Introduction to Financial Derivatives

DERIVATIVES

Definition

Derivative is a product which derives its value from another product(s) called underlying
asset. Financial Derivative is a financial where its value derived from any underlying asset(s)
which may include Equity, Index, Commodity, Currency, Live stock etc.

The underlying asset may assume many forms:

i. Commodities including grain, coffee beans, orange juice;

ii. Precious metals like gold and silver;

iii. Foreign exchange rates or currencies;

iv. Bonds of different types, including medium to long term negotiable debt securities
issued by governments, companies, etc

v. Shares and share warrants of companies traded on recognized stock exchanges and Stock
Index

vi. Short term securities such as T-bills; and

vii. Over- the Counter (OTC)2 money market products such as loans or deposits.

Features of financial derivatives

1.It is a contract: Derivative is defined as the future contract between two parties.
It means there must be a contract-binding on the underlying parties and the
same to be fulfilled in future. The future period may be short or long depending
upon the nature of contract, for example, short term interest rate futures and
long term interest rate futures contract

2.Derives value from underlying asset: Normally, the derivative instruments

have the value which is derived from the values of other underlying assets, such
as agricultural commodities, metals, financial assets, intangible assets, etc.
Value of derivatives depends upon the value of underlying instrument and which
changes as per the changes in the underlying assets, and sometimes, it may be
nil or zero. Hence, they are closely related.
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3.Specified obligation: In general, the counter parties have specified obligation

under the derivative contract. Obviously, the nature of the obligation would be
different as per the type of the instrument of a derivative. For example, the
obligation of the counter parties, under the different derivatives, such as forward
contract, future contract, option contract and swap contract would be different.

4.Direct or exchange traded: The derivatives contracts can be undertaken

directly between the two parties or through the particular exchange like financial
futures contracts. The exchange-traded derivatives are quite liquid and have low
transaction costs in comparison to tailor-made contracts. Example of exchange traded
derivatives are Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P Junior
that are traded on New York Stock Exchange, Tokyo Stock Exchange, National
Stock Exchange, Bombay Stock Exchange and so on

5.Related to notional amount: In general, the financial derivatives are carried

off-balance sheet. The size of the derivative contract depends upon its notional
amount. The notional amount is the amount used to calculate the payoff. For
instance, in the option contract, the potential loss and potential payoff, both
may be different from the value of underlying shares, because the payoff of
derivative products differ from the payoff that their notional amount might
suggest

6.Delivery of underlying asset not involved: Usually, in derivatives trading, the

taking or making of delivery of underlying assets is not involved, rather
underlying transactions are mostly settled by taking offsetting positions in the
derivatives themselves. There is, therefore, no effective limit on the quantity of
claims, which can be traded in respect of underlying assets.

7.May be used as deferred delivery: Derivatives are also known as deferred

delivery or deferred payment instrument. It means that it is easier to take short
or long position in derivatives in comparison to other assets or securities.
Further, it is possible to combine them to match specific, i.e., they are more
easily amenable to financial engineering.

8.Secondary market instruments: Derivatives are mostly secondary market

instruments and have little usefulness in mobilizing fresh capital by the
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corporate world, however, warrants and convertibles are exception in this

respect.

9.Exposure to risk: Although in the market, the standardized, general and

exchange-traded derivatives are being increasingly evolved, however, still there
are so many privately negotiated customized, over-the-counter (OTC) traded
derivatives are in existence. They expose the trading parties to operational risk,
counter-party risk and legal risk. Further, there may also be uncertainty about
the regulatory status of such derivatives.

10.Off balance sheet item: Finally, the derivative instruments, sometimes,

because of their off-balance sheet nature, can be used to clear up the balance
sheet. For example, a fund manager who is restricted from taking particular currency can buy
a structured note whose coupon is tied to the performance of a
particular currency pair.

Types of financial derivatives

Derivatives can be classified as commodity derivatives and financial derivatives. The

difference between these is the nature of the underlying instrument or asset. In a commodity
derivative, the underlying instrument is a commodity which may be wheat, cotton, pepper,
sugar, beans, tobacco, corn, maize, crude oil, natural gas, gold, silver, copper and so on. In a
financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign
exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted that
financial derivative is fairly standard and there are no quality issues whereas in commodity
derivative, the quality may be the underlying matter. However, despite the distinction
between these two from structure and functioning point of view, both are almost similar in
nature.

The most commonly used derivatives contracts are forwards, futures , options and swaps.

1.Forwards:

A forward contract is an agreement between two parties to buy or sell an asset at a specified
point of time in the future. A forward contract is a customised contract between two entities,
where settlement takes place on a specific date in the future at today’s pre-agreed price. In
case of a forward contract the price which is paid/ received by the parties is decided at the
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time of entering into contract. It is the simplest form of derivative contract mostly entered by
individuals in day to day’s life. Forward contract is a cash market transaction in which
delivery of the instrument is deferred until the contract has been made. Although the delivery
is made in the future, the price is determined on the initial trade date.

2.Futures

Futures is a standardized forward contact to buy (long) or sell (short) the underlying asset at a
specified price at a specified future date through a specified exchange. Futures contracts are
traded on exchanges that work as a buyer or seller for the counterparty. Exchange sets the
standardized terms in term of Quality, quantity, Price quotation, Date and Delivery place (in
case of commodity). Futures contracts being traded on organized exchanges impart liquidity
to the transaction. The clearing house, being the counter party to both sides of a transaction,
provides a mechanism that guarantees the honouring of the contract and ensuring very low
level of default.

3.Options

An options contract offers the buyer the opportunity to buy or sell—depending on the type of
contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or
sell the asset if they decide against it. Each options contract will have a specific expiration
date by which the holder must exercise their option. The stated price on an option is known as
the strike price.

Types of Options

a. Call Option:

A call option gives the holder the right, but not the obligation, to buy the underlying security
at the strike price on or before expiration. A call option will therefore become more valuable
as the underlying security rises in price (calls have a positive delta).

A long call can be used to speculate on the price of the underlying rising, since it has
unlimited upside potential but the maximum loss is the premium (price) paid for the option.

b. Put Options:

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Opposite to call options, a put gives the holder the right, but not the obligation, to instead sell
the underlying stock at the strike price on or before expiration. A long put, therefore, is a
short position in the underlying security, since the put gains value as the underlying's price
falls (they have a negative delta).Protective puts can be purchased as a sort of insurance,
providing a price floor for investors to hedge their positions.

4.SWAPs

A swap is a derivative contract between two parties that involves the exchange of preagreed
cash flows of two financial instruments. The cash flows are usually determined using the
notional principal amount (a predetermined nominal value).

The two commonly used swaps are

i)Interest rate swaps: These entail swapping only the interest related cash flows between
the parties in the same currency

ii) Currency Swaps: These entail swapping both principal and interest on different currency
than those in the opposite direction.

Participants of the derivatives market:

1. Hedgers

Hedgers are the investors that invest in the derivatives market to eliminate the risk of any
change in the future prices of the asset. The primary intention is to secure the existing
exposure in the market or to reduce the risk and not to earn profits.

2. Speculators

Speculators are traders who predict the prices of an asset or derivative based on the future
movement of the underlying asset and take calculated risks to earn profits. It is the most
common market activity

3.Arbitrageurs
Arbitrage is the activity of earning profit based on the difference in prices of an asset in two
different markets. Arbitrageurs purchase an asset at a lower price in one market and sell it in
another market at a higher price to gain profits.

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Economic functions of Derivative contracts

1.Risk Management

One of the primary functions of derivatives markets is to effectively manage risks. Businesses
face multiple risks in day-to-day operations, including currency fluctuations, interest rate
changes, and commodity price volatility. Derivative contracts help companies hedge against
these risks, drive profitability and ensure stable operations.

2.Price Discovery

Derivatives offer a platform for traders and investors to express their views on future asset
prices. These price signals are critical for investors, as they help assess market sentiment and
make informed investment decisions. They also enable efficient allocation of resources by
providing real-time insights about market expectations.

3.Liquidity Enhancement

Derivatives markets significantly enhance market liquidity - the ease with which an asset can
be bought or sold without causing a sharp rise/decline in prices. This liquidity benefits both
hedgers and speculators. Hedgers can easily find counterparties to take the other side of their
trades, while speculators can execute their strategies efficiently.

4.Capital Efficiency

Derivatives markets promote capital efficiency by increasing the exposure to underlying

assets without the need for large capital outlays. Derivatives allow a trader to control a
significant position in a stock index by purchasing futures contracts that require only a
fraction of the underlying asset's value as margin. This helps you to diversify portfolios and
optimize capital allocation.

5.Risk Transfer

Derivatives markets facilitate risk transfer from those who are less capable of withstanding
risk to those who are more risk-tolerant. For instance, an insurance company may use
derivatives to transfer the risk of catastrophic events, such as natural disasters or financial
market crashes to the broader financial market. This risk transfer mechanism helps mitigate
systemic risk, distributing it among a broader pool of market participants

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6.Speculation and Investment Opportunities

Traders, investors, and speculators can significantly benefit from derivatives markets. Traders
can profit from price movements in various asset classes without owning the underlying
assets. This ability to speculate on market movements provides a crucial avenue for market
participants to express their views and generate returns.

Limitations of Derivatives

1.High volatility:

Since the value of derivatives is based on certain underlying things such as

commodities, metals and stocks etc., they are exposed to high risk. Most of the
derivatives are traded on open market. And the prices of these commodities metals and
stocks will be continuously changing in nature. So the risk that one may lose their
value is very high.

2. Requires expertise:

In case of mutual funds or shares one can manage with even a limited
knowledge pertaining to his sector of trading. But in case of derivatives it is very
difficult to sustain in the market without expert knowledge in the field.

3. Contract life:

The main problem with the derivative contracts is their limited life. As the time
passes the value of the derivatives will decline and so on. So one may even have
chances of losing completely within that agreed time frame.

Risk Involved in derivatives

1. Counterparty Risk

The probability that the counterparty may not be able to fulfil its obligations.

2. Price Risk

The market functions in terms of superior knowledge relative to peers. Hence, there is always
a risk that the majority of the market may be mispricing these derivatives and may cause
large scale default. This has already happened in an infamous incident including the company
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called “Long Term Capital Management (LTCM)”. LTCM became part of a trillion dollar
default and became a prime example as to how even the smartest management may end up
wrongly guessing the price of derivatives(research about it)

3. Agency Risk

Agency risk means that if there is a principal and an agent, the agent may not act in the best
interest of the principal because their objectives are different from that of the principal. In this
scenario it would mean that if a derivative trader is acting on behalf of a multinational
corporation or a bank, the interests of the organization and that of the individual employee
who is authorized to make decisions may be different.

4. Systemic Risk

System risk refers to the probability of widespread default in all financial markets because of
a default that initially started in derivative markets. In simple words, this is the belief that
because derivatives are so volatile, one major default can cause cascading defaults throughout
the derivatives market. These cascading defaults will then spin out of control and enter the
financial domain in general threatening the existence of the entire financial system. (The
2008 financial crisis effect- research on this one).

Hedging with Derivatives

Futures:
Risk Management Strategies

Primary purpose of derivatives trading in commodities is aimed to reduce price risk from the
seasonal fluctuations. The strategies of risk management include hedging, speculation and
arbitrage.Hedging is an economic function that helps to reduce the price risks in commodities
significantly, if not eliminate altogether. Hedging is the practice of off-setting the price risk
inherent in any cash market position by taking an equal but opposite position in the futures
market. Futures markets believed to be originally developed to meet the requirements of
producers who wanted to hedge against the price risk arising from seasonal fluctuations.
However, the scope of commodity futures has expanded latter with widespread participation
of producers, traders and users of commodities. Hedger is the person who has a position in
physical market and wants to avoid the risk.

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Hedging will be effective only when the following requirements are met

 Driven by the demand and supply over a period the prices of cash and futures markets tend
to move together

 As the maturity date approaches, cash and futures prices tend to converge or reach an
acceptable difference.

Process: Hedging in the futures market in general is a two-step process, depending upon the
hedger's cash market situation.

First step: If the hedger is going to buy a commodity in the cash market at a later time, his
first step is to buy futures contracts. Or if he is going to sell in cash commodity at a later time,
his first step in the hedging process is to sell futures contracts.

Second step: when the cash market transaction takes place, the futures position is no longer
needed for price protection and should therefore be closed. Depending on the initial position
taken long or short, hedger would offset his position by selling or buying back the futures
contract. For example, in June if a farmer expects an output of 100 tonnes of soyabean in
October. Soyabean prices in October are expected to rule relatively lower as it is harvesting
season for soya bean. In order to hedge against the price fall, the farmer sells 100 contracts of
one ton each at Rs.1347 in June. On a fall of price to Rs.1216 per ton in October he makes a
profit of Rs.131 per ton.

Speculation: Contrary to the hedging, speculation involves risk with no cash market position.
Speculators take risk that hedgers want to avoid with a motive to make profits and provide
the necessary liquidity through bid-offers that result into a continuous flow of transactions.
Commodities are becoming increasingly attractive to investor as an alternative asset class that
may allow reduction in overall risk of financial portfolio and enhance returns. Unlike in spot
markets, he has to invest only a margin amount instead of the total amount and can gain
profits to the total extent.

Basis and Basis risk

Understanding basis risk is fundamental for hedging in futures trading

Basis = Spot price – Futures price

Where T is maturity period and t is a specific date

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It is normally quoted as premium or discount in relation to the cash price.

If Sp > Fp then basis is said to be OVER future and called premium

If Sp < Fp then basis is said to be UNDER future and called discount

Option Pricing Models

Option Pricing Models are mathematical models that use certain variables to calculate the
theoretical value of an option. The theoretical value of an option is an estimate of what an
option should be worth using all known inputs. In other words, option pricing models provide
us a fair value of an option. Knowing the estimate of the fair value of an option, finance
professionals could adjust their trading strategies and portfolios. Therefore, option pricing
models are powerful tools for finance professionals involved in options trading.

Binomial Option Pricing Model

The simplest method to price the options is to use a binomial option pricing model. This
model uses the assumption of perfectly efficient markets. Under this assumption, the model
can price the option at each point of a specified time frame.Under the binomial model, we
consider that the price of the underlying asset will either go up or down in the period. Given
the possible prices of the underlying asset and the strike price of an option, we can calculate
the payoff of the option under these scenarios, then discount these payoffs and find the value
of that option as of today.

Black-Scholes Model
The Black-Scholes model is another commonly used option pricing model. This model was
discovered in 1973 by the economists Fischer Black and Myron Scholes. Both Black and
Scholes received the Nobel Memorial Prize in economics for their discovery.
The Black-Scholes model was developed mainly for pricing European options on stocks. The
model operates under certain assumptions regarding the distribution of the stock price and the
economic environment. The assumptions about the stock price distribution include:
 Continuously compounded returns on the stock are normally distributed and independent
over time.

 The volatility of continuously compounded returns is known and constant.

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 Future dividends are known (as a dollar amount or as a fixed dividend yield).
The assumptions about the economic environment are:

 The risk-free rate is known and constant.

 There are no transaction costs or taxes.

 It is possible to short-sell with no cost and to borrow at the risk-free rate.

Nevertheless, these assumptions can be relaxed and adjusted for special circumstances if
necessary. In addition, we could easily use this model to price options on assets other than

stocks (currencies, futures).

The main variables used in the Black-Scholes model include:

 Price of underlying asset (S) is a current market price of the asset

 Strike price (K) is a price at which an option can be exercised

 Volatility (σ) is a measure of how much the security prices will move in the subsequent
periods. Volatility is the trickiest input in the option pricing model as the historical
volatility is not the most reliable input for this model

 Time until expiration (T) is the time between calculation and an option’s exercise date

 Interest rate (r) is a risk-free interest rate

 Dividend yield (δ) was not originally the main input into the model. The original
BlackScholes model was developed for pricing options on non-paying dividends stocks.

Monte Carlo Simulation Model

Valuing options using Monte Carlo simulation is one of the most popular methods among
traders and investors. However, understanding how Monte Carlo simulation works can be
challenging for those who are not familiar with the concept. Monte Carlo simulation is a
statistical method used to estimate the probability of an event occurring by running a large
number of simulations, each with different sets of variables. The result of the simulation is an
estimate of the probability of the event occurring. In the context of option pricing, Monte
Carlo simulation is used to estimate the price of an option based on its underlying asset's
future price movements.
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1. Monte Carlo simulation in option pricing

Monte Carlo simulation is used in option pricing to estimate the price of an option based on
the probability of different future price movements of the underlying asset. The simulation
involves generating a large number of random price movements based on the asset's historical
volatility and using them to calculate the option's price. The simulation creates a probability
distribution of the asset's possible future prices. The distribution is then used to estimate the
option's price.

2. Simulation inputs

The inputs required for a Monte Carlo simulation of option pricing include the current price
of the asset, the strike price of the option, the time to expiration of the option, the risk-free
interest rate, and the asset's historical volatility. The simulation generates random price
movements based on the historical volatility input. The risk-free interest rate is used to
discount the option's estimated future cash flows to their present value.

(Research on Hedging and derivative pricing)

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