The Magic of Financial Derivatives

someone
 Financial Derivatives have been called.
..

• . . .Engines of th e Econom y. . .
Alan Greenspan
(long-time chair of the Federal Reserve)

• . . .Weap ons of Mass

Destr uc tion . . . Warren Buffett
(chair of investment fund Berkshire
Hathaway)
Famous Calamities

• 1994: Orange County, CA:

losses of $1.7 billion
• 1995: Barings Bank: losses of
$1.5 billion
• 1998:
LongTermCapitalManagement
(LTCM) hedge fund, founded by
Meriwether, Merton and
• September 2006: the Hedge Fund
Amaranth closes after losing $6
billion in energy derivatives.
• January 2007: Reading (PA)
School District has to pay
$230,000 to Deutsche Bank
because of a bad derivative
investment
• October 2007: Citigroup, Merrill
Lynch, Bear Stearns, Lehman
Brothers, all declare billions in
losses in derivatives related to
 On the Other Hand

• In November 2006, a hedge

fund with a large stake (stocks
and options) in a company,
which was being bought out,
and whose stock price jumped
20%, made $500 million for the
fund in the process

• The head trader, who takes

20% in fees, earned $100
 So, what is a Financial
Derivative?
 A derivative is a contract between two
parties which derives its value from an
underlying asset.
 The different underlying assets are:
 Currency
 Exchange rate
 Interest rate
 Stocks & stock indices
 Bonds & bond indices
 Commodities
FEATURES OF A DERIVATIVE

• A derivative instrument relates

to the future contract between
two parties
• The derivative instruments
have the value which derived
from the values of other
underlying assets.
• In general the counter parties
have specified obligation
under the derivative contract.
 Economic functions of
Derivative market

• Derivatives help in discovery of future

as well as current prices.

• Speculative trades shift to a more

controlled environment of derivatives
market.

• Act as a catalyst for new

Why derivative is so important today?-
Growth Driving Factors

Increased volatility in asset prices in

Financial Markets
Increased integration between
International Markets
Development of more sophisticated Risk
Management tools, providing economic
agents a wider choice of Risk
Management strategies
Innovations in the derivatives markets,
which optimally combine the risks and
returns over a large number of financial
One of the most important services provided
by the derivatives is to control, avoid, shift
and manage efficiently different types of
risks through various strategies like hedging,
arbitraging, spreading, etc.

Derivatives serve as barometers of the future

trends in prices which result in the discovery
of new prices both on the spot and futures
markets.

The derivatives assist the investors, traders

and managers of large pools of funds to
devise such strategies so that they may make
proper asset allocation increase their yields
and achieve other investment goals.
 Ways derivatives are
• To insure against changes or risk
(hedgers).
• To get a high profit from a certain
market behavior (speculators).
• To get a quick low-risk profit
(arbitrageurs).
• To change the nature of an investment
without the costs of selling one
portfolio and buying another.
 What are the different types of traders/participants in
derivatives market ?
There are three types of traders in the Derivative
market namely                                                     
Hedgers:
They are in the position where they face risk
associated with the price of an asset. They use
derivatives to reduce or eliminate risk.

For example, a farmer may use futures or options to

establish the price for his crop long before he harvests
it. Various factors affect the supply and demand for
that crop, causing prices to rise and fall over the
growing season. The farmer can watch the prices
discovered in trading at the CBOT and, when they
reflect the price he wants, will sell futures contracts to
assure him of a fixed price for his crop.
Speculators:
Speculators wish to bet on the future movement in the
price of an asset. They use derivatives to get extra
leverage. A speculator will buy and sell in anticipation of
future price movements, but has no desire to actually own
the physical commodity.  

Arbitrators:
They are in the business to take advantage of a discrepancy
between prices in two different markets. If, for example,
they see the future prices of an asset getting out of line
with the cash price, they will take offsetting positions in the
 Types of Derivatives

Forwards
A Forward is an agreement between
two parties to purchase or sell an
instrument at a fixed time in the future and
at a certain price
 FEATURES OF A FORWARD
CONTRACT
Forward contracts are bilateral contracts

It specifies the future date at which the delivery and

payment are to be made.

The specified price in a forward contract is refer to as

the delivery price.

It obligates the seller to deliver the asset and also

obligates the buyer to buy the asset.

In forward contract, one of the parties takes along

position to buy the asset at specified future date and one
party takes a short position to sell the same assets at
the same date.
 Example of a forward
contract
• On January 20, 2009 a trader (long
position) 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 (=K) for £1 million on
April 20, 2009
• If the exchange rate rose to 1.65,
the spot price ST is $1,650,000
and the payoff is
 Long and short forward
position profits

Long position (buyer) Short position (seller)

Profi Profi
t t

ST ST
 PAY OFF FROM THE
FORWARD CONTRACT

Example: It is a Gold Forward Contract. On

January 01, 2005, two parties enter into
forward contract for delivery of one kg of
gold on April 01, 2005 at a price of Rs.
5,200/- per 10 grams of gold. If the spot
price of gold on April is 5400. Who will the
gainer or looser?
 1000 gm = I kg
t = January
T = April 1, 2002
FtT = Rs.5, 200/- per 10 grams of gold
If the spot price of the gold is Rs.5, 400/- gain to long position per contract:
No. Of Units X (FSP – Forward Price)
= 100 x (5,400 – 5,200)
= 100 x 200 = 20,000
The long position gains by having purchased gold worth Rs.5, 400/- per 10
gram at the forward price of Rs.5, 200/- per 10 grams. There will be a loss to the
person holding short position.
Loss to Short Position per Contract :
No. of Units X (Forward Price – Future Spot Price)
= 100 x (5,200 – 5,400)
= 100 x –200 = -Rs.20, 000/-
What is `Offsetting the Forward
Contract’

One cannot unilaterally back out from the

obligation arisen in the forward contract,

but he can certainly enter into another

forward position exactly opposite the

original position. This strategy is popularly

known as `offsetting the forward contract’.

EXAMPLE: January 01, 2005, a party X
enters into a forward contract with
another party Y, in which he agrees to
buy one kg of gold on April 01, 2005
for Rs.5,000 per 10 grams of gold. On
February 01, 2005, X decides to get
out of his position, and hence, enters
into another forward contract with Z
which he agrees to sell one kg of gold
on April 01, 2005 for Rs.5,200/- per 10
 Value of forward
contracts
• Let r be the risk-free interest rate, F0 the
forward price for a contract and K the
delivery price.
• The value f of the contract with time to
maturity T is:
f = (F0 - K)e-rT
• At a general time t, 0 <= t <= T:
f = (F0 - K)e-r(T-t)
Example – six month long forward contract
on stock
• Risk-free interest rate is 10%
• The forward price is $25, the delivery
The Advantage/Disadvantage
of A forward Contract
Disadvantage
Advanta • You must make or take delivery
of the commodity and settle on
ge the deliver date and honor the
contract as agreed upon
• Both parties
have limited
•  The buyer and seller are
dependent upon each other.
their risk • In a forward contract, any
profits or losses are not
realized until the contract
"comes due" on the
predetermined date.
 FUTURES CONTRACTS

A future is a standardized derivative contract

between two parties: a buyer and a seller.

Futures are similar to forwards but they are

traded on exchanges and their terms are
standardized.
Being a standardized contract means that the
buyer and seller do not contract directly
with each other.  Instead, they contract with
the intermediary known as the
clearinghouse.  The clearinghouse protects
their potential liability by requiring that
margin be deposited and all positions are
marked-to-market on at least a daily basis

Marking to market : Their value is settled

daily

Underlying assets are generally currencies,

commodities , treasury bonds, stock indices
 THE CLEARING HOUSE

What is clearing House?

The functions of the Clearing House

Buyer Funds Seller

Goods Goods
Buyer (Asset) (Asset) Seller
Clearing
house Funds
(Member) (Member)
(b) Obligations with a clearing house
 TYPES OF MARGIN

• The Initial Margin

• The Maintenance Margin

• The Variation Margin

 Margin

• Initial margin: Initial deposit of funds required to be

deposited.

• Amount required in this account varies from broker

to broker

• Minimum margin requirements for a particular futures contract at a

particular time are set by the exchange on which the contract is
traded. They are typically five to 10 percent of the value of the futures
contract

• Margin calls may bring the value of your margin account to original
initial margin level. Small loss allowed before margin calls.

• Maintenance margin is the loss level which initiates a margin call..

   
Note that once a trader receives a
margin call, he must meet that
call, even if the price has
subsequently moved in his favor.
If no money is deposited on the day
of the margin call or early the
next morning, the commodity
broker will automatically make an
offset trade to terminate the
client’s futures position. Brokers
Example: Gold future contract size = 100 grams

Investor buy one December gold futures contract

on 1st November at on 400/per grams

Value of contract 400 x 100 gm = Rs.40,000/-

Initial margin 10% = 40,000 x 10/100 = 4,000/-

Maintenance margin 75% of initial margin

75/100 x 4000 = Rs.3,000/-
Marking to Markets: Buyers Margin
Marking to Markets: Sellers Margin
 WHAT IS OPTIONS?

An option is a particular type of a

contract between two parties where

one person gives the other person

the right to buy or sell a specific

asset at a specified price within a

specific time period.

PAY OFF PROFILE OF OPTION
 TYPES OF OPTIONS

Call and Put Options

American and European Options

Exchange-traded and OTC-

traded Options
 TYPES OF OPTIONS

Call The option to buy

Put Options: The option to sell

American :The option can be exercised

anytime prior to maturity

European Options: The option can be

exercised at maturity
Longer -dated options are called warrants
and are generally traded over-the-counter
(OTC)

Long-Term Equity Anticipation Securities.

These are options having a maturity of up to
three years.

Basket options are options on portfolios of

underlying assets. The underlying asset is
usually a moving average of a basket of
Strike Price: The parties agree upon a price
at which the underlying asset may be bought
or sold. This price is referred to as exercise
price or strike price

Exercise date: The date at which contract

matures is called exercise date.

Expiration period: At the time of option

contract the exchange specifies the period
during which the option can be exercised or
Example of Call Option

An investor buys a European call option on

satyam will exercise price at RS 280 for a
premium of RS.10.If the price of the share rises
and current market price is RS 350 , the owner
of the option may exercise his option to buy the
shares at Rs 280.
 Example of a call option
• A trader (option holder) buys a European call option with
1,000 shares in deCode with a strike price of $14 and an
expiration date of one year. The option price is $0.5, so
the holder pays $500 (V) for the contract.
• If the deCode share rises to $17, the option holder has a
margin of $2.5 per share and makes a profit of
P = ST – K - V = ($17 - $14)*1,000 - $500 = $2,500.
• If the share rises to only $14.2, the option holder still
exercises the contract, since instead of losing the $500,
he only loses
$500 - ($14.2 – $14.0)*1,000 = $300
• In general, a call option is exercised if
-V < ST – K
Example of Put Option

The investor buys a European put option on

ONGC share with a strike price of Rs 850 and
expiration in June, by paying a premium of RS
25.The investor has the right to sell ONGC
share at RS 850 before the expiry date of the
option. If the current market price of share is
RS 950.The investor should not exercised his
option.
 Test your intuition: a concrete
example
• Current stock price of Microsoft is $19.40. (as of
last night)

• A call-option with strike $20 and 1-year

maturity would pay the difference between the
stock price on January 22, 2009 and the strike
(as long the stock price is higher than the
strike.)
• So if MSFT is worth $30 then, this option would
pay $10. If the stock is below $20 at maturity,
the contract expires worthless. . . . . .
• So, what would you pay to hold this contract?
• What would you want for it if you were the
writer?
 Price can be determined
by
• The market (as in an auction)
• Or mathematical analysis:
in 1973, Fischer Black and Myron
Scholes came up with a model to
price options.
It was an instant hit, and became
the foundation of the options
market.
for the value of European Call and Put-options, Black and
Scholes solved by formula:

• Where N is the cumulative

distribution function for a standard
normal random variable, and d1
and d2 are parameters depending
on S, E, r, t, σ

• This formula is easily programmed

into Maple or other programs
 SWAPS
Swaps have been termed as private agreements
between the two parties to exchange stream of cash
flows against one another.

Why?
• To hedge risks like floating
interest rate, Currency
fluctuations, equity returns
 Example

Housing Loan from

KP Agrees to pay
ICICI Bank
Floating rate to Rahul if
10 Lakhs
He agrees to pay 9% fixe
Floating 8.5 %
 Characteristics

• Two parties involved

• Private agreement
• OTC derivatives
• Cannot be traded
• Termination by mutual consent
 Types of Swaps

• Interest Swaps
• Currency Swaps
• Total Return Swaps
• Equity Swaps
• Commodity Swaps
• Credit Swaps
 Interest Swap

• Parties hedge interest rate

like fixed to floating
• Also called vanilla swaps
• Principal is not exchanged
• Most commonly used
 Example of Interest Rate Swap

A borrows $10 million with a floating

interest rate of Libor + 1% and B
borrows $10 million with a fixed
interest rate of 10%. A and B can
enter into an interest rate swap
arrangement under which A will pay
a fixed rate of interest of 10 percent
and B will pay a floating interest rate
of Libor + 1%.
 Currency Swap

• Parties hedge on currency

fluctuations
• Across two different currencies
• Actual exchange of currency
• Interest rates/variations
swapped
• Transactions are reversed later
 Example of Currency Swap

Company A raises 1 million by issuing

10% German mark bonds and the
company B raises 2 million by issuing
13% dollar bonds. Both the company
Swap the transaction.

In the beginning company A receives

2 million and company B receives 1
million. Both the companies re-
exchange the principal amounts at
the time of maturity.
Company A pays, 2,60,000 to
company B and company B in turn
 Equity Swap

• Parties hedge returns on equity

with Fixed interest
• Generally entered to avoid tax
• Portfolio is not exchanged
• Can be hedged against currency
fluctuations.
 Credit Swap

• Debt is transferred from one

Party to other
• Seller guarantees credit
worthiness
• Buyer will make money
if credit is recovered properly
 Risks

• Bilateral agreements can be

broken
• Risks beyond repayment - Sub
prime

Termination:
Both parties should
agree and close or can
reassign to a third party.
THANK
YOU