Financial Derivatives
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Financial Derivatives
Main Text
Options, Futures and Other Derivative by John C. Hull (preferably latest edition)
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Introduction
Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.
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Introduction
Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.
Similarly, shares and bonds also have price risk.
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Introduction
Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.
Similarly, shares and bonds also have price risk.
Consider the case of a farmer of wheat crop and manufacturer of bread. Do they
face any risk?
5
Introduction
Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.
Similarly, shares and bonds also have price risk.
Consider the case of a farmer of wheat crop and manufacturer of bread. Do they
face any risk?
It is desirable to have some mechanism which can help eliminate or at least
reduce the price risk.
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Introduction
Price of all commodities whether agricultural products such as wheat, rice etc. or
non-agricultural products like gold, silver are subject to price fluctuations.
Similarly, shares and bonds also have price risk.
Consider the case of a farmer of wheat crop and manufacturer of bread. Do they
face any risk?
It is desirable to have some mechanism which can help eliminate or at least
reduce the price risk.
Derivatives have been evolved as an instrument for hedging the price risk
involved in dealing with financial and non-financial assets.
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Derivatives
A derivative is a financial contract whose payoff structure is determined by the
value of an underlying asset.
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Derivatives
A derivative is a financial contract whose payoff structure is determined by the
value of an underlying asset.
The underlying asset may be real asset or financial assets.
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Derivatives
A derivative is a financial contract whose payoff structure is determined by the
value of an underlying asset.
The underlying asset may be real asset or financial assets.
Types of financial derivatives
Forward
Futures
Options
Swaps
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Forward Contract
A forward contract is an agreement between two parties to buy or sell an asset at a
certain future time for a certain future price.
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Forward Contract
A forward contract is an agreement between two parties to buy or sell an asset at a
certain future time for a certain future price.
These contracts are customized: delivery date, price and quantity are negotiated
bilaterally.
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Forward Contract
A forward contract is an agreement between two parties to buy or sell an asset at a
certain future time for a certain future price.
These contracts are customized: delivery date, price and quantity are negotiated
bilaterally.
The buyer of the underlying asset is said to have a long position in the forward contract
whereas the seller of the underlying assets has a short position in forward contract.
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Long Forward Contract
Suppose a manufacturer has taken a long position in a forward contract to
purchase one quintal of wheat at INR 1000 three months from now.
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Long Forward Contract
Suppose a manufacturer has taken a long position in a forward contract to
purchase one quintal of wheat at INR 1000 three months from now.
Profit
Price of Underlying at Maturity, ST
K
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Short Forward Contract
Profit
Price of Underlying at Maturity, ST
K
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Advantages of Forward Contracts
An ideal instrument for hedging the risk arising from price fluctuations of
underlying asset.
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Advantages of Forward Contracts
An ideal instrument for hedging the risk arising from price fluctuations of
underlying asset.
Tailor-made products to meet the requirements of the two counter parties to the
contract.
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Disadvantages of Forward Contracts
Credit risk or default risk
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Disadvantages of Forward Contracts
Credit risk or default risk
There is a possibility that one of the parties to the contract may default or fail to
fulfill his or her obligations under the contract.
Also called counter party risk.
Illiquidity
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Disadvantages of Forward Contracts
Credit risk or default risk
There is a possibility that one of the parties to the contract may default or fail to
fulfill his or her obligations under the contract.
Also called counter party risk.
Illiquidity
A forward contract cannot be cancelled other than the consent of both the parties.
Very difficult, if not impossible, to exit the forward contracts.
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Futures Contracts
Futures contracts are standardized forward contracts.
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Futures Contracts
Futures contracts are standardized forward contracts.
These are traded at organized stock exchanges.
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Futures Contracts
Futures contracts are standardized forward contracts.
These are traded at organized stock exchanges.
It is the respective stock exchange which introduces these contracts.
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Futures Contracts-Standardized
Standardization means that the terms and conditions, popularly called
specifications, are decided in advance and these are same for all the participants
in futures market.
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NSE Derivative Segment
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Clearing Corporation
It eliminates the counter party risks
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Margin System
Initial margin
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Margin System
Initial margin
At the time of entering into the contract
Generally 5%-30%
Maintenance margin
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Margin System
Initial margin
At the time of entering into the contract
Generally 5%-30%
Maintenance margin
It is the minimum balance which buyers and sellers are expected to maintain
Generally 75% of the initial margin.
Variation margin
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Margin System
Initial margin
At the time of entering into the contract
Generally 5%-30%
Maintenance margin
It is the minimum balance which buyers and sellers are expected to maintain
Generally 75% of the initial margin.
Variation margin
When the balance in margin account falls below the maintenance margin level
A margin call is made
Additional funds to be deposited on the basis of the margin call are known as
variation margin.
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Closing out the Futures Contract
Two Ways
Taking the delivery of the assets and making payment
Taking offsetting position in contacts
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Benefits of Futures Contract
No counterparty risk
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Benefits of Futures Contract
No counterparty risk
Liquidity
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Benefits of Futures Contract
No counterparty risk
Liquidity
Risk hedging
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Benefits of Futures Contract
No counterparty risk
Liquidity
Risk hedging
Price discovery
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Benefits of Futures Contract
No counterparty risk
Liquidity
Risk hedging
Price discovery
Market efficiency
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Benefits of Futures Contract
No counterparty risk
Liquidity
Risk hedging
Price discovery
Market efficiency
Leveraging
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Leverage
Suppose the current price of stock
and its futures is INR 100.
An investor anticipates its price to
rise to INR 120. He has INR 1000.
He has two alternative to take
position in the stock .
First, purchase 10 shares @ INR 100
each and the net payoff if his
expectation materializes
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Leverage
Suppose the current price of stock Particular Amount
and its futures is INR 100.
Revenue ( 10*120) 1200
An investor anticipates its price to
rise to INR 120. He has INR 1000. Cost (10*1000) 1000
He has two alternative to take
Profit 200
position in the stock .
First, purchase 10 shares @ INR 100 Percentage return 20%
each and the net payoff if his
expectation materializes
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Leverage
Suppose the margin requirement is 20%. With INR 1000, he can take long a
position in 50 futures contracts.
Spot Market Futures Market
Particular Amount
Revenue ( 10*120) 1200
Cost (10*1000) 1000
Profit 200
Percentage return 20%
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Leverage
Suppose the margin requirement is 20%. With INR 1000, he can take long a
position in 50 futures contracts.
Spot Market Futures Market
Particular Amount Particular Amount
Revenue ( 10*120) 1200 Revenue ( 50*120) 6000
Cost (10*1000) 1000 Cost (50*1000) 5000
Profit 200 Profit 1000
Percentage return 20% Percentage return 100%
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Leverage
Suppose price of stock and futures declines to INR 80
Spot Market Futures Market
Particular Amount
Revenue ( 10*80) 800
Cost (10*1000) 1000
Profit -200
Percentage return -20%
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Leverage
Suppose price of stock and futures declines to INR 80
Spot Market Futures Market
Particular Amount Particular Amount
Revenue ( 10*80) 800 Revenue ( 50*80) 4000
Cost (10*1000) 1000 Cost (50*1000) 5000
Profit -200 Profit -1000
Percentage return -20% Percentage return -100%
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Options
An option contract gives the holder the right-but not the
obligation-to conduct a transaction involving an underlying
security or commodity at a predetermined future date and
at a predetermined price
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Options
Buyer (option holder) has the long position in the contract
Seller (option writer) has the short position in the contract
Buyer and seller are counterparties in the transaction
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Options - Terminology
Call option
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Options - Terminology
Call option
The buyer or holder of the option has the right to purchase the underlying asset at a
predetermined price.
Put option
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Options - Terminology
Call option
The buyer or holder of the option has the right to purchase the underlying asset at a
predetermined price.
Put option
The buyer or the holder of the put option has the right to sell the underlying asset at
a predetermined price.
Exercise Price or Strike Price
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Options - Terminology
Call option
The buyer or holder of the option has the right to purchase the underlying asset at a
predetermined price.
Put option
The buyer or the holder of the put option has the right to sell the underlying asset at
a predetermined price.
Exercise Price or Strike Price
The exercise price is the price the call buyer will pay to-or the put buyer will receive
from-the option seller if the option is exercised.
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Options - Terminology
Expiration time
European options
American options
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Options - Terminology
Expiration time
European options
American options
Option Trading Markets
Options trade both in over-the-counter markets and on exchanges
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Option Premium
The amount which the buyer of the option (whether call or put) has to pay to the
option writer to avail the corresponding right.
At the money:
stock price equals exercise price
In-the-money
option has intrinsic value
Out-of-the-money
option has no intrinsic value
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Intrinsic Value
Intrinsic value is the worth of the option contract
It is the minimum option price.
The difference between option price (premium) and intrinsic value is the time
value of money.
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Intrinsic Value: Call Option [max(0, S – K)]
Strike Price Current Price IV
100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
100 150
100 160
100 170
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Intrinsic Value: Call Option [max(0, S – K)]
Intrinsic Value
Strike Price Current Price IV
80
100 70 0
70
100 80 0
60
100 90 0
Intrinsic Value
50
100 100 0
40
100 110 10
30
100 120 20
20
100 130 30
10
100 140 40
0
100 150 50 60 80 100 120 140 160 180
100 160 60 Stock Price
100 170 70
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Intrinsic Value: Put Option
Strike Price Current Price IV
100 40
100 50
100 60
100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
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Intrinsic Value: Put Option
IV
Strike Price Current Price IV
100 40 60 70
100 50 50 60
100 60 40
Intrinsic Value
50
100 70 30 40
100 80 20 30
100 90 10 20
100 100 0 10
100 110 0 0
100 120 0 20 40 60 80 100 120 140 160
100 130 0 Stock Price
100 140 0
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Payoff: Call Option Holder [ Call Premium INR 10]
Strike Price Current Price IV Payoff
100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
100 150
100 160
100 170
100 180
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Payoff: Call Option Holder [ Call Premium INR 10]
Strike Price Current Price IV Payoff Call Option Holder
80
100 70 0 -10
70
100 80 0 -10
60
100 90 0 -10
50
100 100 0 -10
100 110 10 0 40
Payoff
100 120 20 10 30
100 130 30 20 20
100 140 40 30 10
100 150 50 40 0
60 80 100 120 140 160 180 200
100 160 60 50 -10
100 170 70 60 -20
Stock Price
100 180 80 70
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Call Option Writer [ Call Premium INR 10]
Strike Price Current Price IV Payoff
100 70 IV = - Max [ 0, S – K] or Min [ K – S, 0]
100 80
100 90
100 100
100 110
100 120
100 130
100 140
100 150
100 160
100 170
100 180
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Call Option Writer [ Call Premium INR 10]
Strike Price Current Price IV Payoff
100 70 0 10
100 80 0 10
100 90 0 10
100 100 0 10
100 110 -10 0
100 120 -20 -10
100 130 -30 -20
100 140 -40 -30
100 150 -50 -40
100 160 -60 -50
100 170 -70 -60
100 180 -80 -70
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Call Option Writer [ Call Premium INR 10]
Strike Price Current Price IV Payoff Call Option Writer
20
100 70 0 10
10
100 80 0 10
0
100 90 0 10 60 80 100 120 140 160 180 200
-10
100 100 0 10
100 110 10 0 -20
Payoff
100 120 20 -10 -30
100 130 30 -20 -40
100 140 40 -30 -50
100 150 50 -40 -60
100 160 60 -50 -70
100 170 70 -60 -80
Stock Price
100 180 80 -70
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Put Option Holder
Strike Price Current Price IV Payoff
100 40
100 50
100 60
100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
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Put Option Holder
Strike Price Current Price IV Payoff
100 40 60 50
100 50 50 40
100 60 40 30
100 70 30 20
100 80 20 10
100 90 10 0
100 100 0 -10
100 110 0 -10
100 120 0 -10
100 130 0 -10
100 140 0 -10
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Put Option Holder
Strike Price Current Price IV Payoff Put Option Holder
60
100 40 60 50
100 50 50 40 50
100 60 40 30 40
100 70 30 20 30
100 80 20 10
Payoff
20
100 90 10 0
10
100 100 0 -10
100 110 0 -10 0
30 50 70 90 110 130 150
100 120 0 -10 -10
100 130 0 -10 -20
Stock Price
100 140 0 -10
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Put Option Writer
Strike Price Current Price IV Payoff
100 40
IV = - Max[ K – S, 0 ] or Min [S – K, 0]
100 50
100 60
100 70
100 80
100 90
100 100
100 110
100 120
100 130
100 140
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Put Option Writer
Strike Price Current Price IV Payoff
100 40 -60 -50
100 50 -50 -40
100 60 -40 -30
100 70 -30 -20
100 80 -20 -10
100 90 -10 0
100 100 0 10
100 110 0 10
100 120 0 10
100 130 0 10
100 140 0 10
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Put Option Writer
Strike Price Current Price IV Payoff Put Option Holder
20
100 40 60 -50
10
100 50 50 -40
100 60 40 -30 0
30 50 70 90 110 130 150
100 70 30 -20 -10
100 80 20 -10
Payoff
-20
100 90 10 0
-30
100 100 0 10
100 110 0 10 -40
100 120 0 10 -50
100 130 0 10 -60
Stock Price
100 140 0 10
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Title
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Title
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