Derivatives
Derivatives
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A derivative is a financial instrument, whose
value depends on the value of one or more
basic underlying variables.
Examples:
Underlyings: stocks or market indices
Derivatives: options, futures, forward
contracts
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Derivative products
Forwards
Futures
Options
Warrants
LEAPS
Basket
Swaps
Swaptions
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Participants in derivatives
market
Hedgers face risk associated with the price
of an asset
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Forward Contracts
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.
Forward contracts are normally not exchange
traded.
The party that agrees to buy the asset in the
future is said to have the long position.
The party that agrees to sell the asset in the
future is said to have the short position.
The specified future date for the exchange is
known as the delivery (maturity) date.
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Forward Contracts
The specified price for the sale is known as the
delivery price
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Forward Contracts
Long and Short Positions in a Forward Contract
For Wheat at Rs. 4/Bushel
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3
2
1 Short Position
0
-1 0 1 2 3 4 5 6 7 8
fP
o
y
a
Long Position
-2
-3
-4
Net Wheat Price
Position
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Problems with Forwards
Counter-party risk:
A party to the contract may not fulfill the obligation
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Distinction between
forwards and futures
‘Futures’ was designed to solve the problems of forward
markets
Futures Forward
Organized stock exchange OTC
Standardized contractCustomized
liquid less liquid
Requires margin payment No margin required
Daily settlement End of the period
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Futures Contracts
A futures contract is similar to a forward contract in that it
is an agreement between two parties to buy or sell an asset
at a certain time for a certain price. Futures, however, are
usually exchange traded and, to facilitate trading, are
usually standardized contracts. This results in more
institutional detail than is the case with forwards.
The long and short party usually do not deal with each
other directly or even know each other for that matter. The
exchange acts as a clearinghouse. As far as the two sides
are concerned they are entering into contracts with the
exchange. In fact, the exchange guarantees performance
of the contract regardless of whether the other party fails.
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Futures Contracts
The exchange will usually place restrictions and
conditions on futures. These include:
Daily price (change) limits.
For commodities, grade requirements.
Delivery method and place.
How the contract is quoted.
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Futures payoff
Buy futures (Long asset)
If index goes up futures position starts making profit and
vice versa
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Futures payoff
Sell futures (Short asset)
If index goes down futures position starts making profit
and vice versa
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Pricing futures
Fair value = (S) e^ (r * T)
r = cost of financing (continuously compound interest
rate)
T = Time till expiration in years
e = 2.71828
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Margin Money
Collected from the client/broker
Minimize the risk of settlement default by either
counterparty
Like a security deposit or insurance against a
possible future loss of value
Once the transaction is successfully settled, the
margin money held by the exchange is
released / adjusted against the settlement
liability.
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Types of Margins
Initial Margin
Variation/Maintenance/Mark to market margin
Additional Margin (if any)
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Initial Margin
To cover the largest potential loss in one day
Both buyer and seller have to deposit the
margins
Has to be deposited before opening a position
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Mark to Market Margin
Daily profit or loss obtained by marking the
member’s outstanding position to the market
Receive or pay the difference in cash on the
next working day
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Daily Settlement
In case the position is not closed the same
day
Net total of all the flows everyday would be
equal to the profit/loss calculated earlier
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Example
Let us take the illustration where a long position
is opened at 15550 and closed at 15650
resulting in a profit of 100 points.
Let us assume the daily closing settlement
prices
DAYto be CLOSING PRICE
1 15550
2 15580
3 15560
4 15600
Position closed 15650
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Calculate settlement
prices
DAY CLOSING PRICE Difference Profit/Loss
Position opened –
Long @ 15550
Profit +100
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Application of futures
Hedging – Long security, sell futures
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Application of futures
Speculation – Bullish – buy futures
Bearish – sell futures
Spot price = Rs.1000
Future price = Rs.1006
Contract value = 100 lots consisting 100 securities each
Margin = Rs.20000
Two months later security closes at Rs.1010
Profit = 1010 – 1006 = 4*100 = 400
Rs.400 profit on an investment of Rs.20000 ( 12 percent)
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Application of futures
Arbitrage – Overpriced – Buy spot sell future
Underpriced – Buy futures sell spot
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