Derivatives

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Mapping to Curriculum

▪ Reading 56: Derivatives Markets and Instruments

▪ Reading 57: Basics of Derivative Pricing and Valuation

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 Reading 56: Derivative Markets and Instruments

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Learning Outcomes

The candidate should be able to:

a. Define a derivative and distinguish between exchange—traded and over-the-counter derivatives;
b. Contrast forward commitments with contingent claims;

c. Define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and
compare their basic characteristics;

d. Describe purposes of, and controversies related to, derivative markets; and
e. Explain arbitrage and the role it plays in determining the prices and in promoting the market efficiency.

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What is a Derivative?

D – Derivative
A financial instrument whose value is
D derived from the value of an underlying
asset

A – Underlying Asset or simply called the

‘underlying’ —a fundamental asset;
For example, a Stock, Bond, Currency,
A Commodity, and Interest Rate, etc.

The value of D changes as A changes.

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Types of Derivatives

Main Types of Derivatives

(explained later)

Forwards and Credit

Swaps Options Exotics
Futures Derivatives

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Advantages of Derivatives Market over Cash Market

The advantages of derivates over cash market are:

▪ Easier to go short;
▪ Relatively high degree of leverage;
▪ Lower transaction cost;
▪ High liquidity and
▪ Effective risk management.

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Over the Counter vs Exchange Traded Contracts

Over the Counter (OTC) Exchange Traded

Instruments are Customized Instruments are Standardized

Counterparty can be another corporate entity The exchange is the counterparty

Mark-to-Market is not done; cash is only exchanged Mark-to-Market Everyday (profit/loss is calculated and
at contract expiry settled on a daily basis)
Low Liquidity High Liquidity

High Counter-party risk No counter-party risk

A dealer market with no central trading location Centralized trading location backed by a
clearinghouse
Unregulated or Minimally Regulated Market Regulated Market

No Active Secondary Market Active Secondary Market

Instruments: Swaps, Exotics , Forwards. Instruments: Futures, Options

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Derivatives Payoff

Y-axis → Profit/Loss on (D)

Linear Payout
Non-Linear Payout

X-axis → Value of Underlying (A)

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Types Of Derivatives

Derivatives

Linear Non-Linear

Forwards/ options,
Futures (D) Credit Derivatives

Swaps, Exotics
(D2)

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Forward Contracts

Forwards are contracts whereby parties are committed:

▪ To buy (sell);
▪ An underlying asset;
▪ At some future date (maturity) and
▪ At a delivery price (forward price) set in advance.
When contract is initiated: No cash flow is made between the parties and no cash flow occurs till maturity.
Forward price is such that PV of the contract is zero.
Characteristics of Forwards:
▪ Customized;
▪ Subject to default risk;
▪ Difficult to close out;
▪ Carry low liquidity and
▪ Used by hedgers who intend to hold the position till maturity.

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Forward Markets

Type of Positions

1.Long: The party which has Short: The party which has
agreed to buy the underlying asset agreed to sell the underlying
in the future. It wants to hedge the asset in the future. It wants to
risk of a price increase. hedge the risk of a price decrease.

Who uses Forward Contracts?

Large institutions with existing risk—typically corporations, government units, or non-profit organizations.
Dealers often include:
▪ Banks;
▪ Non-bank financial institutions, for example the securities brokers;
▪ Usually balance long and short position with opposite end users;
▪ Bid/ask spread compensation for administrative costs, default, and price risk; and
▪ Dealers also enter into contracts with other dealers to hedge risk.

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Example Problem

You require gold, one year from now. The current price of a gold is $1000.
You have 3 options, to fulfill your requirement:
1. Buy it now at $1000, and use it after a year (Opportunity cost);
2. Buy it a year from now at the market price prevailing one year from now (price uncertainty); or
3. Enter into an agreement with the vendor so as to purchase the gold a year from now at a price of $1000
(Forward contract).

If we go in for a forward (3rd scenario above), what would be the profit/loss if the market price of the gold
after one year is:

1. $500
2. $1000
3. $1500

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Solution

▪ Taking the Third Scenario, if you locked a fixed price of $1000 for a gold after one year, your profit and loss
would look like:

Agreed upon Price of gold Price of gold (S=spot) Profit and Loss from the Buyer’s
(X=strike) Perspective (S-X)

1000 500 -500

1000 1000 0
1000 1500 500

▪ The Profit and Loss from the vendor’s point of view:

Agreed upon Price of gold Price of gold (S=spot) Profit and Loss from the Seller’s
(X=strike) Perspective (X-S)

1000 500 500

1000 1000 0
1000 1500 -500

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Solution

▪ Payoff from Buyer’s Perspective Payoff from Seller’s Perspective

500

500
0

0 500 1000 1500

0
0 500 1000 1500
-500

-500
Slope of the line is 1
Slope of the line is -1

This is a Zero-Sum Game.

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Futures

Definition
▪ A futures contract is an agreement between two parties in which one party—the buyer—agrees to buy from
another party, the seller, an underlying asset or other derivative, at a future date at a price agreed on today.

Characteristics of Futures

Standardization: Futures contracts have standardized Backed by a Clearinghouse: Each exchange has a
contract terms: clearinghouse:
• Futures contracts specify the quality and quantity of • It guarantees that traders will honor their
goods that can be delivered, delivery time and the obligations.
manner of delivery. • It acts as a buyer to every seller, and as a seller to
• Uniformity promotes market liquidity. every buyer, vice versa.

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Value of a Futures Contract

▪ Futures contracts like forward contract have no value at the origination.

▪ Since futures contract are mark to market daily they differ from forward contract as futures do not accrue
value over the term of the contract, hence the value of future contract will always be zero.
▪ The value of futures contract diverge from zero only during the trading hours, between the times at which the
account is marked to market (MTM):

Value of futures contract = current futures price – previous mark to market price

▪ If the future price increase, the value of long position also increase, and at the end of the MTM period, the
value is set back to zero by the marked to market.

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Mechanics of Future Markets

Specifications of a contract
▪ Asset: If the asset is a commodity, exchange specifies the asset in complete detail: Grade, quality, size, shape,
color, etc.
▪ Contract size: The amount of the asset to be delivered
▪ Delivery arrangement: Place of delivery
▪ Delivery month

Margins
▪ Margin account: Investor deposits a certain amount of money with the broker in the margin account in which the
daily PnL is settled.
▪ Initial margin: The initial amount deposited in the margin account
▪ Maintenance margin: Lesser than the initial margin; if the margin account balance falls below this threshold,
investor is sent a margin call.
▪ Variation Margin: After a margin call, investor needs to get the account back up to the initial margin (Remember!
Not the maintenance margin); the amount to be deposited is called as the variation margin.

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 Margins

▪ In the stock market, 'margin' means that a loan is made.

▪ In the futures market, 'margin' is the amount of money that must be put into an account by a party opening
up a futures position.
▪ Initial Margin Requirement – the amount a futures trader is required to put up at the initiation of the
contract.
▪ This payment can be viewed as collateral.
▪ Both the buyer and seller of a futures contract must deposit margin.
▪ Mark to market prices is done at the settlement price which represents an average of the final trades of
the day.
▪ The additional margin that is deposited to fulfill the maintenance margin requirement is called variation
margin.

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Marking To Market

▪ Marking to market involves adjusting the margin account to reflect the change in the price of the underlying
security.
▪ The exchange imposes price limits within which the future contracts can be traded. If a contract has a daily
price limit of five cents, and it is current price is $2.50, then the contract has made a limited move.
• If the contract price hits above $2.55 the contract has said to be limit up.
• If the contract price hits below $2.45 the contract has said to be limit down.
▪ As no trade will take place the price is said to have locked limit.

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Example Problem

Statement 1: - The additional margin that must be deposited to bring the balance up to the initial margin
requirement, which is known as the maintenance margin.

Statement 2: - The variation margin is the minimum balance that holders of future positions must maintain in their
margin accounts.

Select the correct option.

A. Both the statements are Incorrect.
B. Only one statement is Correct.
C. Both the statements are Correct.

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Solution

A. Both the statements are incorrect. The variation margin is the amount that is paid to bring the level of the
balance to the initial margin, while the maintenance margin is the minimum level that has to be kept in the margin
account.

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Example – Daily Settlement

Day 1 Day 2

▪ Trader goes long at a futures price ▪ At the end of the day, the futures
of $1500 and deposits $200 as IM. price settles at $1350. Loss is
▪ At the close of the day, the futures $100.
price settles at $1450. Loss is $50. ▪ So $100 is withdrawn from the
So $50 is withdrawn from the trader’s account bringing the
trader’s account, bringing the balance to $50.
balance to $150. ▪ The margin balance is below the
MM, so a margin call is issued.
▪ To keep the long position opened,
the trader must deposit enough
money to get the account back up
to the initial margin.
▪ Variation margin = $200-$50 =
$150

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Distinguish Between Forward Contract and Future Contract

▪ Futures are the standardized counterparts of Forwards. They differ on the following aspects:

FORWARDS FUTURES
▪ Traded OTC ▪ Traded on exchanges
▪ Private agreements-highly customized ▪ Standardized contracts
▪ Credit risk is high PnL accumulates till ▪ Clearing house and daily mark to
the end market reduces credit risk
▪ Settlement at the end of contract and on ▪ Settlement can occur over a range of
a specific date dates
▪ Mostly used by hedgers that want to ▪ Usually closed out before maturity
remove the volatility of the underlying and hardly any deliveries happen

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 Swaps

▪ A swap is an agreement to exchange cash flows at specified future dates according to certain specified rules.
▪ Type of swaps:
▪ Interest Rate Swaps and
▪ Currency Swaps.
▪ Traded mostly OTC, these are customized to suit the needs of the parties to the contract.
▪ These are subject to default risk.
▪ Netting – Exchanging only the net amount owed from one party to the other. Netting payments
decrease default risk.
▪ A swap has zero value at the initiation of the contract.

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 Swaps

▪ Swaps can be used to convert the nature of your assets or liabilities (Fixed/Floating).

Swap
Fixed = 4%
A B
Floating =
LIBOR
Interest =
Loan
LIBOR

Bank

▪ Price and value of a swap is similar to the forward contracts, having a value of zero to both the parties at the initiation
of the contract and as the prices change value to either party increases or decreases over the period of the contract.

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 Characteristics of Swaps

▪ Interest rate Swaps do not require the actual exchange of the notional amount of the contract.
▪ Currency Swaps requires the exchange of principal in the respective currencies on initiation and
termination of the contract.
▪ Settlement/Payment Date: Each date the party makes payments.
▪ Settlement Period: The time between Settlement Dates
▪ Termination Date: The final payment date
▪ Tenor: The original maturity of the swap.

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Termination of Swaps

▪ Ways to terminate the contract before maturity:

Mutual Termination Offsetting contract

Cash payment made by the party Enter into another swap with
with negative value of the contract opposite position to the original
(owes) to the counterparty; the swap, in order to offset the
latter’s approval is required. existing positions.

Resale of Swap to another party

Sell swap to another party. This is
an uncommon method.
Counterparty’s approval is
required.

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Example – Plain Vanilla Interest Rate Swap

▪ Microsoft enters into an IRS to receive 6-month LIBOR and pay a fixed rate of 5% per annum
every 6 months for 3 years on a notional principal of $10 million.

Period Libor rate (+) Floating Leg (–) Fixed Leg Net Cash Flow

0 4.20% - - -
1 4.80% 210,000 250,000 (40,000)
2 5.30% 240,000 250,000 (10,000)
3 5.50% 265,000 250,000 15,000
4 5.60% 275,000 250,000 25,000
5 5.90% 280,000 250,000 30,000
6 6.40% 295,000 250,000 45,000
Remember: Current floating rate will determine the floating rate cash flow for the next period.
Net (For floating rate payer) = (Swap fixed rate - LIBOR) X (No. of days/360) X (Notional Principal)
Net (For fixed rate payer) = (LIBOR - Swap fixed rate) X (No. of days/360) X (Notional Principal)

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Example Problem

Which of the following statements regarding a plain vanilla interest rate swap is the most accurate?
A. The notional principal is returned at the end of the swap.
B. The notional principal is swapped.
C. Only the net interest payments are made.

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Solution

C.
The plain vanilla interest rate swap involves trading the fixed interest rate payments for floating rate payments.
Swaps are a zero sum game, what one party gains becomes the loss of the other party. In interest rate swaps,
only the net interest rate payments actually take place because the notional principal swapped is the same for
both the counterparties and in the same currency units, there is no need to actually exchange the cash.

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Options

Options

Call Put

Long Call Short Call Long Put Short Put

The right to The obligation to The right to The obligation to

Buy the underlying Sell the underlying Sell the underlying Buy the underlying

▪ Long options have rights Call Buy

▪ Short options have obligations Put Sell
▪ Seller of an option is also called as option writer.
▪ Option Premium: This is the price that the owner of an option is required to pay to acquire those rights from the
seller.

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European and American Options

Options Type

European American
Options Options

Can be exercised Can be exercised

Option Premium Option Premium
only at the end of at any time before
Is Lower is Higher
its life or on expiration

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Option P/L Formulas

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 Long Call

▪ Profit from buying one European call option—option price = $5, strike price = $100, option life = 2 months

30 Profit ($)

20

10
Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130

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Short Call

▪ Profit from writing one European call option—option price = $5, strike price = $100

Profit ($)

5 110 120 130

0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30

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Long Put

▪ Profit from buying an European put option —option price = $7, strike price = $70.

30 Profit ($)

20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7

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Short Put

▪ Profit from writing an European put option: option price = $7, strike price = $70

Profit ($)
Terminal
stock price ($)
7
40 50 60
0
70 80 90 100
-10

-20

-30

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Options Payoff vs Forward Payoff

If the forward price Payoff for the Payoff for Long Call
at Time 1 is forward position position

1200 200 200

1100 100 100
Payoff means we are
assuming the premium
1000 0 0
to be 0.
900 -100 0
800 -200 0

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Options vs Forward P&L

Payoff
Forward profit and loss

F= $1000

1000 S(T)

K=$1000
C = $50
Profit/Loss of the Call
300

200

100 Terminal
700 800 900 1000 stock price ($)
0
-50 1100 1200 1300

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 Option Payoff Example

At expiration, the ST is $30. If the strike price is $26, what is the put and call option payoff?

Payoff to the call buyer?

Payoff to the put buyer?

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Solution

Payoff to the call buyer:

cT = Max(0,ST – X) = Max(0,$30 – $26) = $4

Payoff to the put buyer:

pT = Max(0,X – ST) = Max(0,$26 – $30) = 0

When the option has a positive payoff it is said to be in the money. In the
example above, the call option is in the money. The put option is out of the
money because X – ST is less than 0. When ST = K, the option is said to be
at the money.

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Example Problem (Option Profit)

▪ Assume that both the put and call on ABC stock have a strike price K = $40. The call initially costs $2, and the
put costs $3.
▪ What is the profit on the call and put if the price of ABC stock at expiration (ST) is $30?

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Solution

▪ Profit to the call buyer: Π = Max(0,ST – K) – c0 =

Max(0,$30 – $40) – $2 = – $2

▪ Profit to the put buyer: Π = Max(0,K – ST) – p0 =

Max(0,$40 – $30) – $3 = $7

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Contingent Claims – Credit Derivatives

▪ As the name suggests, Credit Derivatives are mainly used to hedge Credit Risk.
▪ This is a contact between 2 parties:
• Credit Protection Buyer: Seeks credit protection against a specific credit event and pays a premium
• Credit Protection Seller: Provides protection to the former and receives a premium
▪ Credit Spread Option: The underlying here is the credit spread, i.e., the difference between the bond’s
yield and the benchmark default-free bond. So, the credit protection buyer pays the premium to ensure this
credit spread.
▪ Credit Default Swaps (CDS): The credit protection buyer makes regular payments to the protection seller.
In return, the protection seller makes a payment when any credit event occurs. It is similar to an insurance
contract.
▪ The protection seller would agree to cover the risk only when the premium is sufficient enough to cover the
risk, based on the estimates from actuarial statistics.
▪ CDS sellers tend to be poorly diversified compared to general insurance company, given they provide
protection against systematic financial risk which spreads more rapidly and can impact multiple buyers at
the same time.

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Example Problem

In a credit default swap (CDS), the buyer of credit protection:

A. Exchanges the return on a bond for a fixed or floating rate return.
B. Issues a security that is paid using the cash flows from an underlying bond.
C. Makes a series of payments to a credit protection seller.

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Solution

C.

In a Credit Default Swap (CDS), the buyer of credit protection makes a series of payments to a credit protection
seller. The credit protection seller promises to make a fixed payment to the buyer if an underlying bond or loan
experiences a credit event, such as a default. In a total return swap, the buyer of credit protection exchanges
the return on a bond for a fixed or floating rate return. A security that is paid using the cash flows from an
underlying bond is known as a credit-linked note.

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Purpose Of Derivative Markets

▪ Risk Management: It is a process of balancing the desired and actual level of risk.
▪ Hedging: This involves taking an offsetting position in a derivative in order to balance any gains and
losses to the underlying asset.
• Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions
contrary to what the investor currently has.
• Hedgers reduce their risk by taking an opposite position in the market to what they are trying to hedge.
• The ideal situation in hedging would be to cause one effect to cancel out another.
Speculators: They make bets or guesses on the future prospects of the market.
▪ Example, if a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for
the price of the stock to decline, at which point he or she will buy back the stock and receive a profit.
▪ Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be
extremely risk.
▪ The main purpose of speculation is to profit from betting on the direction in which an asset will move.

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Purpose Of Derivative Markets (Cont.)

▪ Price Information: Futures markets provide valuable information about the prices of the underlying assets
on which futures contracts are based.
• Many of the assets are traded in geographically dispersed regions, thus many different spot prices exist.
• Price of contract with shortest time to expiration often serves as a proxy for the price of underlying asset.
• Prices of all future contracts serve as prices that can be accepted by those who trade contracts in lieu of
facing the risk of uncertain prices.
• Forward contracts and swaps also allows users to substitute a single locked-in price for the uncertainty of
future spot prices.
▪ Reduce transaction costs: Derivatives are characterized by relatively low transaction costs.
• Derivatives are designed to provide a means of managing risks (thus, it serve as a form of insurance).
• Insurance cannot be viable if its price is too high relative to the value of insured asset.
• Thus, derivatives must have low transaction costs otherwise they would not exist.

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Criticism Of Derivatives

1. They are fairly complex for a lot of market participants to understand.

2. These involve a lot of risk (leverage).
3. Mistakenly, derivatives are characterized as a form of legal gambling.

▪ Important distinction between derivatives and gambling is:

• Benefits of derivatives extend much further across society.
• By providing the means of managing risk, they make financial markets work better.

Points To remember:
▪ Too risky and Complex instrument
▪ Linked with gambling
▪ High Leverage involved

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Arbitrage

▪ Law of one price states that securities with identical cash flows must have the same price.
▪ Arbitrage refers to riskless profit. Such profits are generally earned when securities are mispriced.
▪ Example: Short-selling a stock which is mispriced high in one market and simultaneously buying it in another
market where the same security is priced lower.
▪ When several market participants enter arbitrage transactions, securities return to their fair values.
▪ Arbitrage plays an important role in valuing the securities.

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Summary of Reading 56

▪ Forwards are contracts whereby parties are committed to buy (sell) and underlying asset at some future
date (maturity) and at a delivery price (forward price) set in advance.
▪ Futures contract is an agreement between two parties in which one party, the buyer, agrees to buy from
another party, the seller, an underlying asset or other derivative, at a future date at a price agreed on today.
• A swap is an agreement to exchange cash flows at specified future dates according to certain specified rules.
Type of swaps:
‒ Interest Rate Swaps and
‒ Currency Swaps.

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Summary of Reading 56 (Cont.)

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 Knowledge Checks

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Knowledge Check

What is least likely to be true regarding financial derivatives?

A. Derivatives create excess financial risk in the system
B. Derivatives are used for speculation
C. Derivatives helps in price discovery of underlying

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Solution

A. On the contrary, derivatives are meant to transfer the risk on to a party, which is better equipped to handle and
mitigate it. However, derivatives are also used for speculation and they help in price discovery by increasing
liquidity.

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Knowledge Check

Which combination of positions will tend to protect the owner from downside risk?
A. Buy the stock and buy a call option.
B. Sell the stock and buy a call option.
C. Buy the stock and buy a put option.

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Solution

C. The put option will help to remove the downside risk associated with the long position on the stock. If the stock
goes down in value, the put option will be exercised.

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