Derivatives: derivative is a contract between two parties which derives its value/price from an

underlying asset.

Example, A share is a derivative whose value is dependent on the value of the company .

Derivatives : 4 important features of derivatives

1 derivatives is a contract between two parties

2 this contract is expected to be settled at a future date

3 it’s value is derived from the value of the underlying asset

4 no initial investment or very small initial investment is required.

Example: consider a corn farmer and cereal manufacturer.

A decrease in the price of corn is bad for the corn farmer as he cannot get profits for his crops. On
the other hand an increase in the price of corn is not good for cereal manufacturer as they have to
pay more to the producers which will increase their cost .

So it is in the interest of the corn farmer that the prices remain high, while it is good for the cereal
manufacturer that the price of the corn is low

Suppose today price of corn is Rs.2000 per quintal

The farmer wants to sell the corn at the same rate after Four months.

The farmer enters into a contract with cereal manufacturer to sell his produce after four months at
the rate Rs.2000 per quintal, regardless of what the price might be at that time .

Therefore, if after four months, the price of corn falls to Rs.1 970 or rises up to Rs.2020, the farmer
will be bound to sell his produce at Rs.2000 per quintal and the broker or manufacturer will buy the
same.

Functions of derivatives

1. Financial derivatives help in facing financial risk arising due to change in prices, interest rates and
currency rates.

2. They provide commitment to prices for future dates and hence protect a party against future
adverse movements.

3. They provide opportunities to make profit for those who are ready to take risk.

4. In the process derivatives, transfer the risk from those who want to avoid it to those who are
ready to take that risk.

Example, suppose you are an importer and you want to import 10 iPhones from US for $10,000 .

you receive iPhones today and you have to pay $10,000 to US company after three months

Suppose 1US dollar = Rs.80 today

You fear that after three months, the price of one US dollar me go up to Rs.90

In that case iPhones will cost you Rs.90,000

You hedge your risk

You go to bank and sign a contract with bank that gives you the right to purchase $10,000 at the rate
Rs.80 per dollar after three months .

Bank charges a nominal fees of say Rs.1 per dollar . That is bank charges a fees of Rs.10,000.

Now you are protected against advance movements in the price of dollars . Also the bank has earned
a commission of Rs.10,000.

Bank is ready to take risk to earn profit. So Bank is called a speculator here.

You have protected your risk so you will be called a hedger.

There are four types of derivatives

Forwards

Futures

Options

Swaps

Participants in derivatives market or types of traders

1. Hedgers.

2. Speculators.

3. Arbitrageurs

Hedgers : all the parties that avoid risk by incurring cost

Example:the importer discussed above .

Speculators : parties who make profit by taking risk

Example: the bank and above examples

Arbitrageurs : parties who make profit without taking any risk. They want to lock in profit by
simultaneously entering into transaction into 2 or more markets.
Example, the stock of company X is trading at $20 in new York stock exchange while at the same
time it is trading at $20.05 in the London stock exchange

A tradercan buy the stock in New York Stock exchange and immediately sell on London stock
exchange ,earning a profit of 5 cents.

Such a practice

* needs sophisticated software

* has to be beware of inefficiencies in market

* usually large institutions employ 1 person for this

Forward contracts

Relatively simple derivative is a forward contract .

It is an agreement to buy or sell an asset at a certain future time at a certain price.

SPOT CONTRACT: A forward contract can be contrasted with a SPOT contract, which is an
agreement to buy or sell an asset almost immediately.

A forward contract is traded in the OTC market - usually between two financial institutions, or
between a financial institution and one of its clients.

One of the parties to a forward contract assumes a long position and agrees to buy the underlying
asset on a certain specified date for certain specified price .

The other party assumes a short position and agrees to sell the asset on the same date on the same
agreed upon price.

Forward, contracts and foreign exchange are very popular .

Most large banks, employee both spot and forward foreign exchange traders.

Given below is the table (Table 1.1 of the book) of a spot and forward codes for the US dollar great
British pound exchange rate of May 6, 2013 .
The table above provides codes for the exchange rate between the British pound and the US dollar
that might be made by a large international bank on May 6,, 2013

The quote is for the number of US dollars per GBP

The first row indicates that the bank is prepared to buy GBP in the spot market at the rate dollar
1.5541 per GBP and sell sterling in the spot market at the rate dollar 1.5545 per GBP .

The second, third and fourth rows indicate that the bank is prepared to buy sterling in 13 and six
months at dollar 1.5538, dollar 1.5533 and dollar 1.5526, Par GBP respectively and to sell sterling
and 13 and six months at dollar 1.5543, dollar 1.5538 and dollar 1.5532 per GBP respectively.

Forward, contracts can be used to hedge foreign currency risk

Suppose that on may 6, 2013, the treasurer of a US institution knows that the institution will pay £1
million in six months and wants to hedge against exchange rate moves .

Using the quotes in above table, the treasurer can agree to buy £1,000,000 6- months forward at an
exchange rate of 1.5532.

The financial institution has thus taken a long forward contract on GBP . It has agreed that on
November 6, 2013. It will buy £1 million from the bank for $1.5532 million.

The bank has a short forward contract on GBP. The bank has agreed that on November 6,, 2013. It
will sell £1 million for $1.532 million.

Both sides have made a binding commitment.

Understanding Long position versus a Short position

Long position

If an investor has long position, it means that the investor has bought and owns those shares of
stocks .

By contrast, if the investor has short position, it means that the investor owes those stocks to
someone, but actually does not own them yet .

For example: An investor who owns hundred shares of Tesla stock and their portfolio is set to be
long hundred shares. This investor has paid in full the cost of owning the shares.

And an investor who has sold hundred shares of Tesla without yet owning those shares is set to be
short hundred shares. The short investor owes hundred shares at settlement and must fulfil the
obligation by purchasing the shares in the market to deliver.

Payoffs from forward contracts

Consider the position of the financial institution in the USD and GBP discussed above

The forward contract obligates the corporation to buy £1 million for $1,553200.

If the spot exchange rate rose to say 1.600, at the end of six months, the forward contract would be
worth $46,800. ($1,600000-$1,553,200) to the corporation.

It would enable £1 million to be purchased at an exchange rate of 1.5532 rather than 1.6000.

Similarly, if the spot exchange rate fell to 1.5000, at the end of six months, the forward contract
would have a negative value to the institution of $53,200 because it would lead to the financial
institution paying $53,200 more than the market price for sterling .

In general, the payoff from a long position, in a forward contract on one unit of an asset is

ST - K where K is the delivery price and ST is the spot price of the asset at the maturity of the
contract .

This is because the holder of the contract is obligated to buy an asset worth ST for K.

Similarly, the pay off from short position in forward contract on one unit of an asset is

K - ST

These .payoffs can be positive or negative.

Refer to Table 1.2 of book.

In the above example K= 1.5532 and the financial institutions/corporation has a long contract.

When ST is equal to 1.6000, the pay off is $0.0468 per 1 pound

When ST, equal to 1.5000, the Pay off is -$0.0532 per one pound.

Forward prices and spot prices

Consider a stock that pays no dividend and is worth $60

From market one can borrow or lend money for one year at 5%

$60 +5% of 60 = $63

If the forward price is more than this say, $67, you can borrow $60 , buy one share of the stock and
sell it forward for $67

After paying of the loan, you would net profit of four dollars in one year

If the forward price is less than $63, say $58, an investor owning the stock as part of a portfolio
would sell the stock for $60 and enter into a forward contract to buy it back for $58 in one year .

The money from selling would be invested at 5% to earn three dollars. Hence, the investor would
end up five dollar better off than if the stock were kept in the portfolio for the year.
17.6 GAMMA
Gamma (Γ) is the rate of change of delta (Δ) with respect to the price of the underlying
asset.
Gamma (Γ) of a portfolio of options on an underlying asset is the rate of change of the
portfolio’s delta with respect to the price of the underlying asset.
Gamma is the second partial derivative of the portfolio with respect to asset price.
𝜕 2Π
Γ=
𝜕𝑆 2

Figure 19.7 illustrates: When the stock price moves from 𝑆 to 𝑆 ′ , delta hedging assumes that the
option price moves from 𝐶 to 𝐶 ′ , when in fact it moves from 𝐶 to 𝐶 ′′ . The difference between
𝐶 to 𝐶 ′′ leads to a hedging error. The size of the error depends on the curvature of the
relationship between the option price and the stock price. Gamma measures this curvature.
If gamma is small, delta changes slowly, and adjustments to keep a portfolio delta neutral need to
be made only relatively infrequently. However, if gamma is highly negative or highly positive,
delta is very sensitive to the price of the underlying asset. It is then quite risky to leave a delta-
neutral portfolio unchanged for any length of time.
 For a delta-neutral portfolio,
1
ΔΠ = ΘΔ𝑡 + Γ(Δ𝑆)2
2
where ΔΠ and Δ𝑆 are the change in Π and 𝑆 in a small time interval Δ𝑡.

Qus: Suppose that the gamma of a delta-neutral portfolio of options on an asset is −10,000. If a
change of +2 or − 2 in the price of the asset occurs over a short period of time. Find the change
in the value of the portfolio.
Solution:
We know that
For a delta-neutral portfolio,
1
ΔΠ = ΘΔ𝑡 + Γ(Δ𝑆)2
2
where ΔΠ and Δ𝑆 are the change in Π and 𝑆 in a small time interval Δ𝑡.
Here, Γ = −10000, Δ𝑆 = +2 or − 2, (Δ𝑆)2 = 4
For small time interval we can ignore first term ΘΔ𝑡
Therefore,
1 1
ΔΠ = Γ(Δ𝑆)2 = × (−10000) × 4 = −20000
2 2
Required change is −$20000
The value of portfolio will decrease by −$20000.
Calculation of Gamma
For a European call or put option on a non-dividend-paying stock, the gamma is given by
𝑁 ′ (𝑑1 )
Γ=
𝑆0 𝜎√𝑇
Where
ln(𝑆𝑜 ⁄𝐾 )+(𝑟+𝜎2 ⁄2)𝑇
𝑑1 = 𝜎√𝑇

1 2 ⁄2
𝑁 ′ (𝑥) = 𝑒 −𝑥
√2𝜋

Qus: Consider the non-dividend-paying stock where the stock price is $49, the strike price is
$50, the risk-free interest rate is 5% per annum, the stock price volatility is 20% per annum, the
time to maturity is 20 weeks (0.3846 years). Find the gamma for the option. Also find the change
if delta for Δ𝑆 change is stock price.
Solution:
Here, 𝑆0 = $49, 𝐾 = $50, 𝑟 = 0.05, 𝜎 = 0.20, 𝑇 = 0.3846 years
We know that
For a European call or put option on a non-dividend-paying stock, the gamma is given by
𝑁 ′ (𝑑1 )
Γ=
𝑆0 𝜎√𝑇
Where
ln(𝑆𝑜 ⁄𝐾 )+(𝑟+𝜎2 ⁄2)𝑇
𝑑1 = 𝜎√𝑇

1 2 ⁄2
𝑁 ′ (𝑥) = 𝑒 −𝑥
√2𝜋

Therefore,
𝑁 ′ (𝑑1 )
Γ= = 0.066
𝑆0 𝜎√𝑇

 When the stock price change by Δ𝑆, the delta of the option change by 0.066Δ𝑆.
Making a Portfolio Gamma Neutral
Suppose that a delta-neutral portfolio has a gamma equal to Γ, and a traded option has a gamma
equal to Γ𝑇 . If the number of traded options added to the portfolio is 𝑤𝑇 , the gamma of the
portfolio is
𝑤𝑇 Γ𝑇 + Γ
Γ
Hence, To make the portfolio gamma neutral, the position in the traded option is − Γ
𝑇

Including the traded option is likely to change the delta of the portfolio, so the position in the
underlying asset then has to be changed to maintain delta neutrality. Note that the portfolio is
gamma neutral only for a short period of time. As time passes, gamma neutrality can be
Γ
maintained only if the position in the traded option is adjusted so that it is always equal to − Γ .
𝑇

Delta neutrality provides protection against relatively small stock price moves between
rebalancing. Gamma neutrality provides protection against larger movements in this stock price
between hedge rebalancing.
Qus: Suppose that a portfolio is delta neutral and has a gamma of −3,000. The delta and gamma
of a particular traded call option are 0.62 and 1.50, respectively. How can you make the portfolio
gamma neutral? And what can be done to make portfolio delta neutral.
Solution:
We know that
If a delta-neutral portfolio has a gamma equal to Γ, and a traded option has a gamma equal to Γ𝑇 ,
Γ
then To make the portfolio gamma neutral, the position in the traded option is − Γ
𝑇

Here, Γ = −3000, Γ𝑇 = 1.50, and Δ = 0.62

So, To make the portfolio gamma neutral,
Γ −3000
The position in the traded option = − Γ = − = 2000
𝑇 1.50

The portfolio can be made gamma neutral by including in the portfolio a long position of 2000
call options.
To make portfolio delta neutral,
We have to take short position in 2000Δ = 2000 × 0.62 = 1240 units of the underlying asset.
17.7 RELATIONSHIP BETWEEN DELTA, THETA AND GAMMA
The price of a single derivative dependent on a non-dividend-paying stock must satisfy the
𝜕𝑓 𝜕𝑓 1 𝜕2 𝑓
differential equation + 𝑟𝑆 𝜕𝑆 + 2 𝜎 2 𝑆 2 𝜕𝑆2 = 𝑟𝑓. It follows that the value of Π of a portfolio of
𝜕𝑡
such derivatives also satisfies the differential equation.
17.8 VEGA
The vega of a portfolio of derivatives, 𝒱, is the rate of change of the value of the portfolio with
respect to the volatility of the underlying asset.
𝜕Π
𝒱=
𝜕𝜎
If vega is highly positive or highly negative, the portfolio’s value is very sensitive to small
changes in volatility. If it is close to zero, volatility changes have relatively little impact on the
value of the portfolio.
Making a Portfolio Vega Neutral
If 𝒱 is the vega of the portfolio and 𝒱𝑇 is the vega of a traded option.
𝒱
Then a position of − 𝒱 in traded option makes the portfolio instantaneously vega neutral.
𝑇

Calculation of Vega
For a European call or put option on a non-dividend-paying stock, vega is given by

𝒱 = 𝑆0 √𝑇𝑁 ′ (𝑑1 )
Where
ln(𝑆𝑜 ⁄𝐾 )+(𝑟+𝜎2 ⁄2)𝑇 1 2 ⁄2
𝑑1 = and 𝑁 ′ (𝑥) = 𝑒 −𝑥
𝜎√𝑇 √2𝜋

Qus: Consider the non-dividend-paying stock where the stock price is $49, the strike price is
$50, the risk-free interest rate is 5% per annum, the stock price volatility is 20% per annum, the
time to maturity is 20 weeks (0.3846 years). Find the vega of the option. Also find the increase in
the value of the option for 1% increase in the volatility.
Solution:
Here, 𝑆0 = $49, 𝐾 = $50, 𝑟 = 0.05, 𝜎 = 0.20, 𝑇 = 0.3846 years
We know that
For a European call or put option on a non-dividend-paying stock, vega is given by

𝒱 = 𝑆0 √𝑇𝑁 ′ (𝑑1 )
Where
ln(𝑆𝑜 ⁄𝐾 )+(𝑟+𝜎2 ⁄2)𝑇 1 2 ⁄2
𝑑1 = and 𝑁 ′ (𝑥) = 𝑒 −𝑥
𝜎√𝑇 √2𝜋

Therefore,

𝒱 = 𝑆0 √𝑇𝑁 ′ (𝑑1 ) = 12.1

Thus 1% (=0.01) increase in the volatility (from 20% to 21%), the increase in the value of the
option will increase by 0.01 × 12.1 = 0.121
Unfortunately, a portfolio that is gamma neutral will not in general be vega neutral, and vice
versa. If a hedger requires a portfolio to be both gamma and vega neutral, at least two traded
derivatives dependent on the underlying asset must usually be used.
Qus: Consider a portfolio that is delta neutral, with a gamma of −5,000 and a vega of −8,000.
The options shown in the following table can be traded.

Delta Gamma Vega

Portfolio 0 -5000 -8000

Option 1 0.6 0.5 2.0

Option 2 0.5 0.8 1.2

Make the portfolio gamma and vega neutral. And maintain the portfolio delta neutral.
Solution:
Let 𝑤1 and 𝑤2 are the quantities of option 1 and option 2 respectively that are added to the
portfolio to make it Gamma and Vega neutral.
Therefore,
−5000 + 0.5𝑤1 + 0.8𝑤2 = 0
−8000 + 2.0𝑤1 + 1.2𝑤2 = 0
The solution of above two equations is 𝑤1 = 400, 𝑤2 = 6000
Thus, the portfolio can be made gamma and vega neutral by including 400 of Option 1 and 6,000
of Option 2.
By including 400 of Option 1 and 6,000 of Option 2 the portfolio may not be Delta neutral.
The delta of the portfolio, after the addition of the positions in the two traded options, is
400 × 0.6 + 6000 × 0.5 = 3240
Hence, to maintain portfolio delta neutral 3240 units of the asset must be sold.

What position in option 1 and the underlying asset will make the portfolio delta and gamma
neutral?
Answer: Long 10,000 options, short 6000 of the asset
What position in option 1 and the underlying asset will make the portfolio delta and vega
neutral?
Answer: Long 4000 options, short 2400 of the asset.
17.9 RHO
The rho of a portfolio of options is the rate of change of the value of the portfolio with respect to
the interest rate:
𝜕Π
𝑟ℎ𝑜 =
𝜕𝑟
It measures the sensitivity of the value of a portfolio to a change in the interest rate when all else
remains the same.
For a European call option on a non-dividend-paying stock
𝑟ℎ𝑜(call) = 𝐾𝑇𝑒 −𝑟𝑇 𝑁(𝑑2 )
For a European put option on a non-dividend-paying stock
𝑟ℎ𝑜(put) = −𝐾𝑇𝑒 −𝑟𝑇 𝑁(−𝑑2 )
Where
ln(𝑆𝑜 ⁄𝐾 ) + (𝑟 − 𝜎 2 ⁄2)𝑇
𝑑2 =
𝜎√𝑇
Qus: Consider the non-dividend-paying stock where the stock price is $49, the strike price is
$50, the risk-free interest rate is 5% per annum, the stock price volatility is 20% per annum, the
time to maturity is 20 weeks (0.3846 years). Find the rho of the European call option. Also find
the increase in the value of the option for 1% increase in the interest rate.
Solution:
Here, 𝑆0 = $49, 𝐾 = $50, 𝑟 = 0.05, 𝜎 = 0.20, 𝑇 = 0.3846 years
We know that
For a European call option on a non-dividend-paying stock
𝑟ℎ𝑜(call) = 𝐾𝑇𝑒 −𝑟𝑇 𝑁(𝑑2 )
Where
ln(𝑆𝑜 ⁄𝐾 ) + (𝑟 − 𝜎 2 ⁄2)𝑇
𝑑2 =
𝜎√𝑇
Here,
𝑟ℎ𝑜(call) = 𝐾𝑇𝑒 −𝑟𝑇 𝑁(𝑑2 ) = 8.91
Thus, 1% (0.01) increase in the interest rate (from 5% to 6%), the value of the option will
increaes by approximately 0.01 × 8.91 = 0.0891