Session 1

Derivatives, Futures & Options

Rachna Nawhal

Financial Derivatives
Financial instrument whose price is dependent upon or derived from the value of underlying assets The underlying not necessarily has to be an asset. It could be any other random/uncertain event like temperature/weather etc. The most common underlying assets includes:
Stock Bonds Commodities Currencies Interest rates

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. 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. Thus if there was to be no market for the underlying assets, there would be no derivatives.

Broad Categories of Derivatives

Forward Contracts Futures Contracts Options Contracts Swaps

Definition of a Forward Contract

A forward contract is an agreement between two parties that calls for the delivery of an asset on a specified future date at a price that is negotiated at the time of entering into the contract. Every forward contract has a buyer and a seller. The buyer has an obligation to pay cash and take delivery on the future date. The seller has an obligation to take the cash and make delivery on the future date.

Definition of a Futures Contract

A futures contract too is a contract that calls for the delivery of an asset on a specified future date at a price that is fixed at the outset. It too imposes an obligation on the buyer to take delivery and on the seller to make delivery. Thus it is essentially similar to a forward contract.

Forward versus Futures

Yet there are key differences between the two types of contracts. A forward contract is an Over-the-Counter or OTC contract : This means that the terms of the agreement are negotiated individually between the buyer and the seller. Futures contracts are however traded on organized futures exchanges, just the way common stocks are traded on stock exchanges. The features of such contracts, like the date and place of delivery, and the quantity to be delivered per contract, are fixed by the exchange. The only job of the potential buyer and seller while negotiating a contract, is to ensure that they agree on the price at which they wish to transact.
7

Options
An options contract gives the buyer the right to transact on or before a future date at a price that is fixed at the outset. It imposes an obligation on the seller of the contract to transact as per the agreed upon terms, if the buyer of the contract were to exercise his right. We have said that an option holder acquires a right to transact. There are two possible transactions from an investors standpoint purchases and sales. Consequently there are two types of options Calls and Puts. A Call Option gives the holder the right to acquire the asset. A Put Option gives the holder the right to sell the asset. If a call holder were to exercise his right, the seller of the call would have to make delivery of the asset.
8

Options
If the holder of a put were to exercise his right, the seller of the put would have to accept delivery. We have said that an option holder has the right to transact on or before a certain specified date. Certain options permit the holder to exercise his right only on a future date. These are known as European Options. Other types of options permit the holder to exercise his right at any point in time on or before a specified future date. These are known as American Options.
9

Rights
What is the difference between a Right and an Obligation. An Obligation is a binding commitment to perform. A Right however, gives the freedom to perform if desired. It need be exercised only if the holder wishes to do so. In a transaction to trade an asset at a future date, both parties cannot be given rights. For, if it is in the interest of one party to go through with the transaction when the time comes, it obviously will not be in the interest of the other. Consequently while obligations can be imposed on both the parties to the contract, like in the case of a forward or a futures contract, a right can be given to only one of the two parties. Hence, while a buyer of an option acquires a right, the seller has an obligation to perform imposed on him.
10

Longs & Shorts

The buyer of a forward, futures, or options contract is known as the Long. He is said to have taken a Long Position. The seller of a forward, futures, or options contract, is known as the Short. He is said to have taken a Short Position. In the case of options, a Short is also known as the option Writer.

11

Comparison of Futures/Forwards versus Options

Instrument Nature of Longs Commitment Obligation to buy Nature of Shorts Commitment Obligation to sell

Forward/Futures Contract Call Options

Right to buy

Obligation to sell

Put Options

Right to sell

Obligation to buy

12

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.

13

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.

14

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. 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.

15

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. 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 fixedfloating, floating-floating, as well as fixed-fixed swaps.
16

Actors in the Market

There are three broad categories of market participants: Hedgers Speculators Arbitrageurs

17

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. 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.

18

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. 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.
19

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. 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.

20

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.

21

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 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.
22

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. Market participants, like brokerage houses and investment banks have an advantage when it comes to arbitrage vis a vis individuals. Firstly, they do not typically pay commissions for they can arrange their own trades. Secondly, they have ready access to large amounts of capital at a competitive cost.

23

Thank you

24