Derivatives

1. Derivatives

2. What is a Derivative • Derivatives are contracts between buyers and sellers. • Derives its value from the value of some other financial asset or variable • The price of a derivative rises and falls in accordance with the value of the underlying asset • The most common underlying assets includes: • Stock • Bonds • Commodities • Currencies • Interest rates

3. Exchange-traded vs. over-the-counter derivatives • Some derivatives are traded on established exchanges referred to as exchange-traded derivatives • Derivative instruments, including forwards, swaps are traded outside of the formal, established exchanges. These are over-the-counter or OTC-traded derivatives.

4. Types of Financial Derivative • Options • Forward • Futures • Swaps

5. Options • An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date • Unlike a forward/future, this contract gives the right but not the obligation. So its not a binding contract. • The holder will exercise the option only if it is profitable.

6. Options • Major types of option contracts: - calls gives the holder the right to buy the underlying asset - putsgives the holder the right to sell the underlying asset. The complete definition of an option must specify: -Exercise or strike price (X): price at which the right is "exercised." - Expiration date (T): date when the right expires. - When the option can be exercised: anytime (American) at expiration (European). The right to buy/sell an asset has a price: the premium (X), paid upfront.

7. - An option is in-the-money (ITM) if, today, we would exercise it. • For a call: X < St (better to buy at a cheaper price than St) • For a put: St < X (better to sell at a higher price than St) • - An option is at-the-money (ATM) if, today, we would be indifferent to exercise it. • For a call: X = St (same to buy at X or St) • For a put: St = X (same to sell at X or St) • In practice, you never exercise an ATM option, since there are some small brokerage costs associated with exercising an option. • - An option is out-of-the-money (OTM) if, today, we would not exercise it. • For a call: X > St (better to buy at a cheaper price than X) • For a put: St > X (better to sell at a higher price than X)

8. Intrinsic Value is the amount by which the option is in-the-money • C= max [0, S-X] • P= max [0, X-S] • A call / put option on a stock has strike price $ 40, stock current price is $ 37 / share. Calculate how much these options are in or out of the money?

9. You would like to speculate on rise in the price of a certain stock. The current stock price Rs. 29 and 3-month call with strike price of Rs. 30 costs Rs. 2.90. You have Rs. 5,800 to invest. Identify two alternative investment strategies, one in the stock and the other in an option on the stock. What are potential gains and losses from each?

10. Speculation Example • An investor with $4,000 to invest feels that Amazon.com’s stock price will increase over the next 2 months. The current stock price is $40 and the price of a 2-month call option with a strike of 45 is $2 • What are the alternative strategies?

11. The current price of a stock is Rs.94, and three-month European call options with a strike price of Rs.95 currently sell for Rs.4.70. An investor who feels that the price of the stock will increase is trying to decide between buying 100 shares and buying 2,000 call options. Both strategies involve an investment of Rs.9,400. What are potential gains or losses from each strategy? What advice would you give? How high does the stock price have to rise for the option strategy to be more profitable?

12. Forwards • Forward contract is a binding contract which fixes now the buying/selling rate of the underlying asset to be bought/sold at some time in future. • Long Forward • Binding to buy the asset in future at the predetermined rate. • Short Forward • Binding to sell the asset in future at the predetermined rate.

13. Pay Off Pay Off = ST – K (for the long forward) Pay Off = K – ST (for the short forward) T = Time to expiry of the contract ST = Spot Price of the underlying asset at time T K = Strike Price or the price at which the asset will be bought/sold

14. A trader enters into a short cotton futures contract when the futures price is Rs.50 per kg. The contract is for delivery of 100,000 kg. How much does the trader gain or loss if the cotton price at the end of contract is (a) Rs. 48.20 per Kg (b) Rs.51.3 per Kg

15. The price of gold is currently Rs. 60,000 per 10 grams. The forward price for delivery in 1 year is Rs. 78,000. An arbitrageur can borrow money at 10% per annum. What should the arbitrageur do? Assume that the cost of storing gold is zero and that gold provides no income.

16. Futures • A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price • Specification of a standard contract: Gold • Commodity Name • Exchange Name • Size of Contract : 100 troy ounce • Delivery month: Feb/April/June/Aug/Oct/Dec

17. Forwards Traded in dispersed interbank market 24 hr a day. Lacks price transparency Transactions are customized and flexible to meet customers preferences. Counter party risk is variable No cash flows take place until the final maturity of the contract. Futures Traded in centralized exchanges during specified trading hours. Exhibits price transparency. Transactions are highly standardized to promote trading and liquidity. Being one of the two parties, the clearing house standardizes the counterparty risk of all contracts. On a daily basis, cash may flow in or out of the margin account, which is marked to market. FORWARDS Vs.FUTURES

18. Comparison of Futures and Forward Contracts

19. Problems with Future hedging • Contract size is fixed. • Expiration dates are also fixed. • Choice of underlying assets in the futures market is limited.

20. Hedging Examples • A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract • An investor owns 1,000 Microsoft shares currently worth $73 per share. A two-month put with a strike price of $63 costs $2.50. The investor decides to hedge by buying 10 contracts

21. Market Participants • Hedgers • mainly interested in protecting themselves against adverse price changes • want to avoid risk • Speculators • hope to make money in the markets by betting on the direction of prices • “accept” risk • Arbitrageurs • arbitrage involves locking into riskless profit by simultaneously entering into transactions in two or more markets

22. User of Derivative Products • Individuals – leveraging • Institutional Investor - Asset allocation strategy • Corporation - hedging exposure & enhancing yields

23. 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?

26. Swaps • A swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. • Swap - series of payments in the future but forward contract- a single future payment • Interest Rate Swap- fixed-for-floating

27. 6% p.a. Fixed Party A Party B 6 Month KIBOR Interest Rate Swap EXAMPLE • Counter parties:: A and BMaturity:: 5 years A pays to B : 6% fixed p.a.B pays to A : 6-month KIBORPayment terms : semi-annualNotional Principal amount: PKR 10 million.