7/29/2011

Faculty Member IMIS Bhubneswar

By Dr.Surya Dev

Derivative is a contract whose value is derived from the value of the underlying asset.

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Forwards Futures Options Swaps

Buyer

Forward Contract
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price.

Seller Short position

Long position

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar Course on Financial Derivatives Dr Surya Dev IMIS Bhubaneswar

Salient Features of Forward Contract

They are bilateral contracts and hence exposed to counter party risk each contract is custom designed, and hence is unique in terms of contract size, expiration date and asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

P rofit and loss in a F orw ard contract

P osition L on g a forw ard C ontra ct P ro fits F o rw ard pric es rise L osse s F orw ard pric es fa ll

S hort a forw a rd c ontra ct

F orw ard pric es fa ll

F orw a rd price s rise

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

7/29/2011

Long Forward Profit diagram

Profit

Short Forward Profit diagram

Profit

F(0,t)

S(T) Losses

F(0,t)

S(T)

Losses

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Advantages of Buying a Forward Contract over spot transaction

There is no cost to taking a long position in a forward contract. Buying the commodity in the spot market requires an initial cash outlay. Buying the good in the spot market will result in storage and insurance costs. This expense is absent in forward contracts. Forward positions are easier to offset than goods already bought in spot transactions. The amount exposed to default risk in a forward contract is only a fraction of what is at risk in cash transaction.
Course on Financial Derivatives Dr Surya Dev IMIS Bhubaneswar

Disadvantages of forward contract compared to spot contract

In case of forward contract two sets of transaction costs may be incurred. The forward market is more or less reserved for larger organisations. Each party to a forward contract must be concerned about default risk. Unless the asset underlying the forward contract is identical to the item being hedged, the hedge is likely to be imperfect.
Course on Financial Derivatives Dr Surya Dev IMIS Bhubaneswar

Canceling a Forward Contract

The person who is long can approach the other party and negotiate its early termination. In this case the party that has the losing position at time t will have to pay to get out of its obligation. The party who is long to the contract and no longer wants to abide by its terms can approach a third party and agree to sell the good forward, at a fair forward price on day t.
Course on Financial Derivatives Dr Surya Dev IMIS Bhubaneswar Course on Financial Derivatives

Futures Contracts
A futures contract is an agreement between two parties to buy or sell an asset at a certain price at a certain time in the future.

Dr Surya Dev

IMIS Bhubaneswar

7/29/2011

Features of a futures contracts

Quantity of the underlying quality of the underlying the date and month of delivery the units of price quotation and minimum price change location of settlement Same as forward buyer/seller

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Option Contract
An option is a contract that gives the owner the right but not the obligation to buy or sell the underlying asset at a specified price on or before the maturity date.

Types of option contracts

Call option - An option that gives the right but not the obligation to buy the underlying asset at a specified price on or before a particular date. Put option - An option that gives the right but not the obligation to sell the underlying asset at a specified price on or before a particular date.

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Holder (Buyer) Call Option Put Option

Writer (Seller)

Options terminology
Exercise (strike) price - The per share price at which the common stock may be purchased from (in case of call) or sold to a writer (in case of a put). Expiration Date - The date on which option expires. Option premium - The price paid by the buyer of the option to the seller.
Course on Financial Derivatives Dr Surya Dev IMIS Bhubaneswar

Right to Buy Obligation to Sell Right to Sell Obligation to Buy

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

7/29/2011

Options terminology
American Option - In an American option, exercise can take place at any time during the life of the option. European Option - A European option can be exercised only at the end of the life.

Call Option
In the money : Strike price < stock spot price At the money : Strike price = stock spot price Out of the money: Strike price > stock spot price

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Put Option
In the money : Strike price > stock spot price At the money : Strike price = stock spot price
Loss Profit

Payoff of Call Buyer

Out of the money: Strike price < stock spot price

Stock Price

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Payoff of Call Writer

Profit Profit

Payoff of Put Buyer

Stock Price
Loss Loss

Stock Price

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

7/29/2011

Payoff of Put writer

In a swap contract, two parties agree to exchange cash flows at future dates according to a pre arranged formula. To determine the amounts that will be exchanged these prices are applied to a base amount called the notional principal of the swap. The two parties are called counterparties.
Profit

Stock Price
Loss
Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Interest rate Swap

An interest rate swap is an arrangement between two parties to exchange interest payments for specific maturity on an agreed upon notional principal amount. it is a transaction between two counterparties with fixed rate interest liabilities where each exchanges the fixed rate of interest in once currency in return for fixed rate of interest in another currency.

Fixed rate currency Swaps

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar

Course on Financial Derivatives

Dr Surya Dev

IMIS Bhubaneswar