus your payoff to the option is Rs.0 if the stock is less
than 80
 It is (ST-K) if stock is worth more than 80
 Thus, your payoff diagram is:
Options Contracts
Long Call
with Strike Price (K) = 80

80

60

40
Payoff

20

0
0 20 40 60 K = 80 100 120 140 160
-20
Terminal Stock Price
T
Options Contracts
 What if you had the short position?
 Well, after you enter into the contract, you have
granted the option to the long-party.
 If they want to exercise the option, you have to do
so.
 Of course, they will only exercise the option when
it is in there best interest to do so – that is, when
the strike price is lower than the market price of
the stock.
Options Contracts
 If ST<K, Long will just buy the stock in the market,
and so the option will expire, and you will receive 0
at maturity.
 If ST>K, Long party will exercise their option and
you will have to sell them an asset that is worth ST
for K.
 Your payoff:
payoff = min(0,ST-K),
which has a graph that looks like:
Options Contracts Short Call Position
with Strike Price (K) = 80

21.25

0
Payoff to Short Position

0 20 40 60 80 100 120 140 160

-21.25

-42.5

-63.75

-85
Ending Stock Price
Options Contracts
 This is obviously the mirror image of the
long position.
 Notice, however, that at maturity, the short
option position can NEVER have a positive
payout – the best that can happen is that
they get 0.
Options Contracts
 This is why the short option party always
demands an up-front payment – it’s the only
payment they are going to receive.
 Option premium or price.

 Once again, the two positions “net out” to

zero:
Options Contracts
Long and Short Call Strike Prices of 80

100

80

60
40 Long Call
20
Net Position
Payoff

-20 0 20 40 60 80 100 120 140 160

-40
Short Call
-60

-80

-100
Ending Stock Price
Options Contracts
 Recall that a put option grants the long
party the right to sell the underlying at price
K.
 Returning to our example, if K=80, the long
party will only elect to exercise the option if
the price of the stock in the market is less
than 80, otherwise they would just sell it in
the market.
Options Contracts
 The payoff to the holder of the long put
position, therefore is simply
payoff = max(0, K-ST)
Options Contracts
Payoff to Long Put Option
with Strike Price of 80

80
70
60
50
Payoff

40
30
20
10
0
-10 0 20 40 60 80 100 120 140 160

Ending Stock Price

Options Contracts
 The Short granted the option to the Long. The short
has to buy the stock at price K, when long wants.
 Long will only do this when the stock price is less
than the strike price.
 Thus, the payoff function for the short put position is:
payoff = min(0, ST-K)
Options Contracts
Short Put Option Strike Price of 80

0
0 20 40 60 80 100 120 140 160

-21.25
Payoff

-42.5

-63.75

-85
Ending Stock Price
Options Contracts
 Since the short put party can never receive a positive
payout at maturity, they demand a payment up-front
from the long party – that is, they demand that the long
party pay a premium to induce them to enter into the
contract.

 Once again, the short and long positions net out to

zero: when one party wins, the other loses.
Options Contracts
 Since the short put party can never receive
a positive payout at maturity, they demand
a payment up-front from the long party –
that is, they demand that the long party pay
a premium to induce them to enter into the
contract.
Options Contracts
 Once again, the short and long positions
net out to zero: when one party wins, the
other loses.
Options Contracts Long and Short Put Options Strike Prices of 80

100
80

60 Long Position
40

20
Net Position
Payoff

0
0 20 40 60 80 100 120 140 160
-20

-40
-60 Short Position
-80

-100
Ending Stock Price
Options Contracts
 For a European call, the payoff to the
option is:
 Max(0,ST-K)
 For a European put it is
 Max(0,K-ST)
 The short positions are just the negative of
these:
 Short call: -Max(0,ST-K) = Min(0,K-ST)
 Short put: -Max(0,K-ST) = Min(0,ST-K)
Options Contracts
 Traders frequently refer to an option as
being “in the money”, “out of the money” or
“at the money”.
Options Contracts
 An “in the money” option means one where the
price of the underlying is such that if the option
were exercised immediately, the option holder
would receive a payout.
 For a call option this means that St>K
 For a put option this means that St<K
Options Contracts
 An “at the money” option means one where the
strike and exercise prices are the same.
Options Contracts
 An “out of the money” option means one where
the price of the underlying is such that if the
option were exercised immediately, the option
holder would NOT receive a payout.
 For a call option this means that St<K
 For a put option this means that St>K.
Options Contracts
Long Call
with Strike Price (K) = 80

80

60

40 At the money
Payoff

Out of the money In the money

20

0
0 20 40 60 K = 80 100 120 140 160
-20
Terminal Stock Price
T
Options Contracts
 One interesting notion is to look at the
payoff from just owning the stock – its value
is simply the value of the stock:
Options Contracts
Payout Diagram for a Long Position

180

160

140

120

100
Payoff

80

60

40

20

0
0 20 40 60 80 100 120 140 160
Ending Stock Price
Options Contracts
 What is interesting is if we compare the
payoff from a portfolio containing a short
put and a long call with the payoff from just
owning the stock:
Options Contracts
Payoff Diagram for a Long Position

200

150
Stock
100
Long Call
50
P
o
y
a
f

0
0 20 40 60 80 100 120 140 160
-50
Short Put
-100
Ending Stock Price
Options Contracts
 Notice how the payoff to the options
portfolio has the same shape and slope as
the stock position – just offset by some
amount?
 This is hinting at one of the most important
relationships in options theory – Put-Call
parity.
Options Contracts
Payoff Diagram for a Long Position

200

150

100

50
P
o
y
a
f

0
0 20 40 60 80 100 120 140 160
-50

-100
Ending Stock Price
Swaps
 A swap is a contractual agreement between
two parties to exchange specified cash
flows at pre-defined points in time.
 There are two broad categories of swaps –
Interest Rate Swaps and Currency Swaps.
Interest Rate Swaps
 In the case of these contracts, the cash flows
being exchanged, represent interest payments
on a specified principal, which are computed
using two different parameters.
 For instance one interest payment may be
computed using a fixed rate of interest, while the
other may be based on a variable rate such as
LIBOR.
Interest Rate Swaps (Cont…)
 There are also swaps where both the
interest payments are computed using two
different variable rates – For instance one
may be based on the LIBOR and the other
on the Prime Rate of a country.
 Obviously a fixed-fixed swap will not make
sense.
Interest Rate Swaps
 Since both the interest payments are
denominated in the same currency, the actual
principal is not exchanged.
 Consequently the principal is known as a
notional principal.
 Also, once the interest due from one party to
the other is calculated, only the difference or
the net amount is exchanged.
Currency Swaps
 These are also known as cross-currency
swaps.
 In this case the two parties first exchange
principal amounts denominated in two
different currencies.
 Each party will then compute interest on the
amount received by it as per a pre-defined
yardstick, and exchange it periodically.
Currency Swaps
 At the termination of the swap the principal
amounts will be swapped back.
 In this case, since the payments being
exchanged are denominated in two
different currencies, we can have fixed-
floating, floating-floating, as well as fixed-
fixed swaps.
Actors in the Market
 There are three broad categories of market
participants:
 Hedgers
 Speculators
 Arbitrageurs
Hedgers
 These are people who have already
acquired a position in the spot market prior
to entering the derivatives market.
 They may have bought the asset underlying
the derivatives contract, in which case they
are said to be Long in the spot.
Hedgers (Cont…)
 Or else they may have sold the underlying
asset in the spot market without owning it,
in which case they are said to have a Short
position in the spot market.
 In either case they are exposed to Price
Risk.
Hedgers (Cont…)
 Price risk is the risk that the price of the
asset may move in an unfavourable
direction from their standpoint.
 What is adverse depends on whether they
are long or short in the spot market.
 For a long, falling prices represent a
negative movement.
Hedgers (Cont…)
 For a short, rising prices represent an
undesirable movement.
 Both longs and shorts can use derivatives
to minimize, and under certain conditions,
even eliminate Price Risk.
 This is the purpose of hedging.
Speculators
 Unlike hedgers who seek to mitigate their
exposure to risk, speculators consciously
take on risk.
 They are not however gamblers, in the
sense that they do not play the market for
the sheer thrill of it.
Speculators (Cont…)
 They are calculated risk takers, who will
take a risky position, only if they perceive
that the expected return is commensurate
with the risk.
 A speculator may either be betting that the
market will rise, or he could be betting that
the market will fall.
Hedgers & Speculators
 The two categories of investors
complement each other.
 The market needs both types of players to
function efficiently.
 Often if a hedger takes a long position, the
corresponding short position will be taken
by a speculator and vice versa.
Arbitrageurs

 These are traders looking to make costless

and risk-less profits.
 Since derivatives by definition are based on
markets for an underlying asset, it is but
obvious that the price of a derivatives
contract must be related to the price of the
asset in the spot market.
Arbitrageurs (Cont…)
 Arbitrageurs scan the market constantly for
discrepancies from the required pricing
relationships.
 If they see an opportunity for exploiting a
misaligned price without taking a risk, and
after accounting for the opportunity cost of
funds that are required to be deployed, they
will seize it and exploit it to the hilt.
Arbitrageurs (Cont…)
 Arbitrage activities therefore keep the
market efficient.
 That is, such activities ensure that prices
closely conform to their values as predicted
by economic theory.
Why Use Derivatives
 Derivatives have many vital economic roles
in the free market system.
 Firstly, not every one has the same
propensity to take risks.
 Hedgers consciously seek to avoid risk,
while speculators consciously take on risk.
 Thus risk re-allocation is made feasible by
active derivatives markets.
Why Derivatives? (Cont…)
 In a free market economy, prices are
everything.
 It is essential that prices accurately convey
all pertinent information, if decision making
in such economies is to be optimal.
 How does the system ensure that prices
fully reflect all relevant information?
Why Derivatives? (Cont…)
 It does so by allowing people to trade.
 An investor whose perception of the value
of an asset differs from that of others, will
seek to initiate a trade in the market for the
asset.
 If the perception is that the asset is
undervalued, there will be pressure to buy.
Why Derivatives? (Cont…)
 On the other hand if there is a perception
that the asset is overvalued, there will be
pressure to sell.
 The imbalance on one or the other side of
the market will ensure that the price
eventually attains a level where demand is
equal to the supply.
Why Derivatives? (Cont…)
 When new information is obtained by
investors, trades will obviously be induced,
for such information will invariably have
implications for asset prices.
 In practice it is easier and cheaper for
investors to enter derivatives markets as
opposed to cash or spot markets.
Why Derivatives? (Cont…)
 This is because, the investor can trade in a
derivatives market by depositing a relatively
small performance guarantee or collateral
known as the margin.
 On the contrary taking a long position in the
spot market would entail paying the full
price of the asset.
Why Derivatives? (Cont…)
 Similarly it is easier to take a short position
in derivatives than to short sell in the spot
markets.
 In fact, many assets cannot be sold short in
the spot market.
 Consequently new information filters into
derivatives markets very fast.
Why Derivatives? (Cont…)
 Thus derivatives facilitate Price Discovery.
 Because of the high volumes of
transactions in such markets, transactions
costs tend to be lower than in spot markets.
 This in turn fuels even more trading activity.
 Also derivative markets tend to be very
liquid.
Why Derivatives? (Cont…)
 That is, investors who enter these markets,
usually find that traders who are willing to
take the opposite side are readily available.
 This enables traders to trade without having
to induce a transaction by making major
price concessions.
Why Derivatives? (Cont…)
 Derivatives improve the overall efficiency of
the free market system.
 Due to the ease of trading, and the lower
associated costs, information quickly filters
into these markets.
 At the same time spot and derivatives
prices are inextricably linked.
Why Derivatives? (Cont…)
 Consequently, if there is a perceived
misalignment of prices, arbitrageurs will
move in for the kill.
 Their activities will eventually lead to the
efficiency of spot markets as well.
 Finally derivatives facilitate speculation.
 And speculation is vital for the free market
system.