Derivatives

Anilkumar Garag
Types of Derivatives
 Categories of derivatives
 Options
 Futures contracts
 Swaps
 Product characteristics
Categories of Derivatives

Futures Options
Listed, OTC futures Calls
Forward contracts Puts

Derivatives

Swaps
Interest rate swap
Foreign currency swap
Fundamentals of the Futures Market
Market Participants
 Hedgers
 Processors
 Speculators
 Scalpers
Hedgers
A hedger is someone engaged in a
business activity where there is an
unacceptable level of price risk
– E.g., a farmer can lock into the price he will
receive for his soybean crop by selling futures
contracts
Processors
A processor earns his living by
transforming certain commodities into
another form
– Putting on a crush means the processor can
lock in an acceptable profit by appropriate
activities in the futures market
– E.g., a soybean processor buys soybeans and
crushes them into soybean meal and oil
Speculators
A speculator finds attractive investment
opportunities in the futures market and
takes positions in futures in the hope of
making a profit (rather than protecting one)
 The speculator is willing to bear price risk
 The speculator has no economic activity
requiring use of futures contracts
Speculators (cont’d)
 Speculators may go long or short,
depending on anticipated price movements
 A position trader is someone who routinely
maintains futures positions overnight and
sometimes keep a contract for weeks
 A day trader closes out all his positions
before trading closes for the day
Scalpers
 Scalpers are individuals who trade for their
own account, making a living by buying and
selling contracts
– Also called locals

 Scalpers help keep prices continuous and

accurate
Options
 An option is the right to either buy or sell
something at a set price, within a set period
of time
– The right to buy is a call option
– The right to sell is a put option

 Youcan exercise an option if you wish, but

you do not have to do so
Futures Contracts
 Futures contracts involve a promise to
exchange a product for cash by a set
delivery date

 Futures contracts deal with transactions

that will be made in the future
Futures Contracts (cont’d)
 Futures contracts are different from options
in that:

– The buyer of an option can abandon the option if

he or she wishes
– The buyer of a futures contract cannot abandon
the contract
Futures Contracts (cont’d)
A futures contract involves a process
known as marking to market
– Money actually moves between accounts each
day as prices move up and down

A forward contract is functionally similar to

a futures contract, however:
– There is no marking to market
– Forward contracts are not marketable
Product Characteristics (cont’d)
 The underlying asset is that which you have
the right to buy or sell (with options) or the
obligation to buy or deliver (with futures)

 Listed
derivatives trade on an organized
exchange such as the National Stock
Exchange or the BSE (Sensex).
Participants in the Derivatives
World
 Hedging
 Speculation
 Arbitrage
Hedging
 Ifsomeone bears an economic risk and
uses the futures market to reduce that risk,
the person is a hedger

 Hedging is a prudent business practice and

a prudent manager has a legal duty to
understand and use the futures market
hedging mechanism
Speculation
A person or firm who accepts the risk the
hedger does not want to take is a
speculator
 Speculators believe the potential return
outweighs the risk
 The primary purpose of derivatives markets
is not speculation. Rather, they permit the
transfer of risk between market participants
as they desire
Hedgers and Speculators

Risk Transfer
Hedgers Speculators
Arbitrage
 Arbitrage is the existence of a riskless
profit

 Arbitrageopportunities are quickly

exploited and eliminated
Uses of Derivatives
 Risk management
 Income generation
 Financial engineering
Risk Management
 The
hedger’s primary motivation is risk
management
Risk Management (cont’d)
 Someone who is bullish believes prices are
going to rise

 Someone who is bearish believes prices are

going to fall

 Wecan tailor our risk exposure to any points

we wish along a bullish/bearish continuum
Income Generation
 Writing a covered call is a way to generate
income
– Involves giving someone the right to purchase
your stock at a set price in exchange for an up-
front fee (the option premium) that is yours to
keep no matter what happens
 Writing calls is especially popular during a
flat period in the market or when prices are
trending downward
What Options Are and Where
They Come From
 Calland put options
 Categories of options
 Standardized option characteristics
 Where options come from
 Opening and closing transactions
 The role of the clearing corporation
Call and Put Options
 Call Options
– A call option gives its owner the right to buy; it is not a
promise to buy
 For example, a store holding an item for you for a fee is a
call option
 Put Options
– A put option gives its owner the right to sell; it is not a
promise to sell
 For example, a lifetime money back guarantee policy on
items sold by a company is an embedded put option
Categories of Options
 An American option gives its owner the
right to exercise the option anytime prior to
option expiration

A European option may only be exercised at

expiration
Categories of Options (cont’d)
 Optionsgiving the right to buy or sell
shares of stock (stock options) are the best-
known options

 The
underlying asset of an index option is
some market measure like the Nifty index
– Cash-settled
Standardized Option
Characteristics
 Expiration dates
– The last Thursday of the month for options
 Striking price
– The predetermined transaction price, set by the NSE,
depending on current stock price
 Underlying Security
– The security the option gives you the right to buy or sell
– Both puts and calls are based on lot sizes of the underlying
security
Standardized Option
Characteristics (cont’d)

 The option premium is the amount you pay

for the option

 Exchange-traded options are fungible

– For a given company, all options of the same
type with the same expiration and striking price
are identical
Identifying An Option

Expiration (last thursday in October) Type of option

Infosys OCT 2200 Call

Underlying asset Strike price

(Infosys share) (Rs.2200 per share)
Where Options Come From
 Unlike
more familiar securities, there is no
set number of put or call options
– The number in existence changes every day
– Open interest
Transactions
 When someone buys an option as an
opening transaction, the owner of an option
will ultimately do one of three things with it:
– Sell it to someone else
– Let it expire
– Exercise it
 For example, buying a ticket to a movie
Writing the option
 When someone sells an option as an
opening transaction, this is called writing
the option
– No matter what the owner of an option does, the
writer of the option keeps the option premium
that he or she received when it was sold
Terminology

 Open interest: number of contracts open

 At-the-money
 In-the-money
 Out-of-the-money
 LEAP: Long Term Equity AnticiPation Security
 Naked Call or Uncovered Call
 Basics

Option Buyer Option Writer

Call Option Pays Premium Receives Premium

RIGHT TO BUY OBLIGATION TO SELL
Put Option Pays Premium Receives Premium
RIGHT TO SELL OBLIGATION TO BUY
Intrinsic Value and Time Value
 Intrinsicvalue is the amount that an option
is immediately worth given the relation
between the option striking price and the
current stock price
– For a call option, intrinsic value =
stock price – striking price
– For a put option, intrinsic value =
striking price – stock price
– Intrinsic value cannot be < zero
Intrinsic Value and Time Value
(cont’d)
 Intrinsic value (cont’d)
– An option with positive intrinsic value is in-the-
money
– An option with no intrinsic value is out-of-the-
money
– An option whose striking price is exactly equal
to the price of the underlying security is at-the-
money
– Options that are “almost” at-the-money are
near-the-money
Intrinsic Value and Time Value
(cont’d)
 Time value is equal to the premium minus
the intrinsic value
– As an option moves closer to expiration, its time
value decreases (time value decay)
An option is a wasting asset
Profits and Losses With
Options
 Understanding the exercise of an option
 Exercise procedures
 Profit and loss diagrams
 A note on margin requirements
Exercise Procedures
 Notify your broker
 Broker notifies the National Securities
Clearing Corporation
– Selects a contra party to receive the exercise
notice
– Neither the option exerciser nor the option
writer knows the identity of the opposite party
Profit and Loss Diagrams
 Vertical axis reflects profits or losses on the
expiration day resulting from a particular strategy
 Horizontal axis reflects the stock price on the
expiration day
 Any bend in the diagram occurs at the striking
price
 By convention, diagrams ignore the effect of
commissions that must be paid
Buying a Call Option (“Going
Long”)
 Example: buy a ACC-1000-Jan call for Rs.
45
– Maximum loss is Rs. 45
– Profit potential is unlimited
– Breakeven is Rs. 1045
Buying a Call Option (cont’d)

Breakeven = Rs. 1045

0 920 940 960 1000 1100

Maximum
loss = Rs. 45
Writing a Call Option (“Short
Option”)
 Ignoring commissions, the options market
is a zero sum game
– Aggregate gains and losses will always net to
zero
– The most an option writer can make is the
option premium
 Writinga call without owning the underlying
shares is called writing a naked (uncovered)
call
Writing a Call Option (cont’d)

Breakeven = Rs. 1045

Maximum
Profit = Rs. 45
0 860 880 920 955 1000
 Buying a Put Option (“Going
Long”)
 Example: buy a ACC-1000-Jan Put for Rs.
45
– Maximum loss is Rs. 45
– Maximum profit is Rs. 955
– Breakeven is Rs. 955
Buying a Put Option (cont’d)

Breakeven = Rs. 955

840 860 900 940 1000

Rs. 45
Writing a Put Option (“Short
Option”)
 Theput option writer has the obligation to
buy if the put is exercised by the holder
Writing a Put Option (cont’d)

Breakeven = Rs. 955

Rs. 45

880 900 940 1000

Rs. 955
Combinations
 Introduction
 Straddles
 Strangles
 Condors
Introduction
A combination is a strategy in which you
are simultaneously long or short options of
different types
Straddles
A straddle is the best-known option
combination

 You are long a straddle if you own both a

put and a call with the same
– Striking price
– Expiration date
– Underlying security
Straddles (cont’d)
 Youare short a straddle if you are short
both a put and a call with the same
– Striking price
– Expiration date
– Underlying security
Buying a Straddle
A long call is bullish
 A long put is bearish

 Why buy a long straddle?

– Whenever a situation exists when it is likely that
a stock will move sharply one way or the other
Writing a Straddle
 Popular with speculators

 Thestraddle writer wants little movement in

the stock price

 Lossesare potentially unlimited on the

upside because the short call is uncovered
Strangles
A strangle is similar to a straddle, except
the puts and calls have different striking
prices

 Stranglesare very popular with

professional option traders
Buying a Strangle
 Thespeculator long a strangle expects a
sharp price movement either up or down in
the underlying security

 With a long strangle, the most popular

version involves buying a put with a lower
striking price than the call
Condors
A condor is a less risky version of the
strangle, with four different striking prices
Buying a Condor
 There
are various ways to construct a long
condor

 The condor buyer hopes that stock prices

remain in the range between the middle two
striking prices
Writing a Condor
 Thecondor writer makes money when
prices move sharply in either direction

 Themaximum gain is limited to the

premium
Spreads
 Introduction
 Vertical spreads
 Vertical spreads with calls
 Vertical spreads with puts
 Calendar spreads
 Diagonal spreads
 Butterfly spreads
Introduction
 Option spreads are strategies in which the
player is simultaneously long and short
options of the same type, but with different
– Striking prices or
– Expiration dates
Vertical Spreads
 Ina vertical spread, options are selected
vertically from the financial pages
– The options have the same expiration date
– The spreader will long one option and short the
other
 Vertical spreads with calls
– Bullspread
– Bearspread
Bullspread
 Assume a person believes ACC stock will
appreciate soon
 A possible strategy is to construct a vertical
call bullspread and:
– Buy an APR 1000 ACC call
– Write an APR 1040 ACC call
 The spreader trades part of the profit
potential for a reduced cost of the position.
Bearspread
A bearspread is the reverse of a bullspread
– The maximum profit occurs with falling prices
– The investor buys the put option with the lower
striking price and writes the option with the
higher striking price
Bullspread (cont’d)
 Theput spread results in a credit to the
spreader’s account (credit spread)

 Thecall spread results in a debit to the

spreader’s account (debit spread)
Calendar Spreads
 In a calendar spread, options are chosen
horizontally from a given row in the
financial pages
– They have the same striking price
– The spreader will long one option and short the
other
Calendar Spreads (cont’d)
 Calendarspreads are either bullspreads or
bearspreads
– In a bullspread, the spreader will buy a call with
a distant expiration and write a call that is near
expiration
– In a bearspread, the spreader will buy a call that
is near expiration and write a call with a distant
expiration
Calendar Spreads (cont’d)
 Calendarspreaders are concerned with
time decay
– Options are worth more the longer they have
until expiration
Diagonal Spreads
A diagonal spread involves options from
different expiration months and with
different striking prices
– They are chosen diagonally from the option
listing in the financial pages

 Diagonal spreads can be bullish or bearish

Butterfly Spreads
A butterfly spread can be constructed for
very little cost beyond commissions

A butterfly spread can be constructed using

puts and calls
Principles of Futures Contract
Pricing
 The expectations hypothesis
 Normal backwardation
 A full carrying charge market
 Reconciling the three theories
The Expectations Hypothesis
 Theexpectations hypothesis states that the
futures price for a commodity is what the
marketplace expects the cash price to be
when the delivery month arrives
– Price discovery is an important function
performed by futures

 There
is considerable evidence that the
expectations hypothesis is a good predictor
Normal Backwardation
 Basisis the difference between the future
price of a stock and the current cash price
– Normally, the futures price exceeds the cash
price (contango market)
– The futures price may be less than the cash
price (backwardation or inverted market)
A Full Carrying Charge Market
(cont’d)
 Arbitrage exists if someone can buy a
commodity, store it at a known cost, and
get someone to promise to buy it later at a
price that exceeds the cost of storage

 Ina full carrying charge market, the basis

cannot weaken because that would produce
an arbitrage situation
Futures valuation

 Costof carry Model

F=SerT
Where F: Fair Value of Futures Price
S: Spot Price
e = 2.71828
T: Time to expiration in years
r: risk free rate of interest