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What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value
of an asset that underlies the contract.
Examples: futures, forwards, swaps,
options, exotics
Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
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Forward Contracts
An agreement to buy/sell an asset at a
specified future date at a specified
price
The party who agrees to buy the asset
is said to have a long position
The party who agrees to sell the asset
is said to have a short position
In OTC forwards are traded between
financial institutions
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Forward Contracts
Originated primarily to protect cos. from:
Revenue-side risks
Cost-side risks
Spot
Bid
1.4407
Offer
1.4411
1-month forward
1.4408
1.4413
3-month forward
1.4410
1.4415
6-month forward
1.4416
1.4422
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Forward Price
The forward price may be different for
contracts of different maturities (as shown by
the table)
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Example 1
On May 24, 2010 the treasurer of an MNC
enters into a long forward contract to buy
1 million in six months at an exchange
rate of $1.4422/
This obligates the corporation to pay
$1,442,200 for 1 million on November
24, 2010
What are the possible outcomes?
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Profit
Price of Underlying
at Maturity, ST
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Price of
Underlying
at Maturity,
ST
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Futures Contracts
Agreement to buy or sell an asset for a
specified price at a specified future time
A standardised forward contract
A forward contract is traded OTC, while a
futures contract is traded on an exchange
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Options
An option contract gives the holder the
right to buy/sell the underlying asset by a
specified future date for a specified price
2 types: Call & Put options
A call option gives the holder right to buy
A put option gives the holder right to sell
The writer of the option has the obligation
to take the opposite position of the holder
The holder may not exercise the right
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Strike
Price
Jul 2010
Bid
Jul 2010
Offer
Sep 2010
Bid
Sep 2010
Offer
Dec 2010
Bid
Dec 2010
Offer
460
43.30
44.00
51.90
53.90
63.40
64.80
480
28.60
29.00
39.70
40.40
50.80
52.30
500
17.00
17.40
28.30
29.30
40.60
41.30
520
9.00
9.30
19.10
19.90
31.40
32.00
540
4.20
4.40
12.70
13.00
23.10
24.00
560
1.75
2.10
7.40
8.40
16.80
17.70
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Strike
Price
Jul 2010
Bid
Jul 2010
Offer
Sep 2010
Bid
Sep 2010
Offer
Dec 2010
Bid
Dec 2010
Offer
460
6.30
6.60
15.70
16.20
26.00
27.30
480
11.30
11.70
22.20
22.70
33.30
35.00
500
19.50
20.00
30.90
32.60
42.20
43.00
520
31.60
33.90
41.80
43.60
52.80
54.50
540
46.30
47.20
54.90
56.10
64.90
66.20
560
64.30
66.70
70.00
71.30
78.60
80.00
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Options vs Futures/Forwards
A futures/forward contract obligates both
parties to buy or sell at a specified price
An option obligates only one party, writer, to
buy or sell at a specified price; gives the
holder only the right to buy or sell & not the
obligation
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Types of Traders
Hedgers
Speculators
Arbitrageurs
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Hedging Examples
(pages 10-12)
35,000
No Hedging
30,000
Hedging
25,000
Stock Price ($)
20,000
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28
30
32
34
36
38
28
31
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INR 15
INR 27
Range
100X(15-20) =
INR (500)
100X(27-20) =
INR 700
INR
1200
ROI in Strategy
1
(500) / 2000 =
-25%
700 / 2000 =
35%
2000X1 = INR
(2000)
2000 X (2722.50)
-2000X1= INR
7000
INR
9000
(2000) / 2000 =
-100%
7000 / 2000 =
350%
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450%
ROI in Strategy
2
60%
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Arbitrage
All theories on asset pricing or derivatives
pricing create a set of conditions for arriving
at the price such that NO ARBITRAGE will
take place
NO ARBITRAGE CONDITION
The price thus derived will be (theoretically)
the most stable price
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Arbitrage
Arbitrage is the economic process which
tries to keep the prices where they should be
by eliminating all differences
However just because the possibility of
arbitrage is there, the prices will not always
be where they should be
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Arbitrage
Some conditions in which price distortions may
still be there:
Taxes
Transportation costs
Negligible arbitrage gains compared to other
forms of business opportunities
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Underlying
The value & the utility of a derivative arises
out of the underlying
The underlying could be a real asset like a
commodity, or a financial asset like equities
or currencies or something abstract like
stock index, interest rates, weather or
electricity
Accordingly there are commodity
derivatives, stock derivatives, currency
derivatives, index derivatives, interest rate
derivatives, credit derivatives & weather
derivatives
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Interest Rates
In derivatives pricing generally principles
of continuous compounding are followed
This is because in practical terms the
trading of securities/assets happens
more/less at continuous intervals of time
Continuous compounding allows for
situations in which cash flows can occur at
any time on a continuous time-frame
Mathematically continuous rates are
easier to deal with than discrete rates
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Conversion Formulae
Define
Rc : Interest rate pa with continuous compounding
Rm: Interest rate pa with compounding m times
per year
Rm
Rc m ln 1
Rm m e Rc / m 1
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Conversion Formulae
Eg. 1: An interest rate is quoted at 10%pa with
half-yearly compounding. What will be the
equivalent rate with continuous compounding?
Eg. 2: An interest rate is quoted at 8%pa with
continuous compounding. What will be the
equivalent rate with (a) Quarterly compounding
(b) Monthly compounding
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THANK YOU
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