DERIVATIVES :RISK

MITIGATION INSTRUMENT

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SVS GROUP MEMBERS

 SHOAIB CHEJARA (10)

 VISHAL SINGH (57)

 SANDEEP SINGH (55)

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 DERIVATIVES
1. Introduce you to the notion of risk and the role of derivatives in
managing risk.
 Discuss some of the general terms – such as short/long positions,
bid-ask spread – from finance that we need.
1. Introduce you to five major classes of derivative securities.
 Forwards
 Futures
 Options
 Baskets
 Swaps
 Warrants
 LEAPS
 Swaptions

1. Introduce you to the basic viewpoint needed to analyze these

securities.
2. Introduce you to the major traders of these instruments.

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 Basics
 Finance is the study of risk.
 How to measure it
 How to reduce it
 How to allocate it

 All finance problems ultimately boil down to three

main questions:
 What are the cash flows, and when do they occur?
 Who gets the cash flows?
 What is the appropriate discount rate for those cash
flows?

 The difficulty, of course, is that normally none of

those questions have an easy answer.
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 Basics
 As you know from other classes, we can generally classify
risk as being diversifiable or non-diversifiable:
 Diversifiable – risk that is specific to a specific investment – i.e.
the risk that a single company’s stock may go down (i.e.
Enron). This is frequently called idiosyncratic risk.
 Non-diversifiable – risk that is common to all investing in
general and that cannot be reduced – i.e. the risk that the
entire stock market (or bond market, or real estate market)
will crash. This is frequently called systematic risk.
 The market “pays” you for bearing non-diversifiable risk
only – not for bearing diversifiable risk.
 In general the more non-diversifiable risk that you bear, the
greater the expected return to your investment(s).
 Many investors fail to properly diversify, and as a result bear
more risk than they have to in order to earn a given level of
expected return.
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 Basics
 In this sense, we can view the field of finance as
being about two issues:
 The elimination of diversifiable risk in portfolios;
 The allocation of systematic (non-diversifiable) risk to
those members of society that are most willing to bear it.

 Indeed, it is really this second function – the

allocation of systematic risk – that drives rates of
return.
 The expected rate of return is the “price” that the market
pays investors for bearing systematic risk.

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 Basics
 A derivative (or derivative security) is a financial
instrument whose value depends upon the value
of other, more basic, underlying variables.

 Some common examples include things such as

stock options, futures, and forwards.

 It can also extend to something like a

reimbursement program for college credit.
Consider that if your firm reimburses 100% of
costs for an “A”, 75% of costs for a “B”, 50% for
a “C” and 0% for anything less.
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 Basics
 Your “right” to claim this reimbursement, then is tied
to the grade you earn. The value of that
reimbursement plan, therefore, is derived from the
grade you earn.

 We also say that the value is contingent (conditional,

dependant) upon the grade you earn. Thus, your
claim for reimbursement is a “contingent” claim.

 The terms contingent claims and derivatives are used

interchangeably.

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 Basics
 So why do we have derivatives and derivatives
markets?
 Because they somehow allow investors to better control
the level of risk that they bear.

 They can help eliminate idiosyncratic risk.

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 Basics
 Positions – In general if you are buying an asset – be it a
physical stock or bond, or the right to determine whether
or not you will acquire the asset in the future (such as
through an option or futures contract) you are said to be
“LONG” the instrument.
 If you are giving up the asset, or giving up the right to
determine whether or not you will own the asset in the
future, you are said to be “SHORT” the instrument.
 In the stock and bond markets, if you “short” an asset, it means
that you borrow it, sell the asset, and then later buy it back.
 In derivatives markets you generally do not have to borrow the
instrument – you can simply take a position (such as writing an
option) that will require you to give up the asset or determination of
ownership of the asset.
 Usually in derivatives markets the “short” is just the negative of the
“long” position

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 Basics
 Commissions – Virtually all transactions in the financial
markets requires some form of commission payment.
 The size of the commission depends upon the relative position
of the trader: retail traders pay the most, institutional traders
pay less, market makers pay the least (but still pay to the
exchanges.)
 The larger the trade, the smaller the commission is in
percentage terms.
 Bid-Ask spread – Depending upon whether you are
buying or selling an instrument, you will get different
prices. If you wish to sell, you will get a “BID” quote,
and if you wish to buy you will get an “ASK” quote.

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 Basics
 Here are some example stock bid-ask spreads
from 22/08/2010:
 IBM: Bid – 78.77 Ask – 78.79 0.025%
 ATT: Bid – 30.59 Ask – 30.60 0.033%
 Microsoft: Bid – 25.73 Ask – 25.74 0.039%
 Here are some example option bid-ask spreads
(All with good volume)
 IBM Oct 85 Call: Bid – 2.05 Ask – 2.20 7.3171%
 ATT Oct 15 Call: Bid – 0.50 Ask –0.55 10.000%
 MSFT Oct 27.5 : Bid – 0.70 Ask –0.80. 14.285%

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 Basics
 The point of the preceding slide is to demonstrate
that the bid-ask spread can be a huge factor in
determining the profitability of a trade.
 Many of those option positions require at least a 10%
price movement before the trade is profitable.
 Many “trading strategies” that you see people
propose (and that are frequently demonstrated
using “real” data) are based upon using the
average of the bid-ask spread. They usually lose
their effectiveness when the bid-ask spread is
considered.

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 Basics
 Market Efficiency – We normally talk about financial markets as
being efficient information processors.
 Markets efficiently incorporate all publicly available information into
financial asset prices.
 The mechanism through which this is done is by investors
buying/selling based upon their discovery and analysis of new
information.
 The limiting factor in this is the transaction costs associated with
the market.
 For this reason, it is better to say that financial markets are
efficient to within transactions costs. Some financial economists
say that financial markets are efficient to within the bid-ask spread.
 Now, to a large degree for this class we can ignore the bid-ask
spread, but there are some points where it will be particularly
relevant, and we will consider it then.

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 Basics
 Before we begin to examine specific contracts, we
need to consider two additional risks in the market:
 Credit risk – the risk that your trading partner might not
honor their obligations.
 Familiar risk to anybody that has traded on ebay!
 Generally exchanges serve to mitigate this risk.
 Can also be mitigated by escrow accounts.
 Margin requirements are a form of escrow account.
 Liquidity risk – the risk that when you need to buy or sell
an instrument you may not be able to find a counterparty.
 Can be very common for “outsiders” in commodities markets.

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 BSE TRADE STATISTICS FOR 17-09-2010

Product No. of Turnover(Rs. Put Call

contracts cr.) * Ratio

Index Futures 539434 15197.41 -

Stock Futures 759871 23706.58 -

Index Options 2473662 72119.26 1.36

Stock Options 175063 5513.74 0.27

F&O Total 3948030 116536.99 1.23

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NSE TRADE STATISTICS FOR 17-09-
2010
Product No. of Turnover Open Interest
Contracts ( Rs. lakh ) ( No. of
Contracts )
INDEX FUTURES 7 20.66 20

STOCK FUTURES - - -

INDEX OPTIONS - - -

STOCK OPTIONS - - -

F&O Total 7 20.66 -

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 INTRODUCTION OF F & O IN INDIA
 NSE commenced trading in futures & options on individual securities
on November 9, 2001.

 The futures & options contracts are available on 202 securities

stipulated by the Securities & Exchange Board of India (SEBI).

 BSE commenced trading in futures on individual securities on June 9,

2000 .

 The futures & options contracts are available on 31 securities

stipulated by the Securities & Exchange Board of India (SEBI).

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INSTRUMENTS OF DERIVATIVES
 So now we are going to begin examining the basic instruments
of derivatives. In particular we will look at

 Forwards

 Futures

 Options

 Swaps

 Warrants

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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, we will denote this as K.
 .
As time progresses the delivery price doesn’t
change, but the current spot (market) rate does.
Thus, the contract gains (or loses) value over
time.

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 Forward Contracts
 Example:
 Let’s say that you entered into a forward contract to buy
wheat at $4.00/bushel, with delivery in December .

 Let’s say that the delivery date was December 14 and that on
December 14th the market price of wheat is unlikely to be
exactly $4.00/bushel, but that is the price at which you have
agreed (via the forward contract) to buy your wheat.

 If the market price is greater than $4.00/bushel, you are

pleased, because you are able to buy an asset for less than its
market price.

 If, however, the market price is less than $4.00/bushel, you

are not pleased because you are paying more than the market
price for the wheat.

 We can graph the payoff function:

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 Forward Contracts
Payoff to FuturesPosition on Wheat
Wherethe Delivery Price (K) is $4.00/Bushel
4

0
0 1 2 3 4 5 6 7 8
-1
rw
fP
aF
yd
to
s

-2

-3

-4
Wheat Market (Spot) Price, December 14

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 Forward Contracts
 Example:
 In this example you were the long party, but what about
the short party?
 They have agreed to sell wheat to you for $4.00/bushel
on December 14.
 Their payoff is positive if the market price of wheat is
less than $4.00/bushel – they force you to pay more for
the wheat than they could sell it for on the open market.
 Indeed, you could assume that what they do is buy it on
the open market and then immediately deliver it to you in
the forward contract.
 Their payoff is negative, however, if the market price of
wheat is greater than $4.00/bushel.
 They could have sold the wheat for more than $4.00/bushel
had they not agreed to sell it to you.
 So their payoff function is the mirror image of your
payoff function:
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 Forward Contracts
Payoffto Short Futures Positionon Wheat
Wherethe Delivery Price (K) is $4.00/Bushel
4

0
0 1 2 3 4 5 6 7 8
-1
rw
d
s P
o
ftF
a
y

-2

-3

-4
Wheat Market (Spot) Price, December 14

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 Forward Contracts
 Clearly the short position is just the mirror image
of the long position, and, taken together the two
positions cancel each other out:

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 Forward Contracts
Long and Short Positions in a Forward Contract
For Wheat at $4.00/Bushel

3 Short Position
2
Long Position
1
Payoff

0
0 Net 1 2 3 4 5 6 7 8
-1
Position
-2

-3

-4
W heat Price 27
 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 largest futures exchanges are the Chicago
Board of Trade (CBOT) and the Chicago Mercantile
Exchange (CME).

 Futures are traded on a wide range of commodities

and financial assets.

 Usually an exact delivery date is not specified, but

rather a delivery range is specified. The short
position has the option to choose when delivery is
made. This is done to accommodate physical
delivery issues.
 Harvest dates vary from year to year, transportation
schedules change, etc.
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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.

 Note however, that the basic payoffs are the same

as for a forward contract.

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 Options Contracts
 Options on stocks were first traded in 1973. That
was the year the famous Black-Scholes formula
was published, along with Merton’s paper - a set
of academic papers that literally started an
industry.

 There are two basic types of options:

 A Call option gives the holder the right but not
the obligation to buy an asset by a certain date
for a certain price.

 A Put option gives the holder the right but not

the obligation to sell an asset by a certain date
for a certain price.
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 Options Contracts
 The date when the option expires is known as the
exercise date, the expiration date, or the maturity
date.
 The price at which the asset can be purchased or
sold is known as the strike price.
 If an option is said to be European, it means that
the holder of the option can buy or sell (depending
on if it is a call or a put) only on the maturity date.
If the option is said to be an American style option,
the holder can exercise on any date up to and
including the exercise date.
 An options contract is always costly to enter as the
long party. The short party always is always paid to
enter into the contract
 Looking at the payoff diagrams you can see why…
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 Options Contracts (LONG
CALL)
 Let’s say that you entered into a call option on
IBM stock:
 Today IBM is selling for roughly $78.80/share, so let’s
say you entered into a call option that would let you buy
IBM stock in December at a price of $80/share.

 If in December the market price of IBM were greater

than $80, you would exercise your option.

 If, in December IBM stock were selling for less than

$80/share, so you would not exercise your option.

 Thus, your payoff diagram is:

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 Options Contracts (LONG
CALL)
Long Call on IBM
with Strike Price (K) = $80

80

60

40
Payoff

20

0
0 20 40 60 K =80 100 120 140 160
-20
T
IBM Terminal Stock Price
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Options Contracts (SHORT
CALL)
 What if you had the short position?

 Well, after you enter into the contract, you have

granted the option to the long-party.

 If they want to exercise the option, you have to do so.

 Of course, they will only exercise the option when it is in

there best interest to do so – that is, when the strike
price is lower than the market price of the stock.

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 Options Contracts (SHORT
CALL)
Short Call Position on IBM Stock
with Strike Price (K) = $80

21.25

0
Payoff to Short Position

0 20 40 60 80 100 120 140 160

-21.25

-42.5

-63.75

-85
Ending Stock Price

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 Options (L & S CALL
COMBINED)
 This is obviously the mirror image of the long
position.

 Notice, however, that at maturity, the short

option position can NEVER have a positive payout
– the best that can happen is that they get $0.
 This is why the short option party always demands an
up-front payment – it’s the only payment they are going
to receive. This payment is called the option premium
or price.

 Once again, the two positions “net out” to zero:

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 Options (L & S CALL
COMBINED)
Long and Short Call Options on IBM
with Strike Prices of $80

100
80
60 Long Call
40
Net Position
20
Payoff

0
-20 0 20 40 60 80 100 120 140 160
Short Call
-40
-60
-80
-100
Ending Stock Price
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 Options Contracts (LONG
PUT)
 Recall that a put option grants the long party the
right to sell the underlying at price K.
 Returning to our IBM example, if K=80, the long
party will only elect to exercise the option if the
price of the stock in the market is less than $80,
otherwise they would just sell it in the market.

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 Options Contracts (LONG
PUT)
Payoff to Long Put Option on IBM
with Strike Price of $80

80
70
60
50
Payoff

40
30
20
10
0
-10 0 20 40 60 80 100 120 140 160

Ending Stock Price

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 Options Contracts (SHORT
PUT)
 The short position again has granted the option to
the long position. The short has to buy the stock
at price, when the long party wants them to do
so. Of course the long party will only do this when
the stock price is less than the strike price.

 And the payoff diagram looks like:

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 Options Contracts (SHORT
PUT)
Short Put Option on IBM
with Strike Price of $80

0
0 20 40 60 80 100 120 140 160

-21.25
Payoff

-42.5

-63.75

-85
Ending Stock Price
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 Options (L & S PUT
COMBINED)
 Since the short put party can never receive a
positive payout at maturity, they demand a
payment up-front from the long party – that is,
they demand that the long party pay a premium
to induce them to enter into the contract.

 Once again, the short and long positions net out

to zero: when one party wins, the other loses.

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 Options (L & S PUT
COMBINED)
Lo n g an d Sh o rt Pu t O p tio n s o n IBM
w ith Strike Pr ice s o f $8 0

10 0
80 Long Position
60 Net Position
40
20
Payoff

0
-2 0 0 20 4 0Short Position
60 80 10 0 120 140 16 0

-4 0
-6 0
-8 0
-10 0
44
Ending S toc k Pric e
 Options Contracts
 Traders frequently refer to an option as being “in the
money”, “out of the money” or “at the money”.

 An “in the money” option means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would receive a payout.

 An “at the money” option means one where the strike and
exercise prices are the same.

 An “out of the money” option means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would NOT receive a payout.

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 Options Contracts
Lo n g C a ll o n IB M
w ith S tr ik e P r ic e (K ) = $ 8 0

80

60 At the money
Out of the money In the money
40
Payoff

20

0
T
0 20 40 60 K =8 0 100 120 140 160
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-2 0
 DERIVATIVES INSTUMENTS
 Warrants: Options generally have lives of up to one
year, the majority of options traded on options
exchanges having a maximum maturity of nine months.
Longer-dated options are called warrants and are
generally traded over-the-counter.
 LEAPS: The acronym LEAPS means Long-Term Equity
Anticipation Securities. These are options having a
maturity of up to three years.
 Baskets: Basket options are options on portfolios of
underlying assets. The underlying asset is usually a
moving average of a basket of assets. Equity index
options are a form of basket options.

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 CONTD…
 Swaps: Swaps are private agreements between two parties
to exchange cash flows in the future according to a
prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are:
 · Interest rate swaps: These entail swapping only the interest
related cash flows between the parties in the same currency.
 · Currency swaps: These entail swapping both principal and
interest between the parties, with the cash flows in one
direction being in a different currency than those in the
opposite direction.

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 CONTD…
 Swaptions: Swaptions are options to buy or sell
a swap that will become operative at the expiry of
the options. Thus a swaption is an option on a
forward swap. Rather than have calls and puts,
the swaptions market has receiver swaptions and
payer swaptions. A receiver swaption is an option
to receive fixed and pay floating. A payer
swaption is an option to pay fixed and receive
floating.

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RISK MITIGATION IN EQUITY
 One interesting notion is to look at the payoff
from just owning the stock – its value is simply
the value of the stock:

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 Options Contracts
Payout Diagram for a Long Position in IBM Stock

180

160

140

120

100
Payoff

80

60

40

20

0
0 20 40 60 80 100 120 140 160
Ending Stock Price

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 Options Contracts
 What is interesting is if we compare the payout
from a portfolio containing a short put and a long
call with the payout from just owning the stock:

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 Options Contracts
Payout Diagram for a Long Position in IBM Stock

200

150
Stock
100
Long Call
Payoff

50

0
0 20 40 60 80 100 120 140 160
-50
Short Put

-100
Ending Stock Price
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 Options Contracts
 Notice how the payoff to the options portfolio has
the same shape and slope as the stock position –
just offset by some amount?

 This is hinting at one of the most important

relationships in options theory – Put-Call parity.

 It may be easier to see this if we examine the

aggregate position of the options portfolio:

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 Options Contracts
Payout Diagram for a Long Position in IBM Stock

200

150

100
Payoff

50

0
0 20 40 60 80 100 120 140 160
-50

-100
Ending Stock Price
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 Options Contracts
 We will come back to put-call parity in a few weeks,
but it is well worth keeping this diagram in mind.

 So who trades options contracts? Generally there are

three types of options traders:
 Hedgers - these are firms that face a business risk. They
wish to get rid of this uncertainty using a derivative. For
example, an airline might use a derivatives contract to hedge
the risk that jet fuel prices might change. 
 Speculators - They want to take a bet (position) in the market
and simply want to be in place to capture expected up or
down movements.
 Arbitrageurs - They are looking for imperfections in the
capital market.

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