DERIVATIVES IN TREASURY MANAGEMENT
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DERIVATIVES IN TREASURY MANAGEMENT Parikshit Jain 08 EM-028 Sushan rungta 08EM-048 Nilesh Baid 08EM-024. The Nature of Derivatives. A derivative is an instrument whose value depends on the values of other more basic underlying variables. Examples of Derivatives. Swaps Options

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The nature of derivatives

DERIVATIVES IN TREASURY MANAGEMENTParikshit Jain 08 EM-028Sushanrungta 08EM-048NileshBaid 08EM-024


The nature of derivatives

The Nature of Derivatives

A derivative is an instrument whose value depends on the values of other more basic underlying variables


Examples of derivatives

Examples of Derivatives

  • Swaps

  • Options

  • Forward Contracts

  • Futures Contracts


Derivatives markets

Derivatives Markets

  • Exchange Traded

    • standard products

    • trading floor or computer trading

    • virtually no credit risk

  • Over-the-Counter

    • non-standard products

    • telephone market

    • some credit risk


Ways derivatives are used

Ways Derivatives are Used

  • To hedge risks

  • To reflect a view on the future direction of the market

  • To lock in an arbitrage profit

  • To change the nature of a liability

  • To change the nature of an investment without incurring the costs of selling one portfolio and buying another


Forward contracts

Forward Contracts

  • A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price)

  • It can be contrasted with a spot contract which is an agreement to buy or sell immediately


How a forward contract works

How a Forward Contract Works

  • The contract is an over-the-counter (OTC) agreement between 2 companies

  • The delivery price is usually chosen so that the initial value of the contract is zero

  • No money changes hands when contract is first negotiated and it is settled at maturity


The forward price

The Forward Price

  • The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)

  • The forward price may be different for contracts of different maturities


Terminology

Terminology

  • The party that has agreed to buyhas what is termed a long position

  • The party that has agreed to sell has what is termed a short position


Example

Example

  • On January 20, 1998 a trader enters into an agreement to buy £1 million in three months at an exchange rate of 1.6196

  • This obligates the trader to pay $1,619,600 for £1 million on April 20, 1998

  • What are the possible outcomes?


Profit from a long forward position

Profit

Price of Underlying

at Maturity, ST

Profit from aLong Forward Position

K


Profit from a short forward position

Profit

Price of Underlying

at Maturity, ST

Profit from a Short Forward Position

K


Futures contracts

Futures Contracts

  • Agreement to buy or sell an asset for a certain price at a certain time

  • Similar to forward contract

  • Whereas a forward contract is traded OTC a futures contract is traded on an exchange


1 gold an arbitrage opportunity

1. Gold: An Arbitrage Opportunity?

  • Suppose that:

    • The spot price of gold is US$300

    • The 1-year forward price of gold is US$340

    • The 1-year US$ interest rate is 5% per annum

  • Is there an arbitrage opportunity?


2 gold another arbitrage opportunity

2. Gold: Another Arbitrage Opportunity?

  • Suppose that:

    • The spot price of gold is US$300

    • The 1-year forward price of gold is US$300

    • The 1-year US$ interest rate is 5% per annum

  • Is there an arbitrage opportunity?


The forward price of gold

The Forward Price of Gold

If the spot price of gold is S & the forward price for a contract deliverable in T years is F, then

F = S (1+r )T

where r is the 1-year (domestic currency) risk-free rate of interest.

In our examples, S=300, T=1, and r=0.05 so that

F = 300(1+0.05) = 315


1 oil an arbitrage opportunity

1. Oil: An Arbitrage Opportunity?

Suppose that:

  • The spot price of oil is US$19

  • The quoted 1-year futures price of oil is US$25

  • The 1-year US$ interest rate is 5% per annum

  • The storage costs of oil are 2% per annum

  • Is there an arbitrage opportunity?


  • 2 oil another arbitrage opportunity

    2. Oil: Another Arbitrage Opportunity?

    • Suppose that:

      • The spot price of oil is US$19

      • The quoted 1-year futures price of oil is US$16

      • The 1-year US$ interest rate is 5% per annum

      • The storage costs of oil are 2% per annum

    • Is there an arbitrage opportunity?


    Exchanges trading futures

    Exchanges Trading Futures

    • Chicago Board of Trade

    • Chicago Mercantile Exchange

    • BM&F (Sao Paulo, Brazil)

    • LIFFE (London)

    • TIFFE (Tokyo)

    • and many more (see list at end of book)


    Options

    Options

    • A call option is an option to buy a certain asset by a certain date for a certain price (the strike price)

    • A put is an option to sell a certain asset by a certain date for a certain price (the strike price)


    Long call on ibm

    Profit ($)

    30

    20

    10

    Terminal

    stock price ($)

    70

    80

    90

    100

    0

    110

    120

    130

    -5

    Long Call on IBM

    Profit from buying an IBM European call option: option price = $5, strike price = $100, option life = 2 months


    Short call on ibm

    Profit ($)

    110

    120

    130

    5

    0

    70

    80

    90

    100

    Terminal

    stock price ($)

    -10

    -20

    -30

    Short Call on IBM

    Profit from writing an IBM European call option: option price = $5, strike price = $100, option life = 2 months


    Long put on exxon

    Profit ($)

    30

    20

    10

    Terminal

    stock price ($)

    0

    40

    50

    60

    70

    80

    90

    100

    -7

    Long Put on Exxon

    Profit from buying an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths


    Short put on exxon

    Profit ($)

    Terminal

    stock price ($)

    7

    40

    50

    60

    0

    70

    80

    90

    100

    -10

    -20

    -30

    Short Put on Exxon

    Profit from writing an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths


    Payoffs from options what is the option position in each case

    Payoff

    Payoff

    X

    X

    ST

    ST

    Payoff

    Payoff

    X

    X

    ST

    ST

    Payoffs from OptionsWhat is the Option Position in Each Case?

    X = Strike price, ST = Price of asset at maturity


    Types of traders

    Types of Traders

    • Hedgers

    • Speculators

    • Arbitrageurs

    Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators


    Hedging examples

    Hedging Examples

    • A US company will pay £1 million for imports from Britain in 6 months and decides to hedge using a long position in a forward contract

    • An investor owns 500 IBM shares currently worth $102 per share. A two- month put with a strike price of $100 costs $4. The investor decides to hedge by buying 5 contracts


    Speculation example

    Speculation Example

    • An investor with $7,800 to invest feels that Exxon’s stock price will increase over the next 3 months. The current stock price is $78 and the price of a 3-month call option with a strike of 80 is $3

    • What are the alternative strategies?


    Arbitrage example

    Arbitrage Example

    • A stock price is quoted as £100 in London and $172 in New York

    • The current exchange rate is 1.7500

    • What is the arbitrage opportunity?


    Exchanges trading options

    Exchanges Trading Options

    • Chicago Board Options Exchange

    • American Stock Exchange

    • Philadelphia Stock Exchange

    • Pacific Stock Exchange

    • European Options Exchange

    • Australian Options Market

    • and many more (see list at end of book)


    Futures markets and the use of futures for hedging

    Futures Markets and the Use of Futuresfor Hedging


    Futures contracts1

    Futures Contracts

    • Available on a wide range of underlyings

    • Exchange traded

    • Specifications need to be defined:

      • What can be delivered,

      • Where it can be delivered, &

      • When it can be delivered

    • Settled daily


    Margins

    Margins

    • A margin is cash or marketable securities deposited by an investor with his or her broker

    • The balance in the margin account is adjusted to reflect daily settlement

    • Margins minimize the possibility of a loss through a default on a contract


    Example of a futures trade

    Example of a Futures Trade

    • An investor takes a long position in 2 December gold futures contracts on June 3

      • contract size is 100 oz.

      • futures price is US$400

      • margin requirement is US$2,000/contract (US$4,000 in total)

      • maintenance margin is US$1,500/contract (US$3,000 in total)


    A possible outcome

    A Possible Outcome

    Daily

    Cumulative

    Margin

    Futures

    Gain

    Gain

    Account

    Margin

    Price

    (Loss)

    (Loss)

    Balance

    Call

    Day

    (US$)

    (US$)

    (US$)

    (US$)

    (US$)

    400.00

    4,000

    3-Jun

    397.00

    (600)

    (600)

    3,400

    0

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    11-Jun

    393.30

    (420)

    (1,340)

    2,660

    1,340

    4,000

    +

    =

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    3,000

    <

    17-Jun

    387.00

    (1,140)

    (2,600)

    2,740

    1,260

    4,000

    +

    =

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    .

    24-Jun

    392.30

    260

    (1,540)

    5,060

    0


    Other key points about futures

    Other Key Points About Futures

    • They are settled daily

    • Closing out a futures position involves entering into an offsetting trade

    • Most contracts are closed out before maturity


    Delivery

    Delivery

    • If a contract is not closed out before maturity, it usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses.

    • A few contracts (for example, those on stock indices and Eurodollars) are settled in cash


    Some terminology

    Some Terminology

    • Open interest: the total number of contracts outstanding

      • equal to number of long positions or number of short positions

    • Settlement price: the price just before the final bell each day

      • used for the daily settlement process

    • Volume of trading: the number of trades in 1 day


    Convergence of futures to spot

    Convergence of Futures to Spot

    Futures

    Price

    Spot Price

    Futures

    Price

    Spot Price

    Time

    Time

    (a)

    (b)


    Questions

    Questions

    • When a new trade is completed what are the possible effects on the open interest?

    • Can the volume of trading in a day be greater than the open interest?


    Regulation of futures

    Regulation of Futures

    • Regulation is designed to protect the public interest

    • Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups


    Accounting tax

    Accounting & Tax

    • If a contract is used for

      • Hedging: it is logical to recognize profits (losses) at the same time as on the item being hedged

      • Speculation: it is logical to recognize profits (losses) on a mark to market basis

    • Roughly speaking, this is what the treatment of futures in the U.S.and many other countries attempts to achieve


    Long short hedges

    Long & Short Hedges

    • A long futures hedge is appropriate when you know you will purchase an asset in the future & want to lock in the price

    • A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price


    Basis risk

    Basis Risk

    • Basis is the difference between spot & futures

    • Basis risk arises because of the uncertainty about the basis when the hedge is closed out


    Long hedge

    Long Hedge

    • Suppose that

      F1 :Initial Futures Price

      F2: Final Futures Price

      S2: Final Asset Price

    • You hedge the future purchase of an asset by entering into a long futures contract

    • Cost of Asset=S2 -F2+F1= F1+ Basis


    Short hedge

    Short Hedge

    • Suppose that

      F1 :Initial Futures Price

      F2: Final Futures Price

      S2: Final Asset Price

    • You hedge the future sale of an asset by entering into a short futures contract

    • Price Realized=S2 -F2+F1= F1+ Basis


    Choice of contract

    Choice of Contract

    • Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge

    • When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. There are then 2 components to basis


    Optimal hedge ratio

    Optimal Hedge Ratio

    • Proportion of the exposure that should optimally be hedged iswhere

      S : spot price,

      F : futures price, sS : standard deviation of DS , sF : standard deviation of DF &

      r: coefficient of correlation between DS & DF


    Rolling the hedge forward

    Rolling The Hedge Forward

    • We can use a series of futures contracts to increase the life of a hedge

    • Each time we switch from 1 futures contract to another we incur a type of basis risk


    Forward contracts vs futures contracts

    Forward Contracts vs Futures Contracts

    FORWARDS

    FUTURES

    Private contract between 2 parties

    Exchange traded

    Non-standard contract

    Standard contract

    Usually 1 specified delivery date

    Range of delivery dates

    Settled at maturity

    Settled daily

    Delivery or final cash

    Contract usually closed out

    settlement usually occurs

    prior to maturity


    Swaps

    Swaps


    Nature of swaps

    Nature of Swaps

    • A swap is an agreement to exchange cash flows at specified future times according to certain specified rules


    An example of a plain vanilla interest rate swap

    An Example of a “Plain Vanilla” Interest Rate Swap

    • An agreement by “Company B” to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million

    • Next slide illustrates cash flows


    Cash flows to company b

    ---------Millions of Dollars---------

    LIBOR

    FLOATING

    FIXED

    Net

    Date

    Rate

    Cash Flow

    Cash Flow

    Cash Flow

    Mar.1, 1998

    4.2%

    Sept. 1, 1998

    4.8%

    +2.10

    –2.50

    –0.40

    Mar.1, 1999

    5.3%

    +2.40

    –2.50

    –0.10

    Sept. 1, 1999

    5.5%

    +2.65

    –2.50

    +0.15

    Mar.1, 2000

    5.6%

    +2.75

    –2.50

    +0.25

    Sept. 1, 2000

    5.9%

    +2.80

    –2.50

    +0.30

    Mar.1, 2001

    6.4%

    +2.95

    –2.50

    +0.45

    Cash Flows to Company B


    Typical uses of an interest rate swap

    Converting a liability from

    fixed rate to floating rate

    floating rate to fixed rate

    Converting an investment from

    fixed rate to floating rate

    floating rate to fixed rate

    Typical Uses of anInterest Rate Swap


    A and b transform a liability

    A and B Transform a Liability

    5%

    5.2%

    A

    B

    LIBOR+0.8%

    LIBOR


    Financial institution is involved

    Financial Institution is Involved

    4.985%

    5.015%

    5.2%

    A

    F.I.

    B

    LIBOR+0.8%

    LIBOR

    LIBOR


    A and b transform an asset

    A and B Transform an Asset

    5%

    4.7%

    A

    B

    LIBOR-0.25%

    LIBOR


    Financial institution is involved1

    Financial Institution is Involved

    4.985%

    5.015%

    4.7%

    A

    F.I.

    B

    LIBOR-0.25%

    LIBOR

    LIBOR


    The comparative advantage argument

    Fixed

    Floating

    Company A

    10.00%

    6-month LIBOR + 0.30%

    Company B

    11.20%

    6-month LIBOR + 1.00%

    The Comparative Advantage Argument

    • Company A wants to borrow floating

    • Company B wants to borrow fixed


    The swap

    The Swap

    9.95%

    10%

    A

    B

    LIBOR+1%

    LIBOR


    The swap when a financial institution is involved

    The Swap when a Financial Institution is Involved

    9.93%

    9.97%

    10%

    A

    F.I.

    B

    LIBOR+1%

    LIBOR

    LIBOR


    Criticism of the comparative advantage argument

    Criticism of the Comparative Advantage Argument

    • The 10.0% and 11.2% rates available to A and B in fixed rate markets are 5-year rates

    • The LIBOR+0.3% and LIBOR+1% rates available in the floating rate market are six-month rates

    • B’s fixed rate depends on the spread above LIBOR it borrows at in the future


    Valuation of an interest rate swap

    Valuation of an Interest Rate Swap

    • Interest rate swaps can be valued as the difference between the value of a fixed-rate bond & the value of a floating-rate bond

    • Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)


    Valuation in terms of bonds

    Valuation in Terms of Bonds

    • The fixed rate bond is valued in the usual way

    • The floating rate bond is valued by noting that it is worth par immediately after the next payment date


    Valuation in terms of fras

    Valuation in Terms of FRAs

    • Each exchange of payments in an interest rate swap is an FRA

    • The FRAs can be valued on the assumption that today’s forward rates are realized


    An example of a currency swap

    An Example of a Currency Swap

    An agreement to pay 11% on a sterling principal of £10,000,000 & receive 8% on a US$ principal of $15,000,000 every year for 5 years


    Exchange of principal

    Exchange of Principal

    • In an interest rate swapthe principal is not exchanged

    • In a currency swap the principal is exchanged at the beginning &the end of the swap


    The cash flows

    The Cash Flows

    Dollars

    Pounds

    $

    £

    Years

    ------millions------

    0

    –15.00

    +10.00

    +1.20

    1

    –1.10

    2

    +1.20

    –1.10

    3

    +1.20

    –1.10

    4

    +1.20

    –1.10

    5

    +16.20

    -11.10


    Typical uses of a currency swap

    Conversion from a liability in one currency to a liability in another currency

    Conversion from an investment in one currency to an investment in another currency

    Typical Uses of a Currency Swap


    Comparative advantage arguments for currency swaps

    USD

    AUD

    Company A

    5.0%

    12.6%

    Company B

    7.0%

    13.0%

    Comparative Advantage Arguments for Currency Swaps

    • Company A wants to borrow AUD

    • Company B wants to borrow USD


    Valuation of currency swaps

    Valuationof Currency Swaps

    • Like interest rate swaps, currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts


    Swaps forwards

    Swaps & Forwards

    • A swap can be regarded as a convenient way of packaging forward contracts

    • The “plain vanilla” interest rate swap in our example consisted of 6 FRAs

    • The “fixed for fixed” currency swap in our example consisted of a cash transaction & 5 forward contracts


    Swaps forwards continued

    Swaps & Forwards(continued)

    • The value of the swap is the sum of the values of the forward contracts underlying the swap

    • Swaps are normally “at the money” initially

      • This means that it costs NOTHING to enter into a swap

      • It does NOT mean that each forward contract underlying a swap is “at the money” initially


    Credit risk

    Credit Risk

    • A swap is worth zero to a company initially

    • At a future time its value is liable to beeither positive or negative

    • The company has credit risk exposure only when its value is positive


    Examples of other types of swaps

    Examples of Other Types of Swaps

    • Amortizing & step-up swaps

    • Extendible & puttable swaps

    • Index amortizing swaps

    • Equity swaps

    • Commodity swaps

    • Differential swaps


    Options markets

    Options Markets


    Assets underlying exchange traded options

    Assets UnderlyingExchange-Traded Options

    • Stocks

    • Foreign Currency

    • Stock Indices

    • Futures


    Specification of exchange traded options

    Specification ofExchange-Traded Options

    • Expiration date

    • Strike price

    • European or American

    • Call or Put (option class)


    Terminology1

    Terminology

    Moneyness :

    • At-the-money option

    • In-the-money option

    • Out-of-the-money option


    Terminology continued

    Terminology(continued)

    • Option class

    • Option series

    • Intrinsic value

    • Time value


    Dividends stock splits

    Dividends & Stock Splits

    • Suppose you own N options with a strike price of X :

      • No adjustments are made to the option terms for cash dividends

      • When there is an n-for-m stock split,

        • the strike price is reduced to mX/n

        • the no. of options is increased to nN/m

      • Stock dividends are handled in a manner similar to stock splits


    Dividends stock splits continued

    Dividends & Stock Splits(continued)

    • Consider a call option to buy 100 shares for $20/share

    • How should terms be adjusted:

      • for a 2-for-1 stock split?

      • for a 5% stock dividend?


    Organization of trading

    Types of traders:

    Market makers

    Floor brokers

    Alternative systems for limit orders

    Order book officials

    Specialists

    Organization of Trading


    Margins1

    Margins

    • Margins are required when options are sold

    • When a naked option is written the margin is the greater of:

      • A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money

      • A total of 100% of the proceeds of the sale plus 10% of the underlying share price

    • For other trading strategies there are special rules


    Warrants

    Warrants

    • Warrants are options that are issued (or written) by acorporation or a financial institution

    • The number of warrants outstanding is determined by the size of the original issue & changes only when they are exercised or when they expire


    Warrants continued

    Warrants(continued)

    • Warrants are traded in the same way as stocks

    • The issuer settles up with the holder when a warrant is exercised

    • When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued


    Executive stock options

    Executive Stock Options

    • Option issued by a company to executives

    • When the option is exercised the company issues more stock

    • Usually at-the-money when issued


    Executive stock options continued

    Executive Stock Options continued

    • They become vested after a period ot time

    • They cannot be sold

    • They often last for as long as 10 or 15 years


    Convertible bonds

    Convertible Bonds

    • Convertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio


    Convertible bonds continued

    Convertible Bonds(continued)

    • Very often a convertible is callable

    • The call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose


    The nature of derivatives

    TYPES OF DERIVATIVES

    • Forwards

    • A forward contract is customized contract between two entities, where settlement

    • takes place on a specific date in the future at today’s pre-agreed price.

    • Futures

    • An agreement between two parties to buy or sell an asset at a certain time in the

    • future at a certain price . Futures contacts are special types of forward

    • contracts in the contracts in the sense that the former are standardized

    • exchange-traded contracts.

    • Options

    • Options are of two types – calls and puts. Calls give the buyer the right but not the

    • obligation to buy a given quantity of the underlying asset, at a given price on or

    • before a given future date. Puts give the buyer the right, but not obligation to sell a

    • given quantity of the underlying asset at a given price on or before a given date.


    The nature of derivatives

    FUTURES

    OPTIONS

    Futures contract is an agreement to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obliged to buy/sell the underlying asset.

    In options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset.

    Unlimited upside & downside for both buyer and seller.

    Limited downside (to the extent of premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited.

    Futures contracts prices are affected mainly by the prices of the underlying asset

    Prices of options are however, affected by a)prices of the underlying asset, b)time remaining for expiry of the contract and c)volatility of the underlying asset.

    DIFFERENCE BETWEEN FUTURES & OPTIONS


    The nature of derivatives

    OPTION TERMINOLOGY (For The Equity Markets)

    • Options

    • Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.

    • Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.

    • Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.

    • Call Option - Option to buy.

    • Put Option - Option to sell.

    • American Option - An option which can be exercised anytime on or before the expiry date.

    • Strike Price/ Exercise Price - Price at which the option is to be exercised.

    • Expiration Date - Date on which the option expires.

    • European Option - An option which can be exercised only on expiry date.

    • Exercise Date - Date on which the option gets exercised by the option holder/buyer.

    • Option Premium - The price paid by the option buyer to the option seller for granting the option.


    The nature of derivatives

    Call Option

    Put Option

    Option Buyer

    Buys the right to buy the underlying asset at the Strike Price

    Buys the right to sell the underlying asset at the Strike Price

    Option Seller

    Has the obligation to sell the underlying asset to the option holder at the Strike Price

    Has the obligation to buy the underlying asset from the option holder at the Strike Price


    The nature of derivatives

    Illustration on Call Option

    An investor buys one European Call option on one share of Neyveli Lignite at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity.On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.


    The nature of derivatives

    Illustration on Put Options

    An investor buys one European Put Option on one share of Neyveli Lignite at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a change in the spot price.


    The nature of derivatives

    STRATEGIES OF TRADING IN

    FUTURE AND OPTIONS


    The nature of derivatives

    USING STOCK OPTIONS

    Hedging:Have stock, buy puts

    Speculation: bullish stock, buy calls or sell puts

    Speculation : bearish Stock, buy put or sell calls


    The nature of derivatives

    BULLISH

    STRATEGIES


    The nature of derivatives

    LONG CALL

    Market Opinion - Bullish

    Most popular strategy with investors.

    Used by investors because of better leveraging compared to buying the underlying stock – insurance

    against decline in the value of the underlying

    Profit +

    0

    BEP

    S

    Underlying Asset Price

    Stock Price

    Lower Higher

    DR

    Loss -


    The nature of derivatives

    Risk Reward ScenarioMaximum Loss = Limited (Premium Paid)Maximum Profit = UnlimitedProfit at expiration = Stock Price at expiration – Strike Price – Premium paidBreak even point at Expiration = Strike Price + Premium paid


    The nature of derivatives

    SHORT PUT

    Market Opinion - Bullish

    Profit +

    CR

    0

    BEP

    S

    Underlying Asset Price

    Stock Price

    Lower Higher

    Loss -

    Risk Reward Scenario

    Maximum Loss – Unlimited

    Maximum Profit – Limited (to the extent of option premium)

    Makes profit if the Stock price at expiration > Strike price - premium


    The nature of derivatives

    BULL CALL SPREADFor Investors who are bullish but at the same time conservativeBUY A CALL CLOSER TO SPOT PRICE & WRITE A CALL WITH A HIGHER PRICEIn a market that has bottomed out, when stocks rise, they rise in small steps for a short duration. Bull Call Spread can be Used where gains & losses are limited.

    CESE Spot Price= Rs.250Premium of 260 CA= Rs.10Premium of 270 CA= Rs. 6Strategy – Buy 260 CA @ Rs.10 & Sell 270 CA @ Rs.6Net Outflow = Rs.4


    The nature of derivatives

    Risk is Low & confined to Spread. Return is also limited. While Trading try to minimize the Spread.


    The nature of derivatives

    BULL PUT SPREADFor Investors who are bullish but at the same time conservativeWrite a PUT Option with a higher Strike Price and Buy a Put Option with a lower Strike PriceCESESpot Price = Rs.270Premium on Rs. 270 PA = Rs.12Premium on Rs. 250 PA = Rs. 3Sell Rs.270 PA and Buy Rs.250 PANet Inflow = Rs. 9


    The nature of derivatives

    COVERED CALLNeutral to Bullish Buy The Stock & Write A Call Perception – Bullish on the Stock in the long term but expecting little variation during the lifetime of Call ContractIncome received from the premium on Call CESESpot Price = Rs.270Premium on Rs. 270 CA = Rs. 12Buy CESE @ Rs.270 and sell Rs. 270 CA @ Rs.12. Stock Price at Expiration Net Profit/Loss230- 28 (- 40 + 12)250- 8 ( -20+12)270+ 12 ( + 12)300+ 12 (-30+30+12)350+ 12 (-80 +80+12)Profits are limited . Losses can be unlimited


    The nature of derivatives

    COVERED CALL

    Profit +

    0

    BEP

    Strike Price

    Stock Price

    Lower Higher

    Loss -


    The nature of derivatives

    MARRIED PUT

    A person is bullish on the stock but is concerned about near term downside due to market risks.

    Buy a PUT Option and at the same time buy equivalent number of shares.

    Benefits of Stock ownership & Insurance against too much downside.

    Maximum Profit – Unlimited

    Maximum Loss – Limited = Stock Purchase Price – Strike Price + Premium Paid

    Profit at Expiration = Profit in Underlying Share Value – Premium Paid

    CESE :

    Spot Price = Rs.270

    Premium on Rs.250 PA = Rs. 3

    Buy shares of CESE @ Rs.270/- and Buy Rs.250 PA @ Rs.3

    Stock Price at ExpirationNet Profit/ Loss

    230 - 23 (- 40 + 20-3)

    250 - 23 ( -20-3)

    270 - 3 (Loss of Premium Paid)

    300 +27 (30-3)

    350 +77 (80-3)

    Maximum Loss restricted to Rs.23 , Profit Unlimited


    The nature of derivatives

    MARRIED PUT

    Profit +

    BEP

    Strike Price

    Stock Price

    Loss -Lower Higher


    The nature of derivatives

    THE OPTIMAL BULL STRATEGY

    LONG CALL: BULLISH BUT RISK AVERSE; INSIDER WITH LIMITED CAPITAL

    SHORT PUT: LONG TERM BULLISH BUT LOOKING FOR LOWER COST.

    COVERED CALL: LONG TERM BULLISH BUT NOT EXPECTING UPSIDE IN NEAR TERM

    MARRIED PUT : BULLISH BUT AFRAID OF NEAR TERM DOWNSIDE RISK

    BULL CALL SPREAD: MILDLY BULLISH AS WELL AS RISK AVERSE.

    BULL PUT SPREAD: BULLISH BUT LOOKING FOR LOWER COSTS AND SCARED OF A MAJOR FALL.


    The nature of derivatives

    BEARISH

    STRATEGIES


    The nature of derivatives

    LONG PUTMarket Opinion – BearishFor investors who want to make money from a downward price move in the underlying stockOffers a leveraged alternative to a bearish or short sale of the underlying stock.

    Profit +

    0

    DR

    Loss -

    Underlying Asset Price

    S

    BEP

    Stock Price

    Lower Higher


    The nature of derivatives

    Risk Reward ScenarioMaximum Loss – Limited (Premium Paid)Maximum Profit - Limited to the extent of price of stockProfit at expiration - Strike Price – Stock Price at expiration - Premium paidBreak even point at Expiration – Strike Price - Premium paid


    The nature of derivatives

    SHORT CALL

    Market Opinion – Bearish

    Profit +

    CR

    0

    Loss -

    Underlying Asset Price

    BEP

    S

    Stock Price

    Lower Higher

    Risk Reward Scenario

    Maximum Loss – Unlimited

    Maximum Profit - Limited (to the extent of option premium)

    Makes profit if the Stock price at expiration < Strike price + premium


    The nature of derivatives

    BEAR CALL SPREAD

    Low Risk Low Reward Strategy

    Sell a Call Option with a Lower Strike Price and Buying a Call Option with a Higher Strike Price

    CESESpot Price = Rs.270

    Premium on Rs. 290 CA = Rs. 5

    Premium on Rs. 270 CA = Rs. 12

    Sell Rs.270 CA and Buy Rs.290 CA

    Net Inflow = Rs. 7

    Stock Price at ExpirationNet Profit/ Loss

    230 + 7 (Both Options expire worthless )

    250 + 7 (Both Options expire worthless )

    270 + 7 ((Both Options expire worthless)

    300 - 13 (-30+10+7)

    350 - 13 ( -80+60+7)

    Maximum Possible Profit = Rs.7 & Loss = Rs.13

    Limited Upside & Downside


    The nature of derivatives

    BEAR PUT SPREAD

    Again a LOW RISK, LOW RETURN Strategy

    Gains as Well as Losses are Limited

    BUY PUT OPTION AT A HIGHER STRIKE PRICE AND SELL ANOTHER WITH A

    LOWER STRIKE PRICE

    Profit Accrues when the price of underlying stock goes down.

    IPCLSpot Price = Rs.260

    Premium on Rs. 250 PA = Rs. 6

    Premium on Rs. 230 PA = Rs. 2

    BUY Rs.250 PA and SELL Rs.230 PA

    Net Outflow = Rs. 4

    Stock Price at ExpirationNet Profit/ Loss

    200 + 16 (+50-30-4)

    230 + 16 (+20-4)

    250 - 4 Both options expire w’thles

    270 - 4 Both options expire w’thles

    300- 4 Both options expire w’thles

    Maximum Possible Profit = Rs.16 & Loss = Rs.4

    Limited Upside & Downside


    The nature of derivatives

    BEAR PUT SPREAD

    Profit +

    0

    Loss -

    Higher Strike

    Price

    Lower Strike

    Price

    BEP

    Stock Price

    Lower Higher


    The nature of derivatives

    NEUTRAL

    STRATEGIES


    The nature of derivatives

    SHORT STRADDLE

    WRITE CALL & PUT OPTIONS

    If you expect the Stock to show very little volatility, it is worthwhile to write a call & put option.

    Ashok Leyland – has been range bound for the last 3 months. You don’t expect it to move up or down too much.

    Ashok Leyland Spot PriceRs. 25

    Premium of Rs.25 CARs. 1.5

    Premium on Rs.25 PARs. 1.5

    Sell Rs.25 CA and Rs.25 PA.

    Total Premium Received = Rs.3 .

    Investor incurs a loss incase price drops below Rs. 22 or goes up above Rs. 28

    Risky Strategy since profits limited but losses unlimited.


    The nature of derivatives

    SHORT STRANGLE

    SELL OUT OF MONEY CALL & PUT OPTIONS

    CESESpot Price = Rs.270

    Premium on Rs. 250 PA= Rs.5

    Premium on Rs. 290 CA = Rs.4

    Sell CESE Rs. 250 PA @ Rs.5 and sell Rs.290 CA @ Rs.4.

    Total Premium Received = Rs. 9

    You start incurring a loss if price goes above Rs. 299 or drops below Rs. 241


    The nature of derivatives

    VOLATILITY

    STRATEGIES


    The nature of derivatives

    STRADDLE

    Long Straddle

    Buying a Straddle is simultaneous purchase of a CALL & PUT option for a Stock, with same expiration date & Strike Price.

    Why Straddle – If you expect the stock to fluctuate wildly but unsure of the direction. Enables investors to make profits on both upward and downward fluctuation of stock. Potential gain can be unlimited

    IPCL

    Spot Price = Rs. 250

    Premium on Rs. 250 CA= Rs. 12

    Premium on Rs. 250 PA= Rs. 12

    BUY Rs. 250 CA and Rs. 250 PA

    You Start making profits if Price goes above Rs. 274 or goes below Rs. 226


    The nature of derivatives

    STRANGLE

    Long Strangle

    Buying a Strangle is simultaneous purchase of Out of Money CALL & PUT option for a Stock, with same expiration date.

    IPCL

    Spot Price = Rs. 250

    Premium on Rs. 270 CA= Rs. 5

    Premium on Rs. 230 PA= Rs. 5

    BUY Rs. 270 CA and Rs. 230 PA

    Total Premium Paid = Rs. 10

    You Start making profits if Price goes above Rs. 280 or goes below Rs. 220


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