Introduction to Derivatives

Derivatives– Overview and Definitions

A derivative instrument is defined as a private contract
whose value is derived from some underlying asset price,
reference rate or Index.

A derivative instrument is a contract between two parties –

buyer and seller - who agree to exchange some asset for cash
at some future date/s, at a predetermined price.

The main categories of derivatives are:

Futures and Forward contracts

Swap contracts

option contracts
 Futures, Forward and Swap contracts are distinctly different
from option contracts:

With an Options contract the buyer has the right to buy or

sell some asset in the future.

With Futures, forward and swap contracts the buyer is

obligated to buy some asset in the future
Forward Contracts
Forward contract is a private agreement to exchange a given
asset against cash at a fixed point in the future, at a
predetermined price.
The terms of the contract are: Underlying Asset, quantity, or
number of units or shares, date to delivery, and price at which
the exchange will be done.
The seller of the contract has to deliver the asset while the
buyer has a commitment to receive the asset.
Thus: the seller of the contract is in a short position, while the
buyer is in a long position.
Denoting
T – time to delivery, also called the maturity date
t – current time
– T-t: time to maturity
St – current spot price of the underlying asset
F – forward price of the asset to delivery at T
Vt – current value of the contract
n - quantity, or number of units in contract
The notional amount, also called the principal value is
defined as the amount nF to pay at maturity
The value of the forward contract at expiration, for one unit of
the underlying asset is,

VT = ST - F

Profit or Loss on Long and Short Forward Contract

Profit or Loss Profit or Loss

Buy Forward
Sell Forward

ST ST
F F
Futures Contract
futures contracts are differ from forward contracts as follows:

1. Futures are traded in organized exchanges in contrast to

forwards, which are traded on OTC market.

2. Standardization – Futures contracts are offered with a

limited choice of expiration dates and trade in fixed contract
size.

3. Clearinghouse – After each transaction, the clearinghouse

interpose itself between the buyer and the seller, ensuring the
performance of the contract.
Futures Contracts
Marking to Market – Futures are marked to market on a daily
basis which involves cash settlement of the gains and the
losses on the contract every day.

Cash flows to Buyer and Seller of Cotton Futures Contracts

Closing Price 24/11 25/11 26/11
(cents per pound) 90.75 93.75 90.25
Buyer Purchases cotton Buyer receives 3 Buyer pays 3.5
futures at 90.75 cents per pound cents per pound
cents per pound

Seller Sells cotton futures Seller pays 3 Seller receives

at 90.75 cents per cents per pound 3.5 cents per
pound pound
Margin Requirements
To provide some guarantee of the contract’s performance, initial
margin are required by the clearinghouse for both buyer and
seller.

The initial margin is the monies placed with the clearing house
when the trade is initially executed.

When the minimum margin level is reached, the investor have

to post more margin.

In case he/she fails to meet the margin call, the broker has the
right to liquidate the position.
Futures Contracts
The main categories of forward/futures contracts are:
Currency
Commodity
Stock Index
Bond
Valuing Futures Contracts

Generally forward contracts are established so their initial

value is zero.

This is achieved by setting the forward price F so there will

be no arbitrage relationship between the spot and the futures
market.

No-arbitrage is a situation where economically equivalent

portfolio have the same price.
Stock Index Futures
The most active contract is the S&P500 futures contract traded
on the CME, where the contract notional is defined as $250
times the index level.

If we actually invested in the S&P500 index, our rate of return

would be higher than the index, because we would receive the
cash dividends.

The pricing formula is derived by the no-arbitrage argument,

using a strategy composed of buying the Index , selling a futures
contract, and borrowing. such that the net investment is zero
 Strategy Cash Flow Today Cash Flow at the
End of the Period
Borrow S0
S0  S0 (1  r ) τ
Buy the index for S0  S0 ST  D
Sell One futures contract 0 F0  ST
Net Position 0 F0  S0 (1  r ) τ  D

0  F0  S0 (1  r )  D
τ F0  S0 (1  r ) τ  D

 D
F0  S0 (1  r )  S0  S0 (1  r  d) 
S0
If we have annualized and continuing compounded dividend and
interest:
 r  d τ
F0  S0 e
Numerical Example
Suppose the NYSE Index closed at 342. If dividend yield is 2%
and the current risk-free interest rate is 4%, what is the
equilibrium value of a six-month futures contract on the NYSE
Index?

F0  S0 (1  r  d) τ 
342  (1  0.04  0.02)1/ 2  $345.4

Assume that the futures contract is traded at $347, show

arbitrage strategy!
Strategy Cash Flow Today Cash Flow at the
End of the Period
Borrow S0 342  342  (1.04)0.5  348.8
Buy the index for S0  342 ST  0.01 342  ST  3.42

Sell One futures contract 0 347  ST

Net Position 0 1.6  347  345.4

Currency Futures
Currency futures contracts are used by firms having exposure
to foreign exchange risk.

For example, a U.S. firm sell its goods in UK and therefore

receives British pound in exchange for its product.

To minimize the effect of FX risk on the value of the product

sold, the firm may enter into a futures contract to sell British
pound in the future with predetermined $/£ exchange rate.
 Strategy Cash Flow Today Cash Flow at the
End of the Period
Borrow 1 £ S0  ST (1  rF ) τ
Lend S0 Dollars in the US  S0 S0 (1  rL ) τ

Buy futures position to buy 0 (1  rF ) τ (ST  F0 )

(1  rF ) τ £
Net Position 0 S0 (1  rL ) τ  F0 (1  rF ) τ

τ
 1  rL 
0  S0 (1  rL )  F0 (1  rF )
τ τ
F0  S0    S0 (1  rL  rF ) τ
 1  rF 
If we have annualized and continuing compounded interest:

 rL  rF τ
F0  S0 e
Numerical Example
Suppose you are an arbitrage trader in the Swiss franc foreign
exchange rate. You observe the following information:

$0.65 $0.64
S0  , F0  , rL  3%, rF  6%, τ  1 / 2
SwF SwF

Are these prices in equilibrium? How will you profit if they

are not?

The equilibrium futures price should be:

1
 1  rL 
1/ 2
2
 1.03 

F0  S0  
  0.65     $0.6407
 1  rF   1.06 
Thus, the current future price is lower than the equilibrium
price.

Strategy Cash Flow Today Cash Flow at the End of

the Period
Borrow 1 £ $0.65  ST  (1.06)1/ 2
Lend $0.65 Dollars in US  $0.65 $0.65  (1.03)1/ 2
Buy futures position to buy
0 (1.06)1/ 2  (ST  $0.64)
(1.06)1/ 2 £
Net Position 0 $0.65  (1.03)1/ 2  $0.64  (1.06)1/ 2  $0.0007
Numerical Example
Assume that the British pound Des 2004 futures contract
settled at $1.6664/£ and Mar 2005 contract settled at $1.6604/£
What is the implied interest rate difference between the pound
and dollar?
τ1 τ2
 1  rL   1  rL 
FDes 2004  S0   FMer 2005  S0  
 1  rF   1  rF 

τ 2  τ1
FMer 2004  1  rL 
  
FDes 2004  1  rF 
 τ2  τ1  3 / 12  1/ 4

1/ 4
1.6604  1  rL 
  
1.6664  1  rF 

1/ 4
 1  rL 
   0.9857  (1  rL  rF )1/ 4
 1  rF 

rL  rF  1.43%
Commodity Futures
To price commodity futures, we need to consider storage costs
and insurance costs.
The pricing formula is derived by using a strategy composed of
buying the asset , selling a futures contract, and borrowing.

Strategy Cash Flow Today Cash Flow at the End of

the Period
Buy the asset at price S0  S0 ST  C

Borrow S0 S0  S0 (1  r ) τ
Sell a futures contract on 0 F0  ST
the asset
Net Position 0 F0  S0 (1  r ) τ  C

F0  S0 (1  r ) τ  C
Numerical Example
Assume that the spot price of gold is $650 per ounce and the
one year futures price is $678. If the risk-free interest is 3%,
what is the implied storage cost for gold in percent?

F0  S0 (1  r ) τ  C
678  650 1.03  C
C  $8.5

C 8.5
  1.3%
S0 650
Swap Contracts
Swap contracts are OTC agreements to exchange a series of
cash flow according to some pre-specified terms.

The underlying asset can be :

an interest rate, an exchange rate, an equity, a commodity price
or any other index.

The most common swap contracts are: an Interest Rate

Swap (IRS), a Foreign Exchange Swap (FES) and a Credit
Default Swap (CDS)
Interest Rate Swap
Consider the case of a firm that has issued long term bonds
with total par value of $10M at a fixed interest rate of 8%.
However, it can change the nature of its obligation from fixed
rate to floating rate by entering a swap agreement to pay a
floating rate and to receive a fixed rate.

A swap with notional principle of $10M that exchanges

LIBOR for an 8% fixed rate:

$800K ↔ $10M * rLIBOR

Suppose that the swap is for three years and the LIBOR rates
turns out to be 7%, 8% and 9% in the next three years
 $900K
$800K
$700K
Floating rate payments

Fixed rate payments

$800K $800K $800K

LIBOR 7% 8% 9%
IRS - Pricing
A swap contract can be viewed as a portfolio of forward
transactions, but instead of each transaction being priced
independently, on forward price is applied to all of the
transactions.

The Yield and the Forward Curve

year Forward curve (%) Yield Curve (%)
Ft-1,t yt
1 7 7

2 9 8

3 11.03 9
F* – Fixed rate
yt, is the appropriate yield from the yield curve for discounting
dollars cash flows.

F0,1 F1, 2 F2,3

  
(1  y1 ) (1  y 2 ) 2
(1  y3 ) 3

 1 1 1 
F 
*
  
3 
 (1  y1 ) (1  y 2 ) (1  y3 ) 
2

.07 .09 .1103

  
(1  .07) (1  .08) (1  .09)
2 3

F* F* F*
   F*
 8.88%
(1  .07) (1  .08) (1  .09)
2 3
IRS – Quotations
Swaps are quoted in terms of spreads relative to the yield of
similar-maturity Treasury notes.

For instance, a dealer quote 10 years swap rates as 31/35bp

against LIBOR.

If the current note yield is 7%:

The dealer is willing to pay 7%+0.31%=7.31% against

receiving LIBOR and to receive 7%+0.35%= 7.35% against
paying LIBOR.
Interest Rate Swap – Motivation
Consider two firms, A and B that can raise funds either at
fixed or floating rates, $100M over 10 years. A want to raise
floating and B want to raise fixed.

Cost of Capital Comparison

Firm Fixed (%) Floating (%)

A 10 LIBOR+0.3

B 11.2 LIBOR+1
Interest Rate Swap – Motivation
Firm A has an absolute advantage in both markets
However, it has a comparative advantage in raising fixed
If both will directly issue funds in their desired market, the total
cost: LIBOR+0.3% (for A) + 11.2% (for B) = LIBOR + 11.5%
If they will raise funds where each has a comparative advantage,
the total cost: 10% (for A) + LIBOR+ 1% (for B) = LIBOR + 11%.
Thus, the gain to both firms from entering a swap is:
11.5%-11%= 0.5%.
A swap that splits the benefit equally between the two parties:
Swap to firm A
Firm A issues fixed debt at 10% and enters a swap whereby it
promises to pay LIBOR+0.05% in exchange to receiving 10% fixed
payments, which will offset the required debt payments.

Operation Fixed Floating

Issue debt Pay 10%
Enter swap Receive 10% Pay LIBOR+0.05%
Net Pay LIBOR+0.05%
Direct cost Pay LIBOR+0.3%
Saving 0.25%
A swap that splits the benefit equally between the two parties:
Swap to firm B
Firm B issues floating debt at LIBOR+1% and enters a swap
whereby it promises to pay 10% fixed payments in exchange to
receiving LIBOR+0.05%, which is less than the direct cost by
0.25%

Operation Floating Fixed

Issue debt Pay LIBOR+1% Pay 10%
Enter swap Receive LIBOR+0.05%
Net Pay 10.95%
Direct cost Pay 11.2%
Saving 0.25%
Foreign Exchange Swap
Foreign Exchange Swaps are agreements between to parties
to exchange currencies according to a pre-determined formula.
FES enable the firm to quickly and cheaply hedge its
currency exposure.
For Instants, a U.S. firm sell its goods in UK and therefore
receives British pound in exchange for its product.
To minimize the effect of FX risk on the value of the
product sold, the firm may enter into a swap contract to sell
British pound in the future with predetermined $/£ exchange
rate.
Foreign Exchange Swap
A U.S. firm has a 3 years contract of selling goods to UK
firm for £100M each year. The U.S. firm can enter to a FES
whereby it promises to pay £100M in exchange to receiving
$X.

The current exchange rate is: $1.8/£

The term structure of US and UK interest rate

year US (%) UK (%)

1 2 4
2 3 4
3 3.5 4
The Forward rates:
2
F1  1.8 
1.02
 1.76  1.03 
F2  1.8     1.766
1.04  1.04 
3
 1.035 
F3  1.8     1.774 Therefore,
 1.04 

£100M £100M £100M

$176M $176.6M $177.4M

Alternatively, we can calculate a constant rate of F* dollars per
pound to be exchanged each year:

F1 F2 F3 F* F* F*
    
1  y1 1  y 2  1  y 3  1  y1 1  y 2  1  y 3 3
2 3 2

where y1, y2 and y3 are the appropriate yields from the yield
curve for discounting dollars cash flows.

1.76 1.766 1.774 F* F* F*

    
1  .02 1  .03 1  .035 1  .02 1  .03 1  .0353
2 3 2

F*  1.7665
In this case the swap agreement will be:

£100M £100M £100M

$176.65M $176.65M $176.65M

Credit Default Swap
In a credit default swap contract, a protection buyer pays a
premium to the protection seller in exchange of payment if
credit event – default - occurs.
Buyer Periodic Payment Seller

Contingent Payment

The contingent payment is triggered by a Credit Event on the

underlying credit

Investing in a risky bond is equivalent to investing in a risk-

free bond plus selling a credit default.
Numerical Example
A protection buyer enters a 1-year CDS on a notional of
$100M worth of 10-year bonds issued by XYZ. The swap
entails an annual payment of 50bp.

At the beginning of the year, the buyer pays $500K to the

protection seller.

At the end of the year, XYZ defaults on this bond, which

now traded at 40% of the notional value (Recovery Rate)
The seller has to pay $60M (Loss Given Default).